United States: Kiwi Defense Doesn't Get Off The Ground In Preference Litigation Involving Related, But Severable, Contracts

Among the required elements of a claim to avoid a preferential transfer under section 547(b) of the Bankruptcy Code is that, if the creditor-transferee were permitted to retain a pre-bankruptcy payment, it would end up being paid more than it would receive in a hypothetical liquidation of the debtor under chapter 7, assuming the transfer did not occur. This requirement and a defense to preference liability predicated on it—the "Kiwi defense"—were the subject of a ruling handed down by a Delaware bankruptcy court. In Pirinate Consulting Grp., LLC v. C. R. Meyer & Sons Co. (In re NewPage Corp.), 2017 BL 44198 (Bankr. D. Del. Feb. 13, 2017), the court ruled that, although the Kiwi defense can preclude avoidance of prepetition payments under a series of integrated agreements assumed under a chapter 11 plan, the agreements before it were severable, rather than a single, integrated contract. Because there was no evidence that each individual agreement was executory and thus eligible for assumption, the court denied a motion for summary judgment that the Kiwi defense insulated the transfers from avoidance.

Assumption and Rejection of Executory Contracts and Unexpired Leases

With certain exceptions and subject to various conditions, section 365(a) of the Bankruptcy Code authorizes a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume, assume and assign, or reject most "executory" contracts or unexpired leases. A contract is generally deemed to be "executory" if material obligations remain to be performed by both parties as of the bankruptcy petition date.

A contract can be assumed only if the DIP or trustee "cures" existing defaults and provides adequate assurance of its future performance or, in the case of assumption and assignment, that of the proposed assignee. If the bankruptcy court authorizes the assumption of a contract or lease, both the cure obligations and any subsequent claims for breach of the assumed agreement are entitled to priority as administrative expenses. By contrast, if the DIP or trustee debtor rejects a contract, claims arising from the rejection will generally be treated as prepetition unsecured claims.

Avoidance of Preferential Transfers: The Kiwi Defense

Section 547 of the Bankruptcy Code permits a trustee or DIP to avoid preferential transfers. A transfer made by a debtor to or for the benefit of a creditor on account of an antecedent debt within 90 days of a bankruptcy filing (or one year, if the transferee is an "insider") can be avoided if the debtor was insolvent at the time of the transfer and if the transfer allows the creditor to receive more than it would have received in a hypothetical liquidation under chapter 7 of the Bankruptcy Code had the transfer not occurred.

If a DIP or trustee assumes an executory contract or unexpired lease, assumption may preclude avoidance of otherwise preferential transfers received under the contract by the nondebtor party. This is sometimes referred to as the "Kiwi defense" because it is derived from a ruling by the U.S. Court of Appeals for the Third Circuit in Kimmelman v. Port Auth. of N.Y. & N.J. (In re Kiwi Int'l Airlines, Inc.), 344 F.3d 311 (3d Cir. 2003). In Kiwi, a chapter 7 trustee sued certain creditors to avoid and recover $3.9 million in payments made within 90 days of the debtor's chapter 11 filing. Before the case was converted to a chapter 7 liquidation, the debtor assumed contracts with each of the creditors and, as required by section 365(b) and by section 1110 (which applies to executory aircraft leases), cured all outstanding defaults and provided adequate assurance of its future performance.

The bankruptcy court ruled that because payment defaults under the contracts had to be cured as a condition to assumption, the prepetition payments to the defendants did not improve their position and were therefore not preferential. In other words, the payments would not allow the defendants to receive more than they would have received in a hypothetical chapter 7 liquidation had the payments not been made.

The district court and the Third Circuit affirmed on appeal. Assumption of the defendants' contracts, the Third Circuit explained, transformed their prepetition claims into priority administrative expenses. As such, none of the defendants received more than they would have received in a chapter 7 liquidation. See also generally Collier on Bankruptcy ¶ 547.03[7] (16th ed. 2017) ("[P]referential payments made pursuant to a contract that was assumed during the subsequent bankruptcy case are immune from preference attack. If the payments had not been made, the amount necessary to assume the contract would have been commensurately increased. The transferee received no more than it would have received under chapter 7.").

In Pirinate Consulting, the court considered whether the Kiwi defense insulated from avoidance under section 547(b) pre-bankruptcy payments under a series of related purchase orders governed by a master construction agreement.

