The next time you are faced with a preference claim, before spending a lot of time conducting a thorough analysis of the statutory defenses to a preference, i.e., new value and ordinary course of business defenses, determine first whether or not the creditor is (or will likely become) a party to an assumed contract in the debtor’s bankruptcy case.  If the creditor is, then you are likely to have a “slam dunk” defense to a preference claim in the case.  The seminal case on the subject can be found in In re Superior Toy Manufacturing Co., Inc., 78 F.3d 1169 (7th Cir. 1996) where the debtor assumed a prepetition executory licensing agreement with a non-debtor party pursuant to 11 U.S.C. Section 365.  Subsequently, an order of assumption was entered by the bankruptcy court.  The debtor’s case later converted to a Chapter 7 case in which the bankruptcy trustee filed a complaint to recover approximately $50,000 in prepetition payments made in connection with the licensing agreement.  The non-debtor party filed a motion to dismiss, claiming as a matter of law that the trustee would be unable to prove that the payment had any preferential effect as required under Section 547(b)(5).  The 7th Circuit agreed with the non-debtor contracting party and dismissed the trustee’s complaint.

The court reasoned after conducting a thorough statutory analysis, that Section 365 unequivocally required that all amounts due under an executory contract must be paid before the contract can be assumed.  The court reasoned that “[a]n assumption order divests the trustee of subsequent claims to monies paid under that contract whether they were paid prepetition or postpetition”.  Id at p. 1175.  In closing the court noted that its decision was consistent with the holdings from other circuits, namely In re LCO Enterprises, 12 F.3d 938 (9th Cir. 1993) and in Seidle v. GATX Leasing Corp., 778 F.2d 659 (11th Cir. 1985).[1]

So the Section 365 defense is simple – payments made under an assumed executory contract or unexpired lease pursuant to Section 365 – cannot be subject to a preference claim if the following elements are present:  (i) there must be a prepetition executory contract or unexpired lease; (ii) an order for assumption on the contract or lease is entered pursuant to Section 365 and (iii) the challenged payments were made according to the contract or lease during the preference period.  This should provide good news to creditors under contract or lease with an entity that files for bankruptcy.

[1]Superior Toy has been cited favorably by other circuit courts, e.g., In re Kiwi International Airlines, Inc., 344 F.3d 311 (3rd Cir. 2003) and In re Burger Boys, Inc., 94 F.3d 755 (2nd Cir. 1996).

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