Pirinate Consulting

NewPage Corporation ("NewPage"), a producer of printing and specialty papers in North America, filed for chapter 11 protection in September 2011 in the District of Delaware. NewPage's confirmed chapter 11 plan provided that any executory contract which had not been assumed or rejected during the case, or which had expired prior to plan confirmation, would be assumed. The plan also created a litigation trust for estate avoidance claims.

Prior to filing for bankruptcy, NewPage entered into a master construction agreement (the "MCA") with C. R. Meyer & Sons Co. ("CRM"), pursuant to which CRM provided general contracting services for large construction projects. The MCA provided that work projects would be assigned to CRM under separate purchase orders, each of which constituted a separate contract.

In October 2013, the litigation trustee sued CRM to avoid as preferential transfers approximately $3.2 million paid by NewPage to CRM under the purchase orders prior to filing for bankruptcy. On cross motions for summary judgment, CRM argued that the transfers were insulated from avoidance under the Kiwi defense because the MCA and each of the purchase orders constituted a single, integrated contract which had been assumed under NewPage's confirmed chapter 11 plan. The trustee countered that the MCA and the purchase orders constituted separate, severable, and distinct agreements and that the Kiwi defense could not apply to all prepetition payments absent a showing that each individual purchase order was executory and had been assumed under the plan.

The Bankruptcy Court's Ruling

The bankruptcy court looked to state law—here, that of Michigan and Wisconsin—to determine whether the MCA and the purchase orders constituted a single agreement. It noted that, under the laws of both states, the intent of the parties is the "first and foremost consideration in analyzing the divisibility of contracts." The court further explained that, under state law, the parties' assignment of separate prices for separate phases of work generally evinces an intent to create separate contracts.

The court found that, because the right to payment arose under each separate purchase order, which itself related to a separate work order, the intent of the parties was to create separate, severable contracts. Moreover, the MCA expressly provided that each new purchase order would constitute a separate contract. Thus, the court concluded that the parties' intent in entering into each purchase order was to form an agreement separate from the MCA and the other outstanding purchase orders.

Next, the court ruled that CRM had not met its burden of demonstrating that all of the purchase orders were executory contracts, such that the Kiwi defense would shield the transfers from avoidance as preferences. In the Third Circuit, the court explained, whether a contract is executory turns on whether there remain " 'obligations of both the bankrupt and the other party to the contract so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other' " (quoting In re LG Philips Displays USA, Inc., 2006 BL 71563, at *3 (Bankr. D. Del. June 21, 2006)).

CRM's entire argument, the court stated, rested on the erroneous premise that the MCA and the purchase orders constituted an integrated agreement. As a consequence, neither CRM nor the trustee presented any evidence regarding the executoriness of each individual purchase order. Accordingly, the court concluded that it could not rule on whether the purchase orders were immune from avoidance under the Kiwi defense because the parties had yet to establish whether the individual purchase orders were executory and could therefore be assumed.

However, the court held that the MCA was an executory contract which had been assumed under the plan. In this regard, the court found mutual unperformed obligations of both parties, including: (i) CRM's obligation to provide all necessary engineering and servicing items in order to complete the purchase orders, as well as to complete the work on schedule; (ii) CRM's obligation to comply with certain insurance provisions during the pendency of its work for NewPage; (iii) NewPage's obligation to reimburse CRM for certain expenses and comply with the payment terms in each purchase order; and (iv) the obligation of both parties to maintain confidentiality.

Outlook

Pirinate adds a wrinkle to the Kiwi defense in cases involving a master agreement with ancillary, stand-alone agreements. If such a group of agreements is not deemed a single contract under applicable nonbankruptcy law, the assumption of one or more of the agreements, but not the others, may mean that transfers under agreements which are not assumed will not be insulated from avoidance as preferential transfers. Thus, a thorough understanding of applicable state law is paramount in assessing potential avoidance exposure. Given the importance of discerning the parties' intent in such an inquiry, master and ancillary agreements should be drafted to provide clearly that they are intended to be a single, integrated agreement, or the parties will face the risk that the agreements will be deemed severable under state law.

Pirinate also highlights the importance of carefully coordinating each component of a chapter 11 debtor's reorganization strategy. Because section 365(b) of the Bankruptcy Code effectively transforms a pre-bankruptcy default claim into an administrative expense claim, the consequences of assuming a contract can be significant. Given the consequences, any DIP or trustee should assess whether any assumed agreement is required for reorganization. In addition, the effect of assumption on any causes of action against the counterparty to an executory contract should be thoroughly evaluated.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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