When Confirmed-Plan Payments Become Preferences: Toy King Holds That Distributions Made Under a Prior Chapter 11 Plan Are Avoidable in a Subsequent Bankruptcy, and Clarifies Initial Transferee Liability, Insider Reach-Back, and Secured Creditor Overpayments

Introduction

This memorandum of decision arises from the collapse of a toy retailer that reorganized once (Toy King I, confirmed in May 1989) and failed again within nine months (Toy King II, filed February 1990). The Official Committee of Unsecured Creditors, authorized to prosecute estate claims, pursued the debtor’s insiders, their special-purpose entities (T.K. Acquisitions, Inc. “TKA” and MD Financial, Inc. “MD”), and its principal lender (Liberty Savings Bank, FSB “Liberty”).

The court tried a sprawling set of issues over 17 trial days: preference and fraudulent transfer avoidance, transferee liability (including the “conduit” exception and §550(b) “good faith” defense), insider reach-back under §547(b)(4)(B), ordinary course defenses, breach of confirmed plan (contract theory), fiduciary duty and corporate-law remedies, UCC perfection/proceeds and cross-state filing timetables, secured claim valuation and oversecured interest under §506, contribution/subrogation among co-guarantors, and equitable subordination under §510(c).

The court awarded aggregate recoveries of $2,903,844, denying some claims but entering detailed judgments against Liberty, TKA, MD, and individual insiders (principally Morrow and Angle). Most notably, on an issue of first impression, it held that a payment made pursuant to a confirmed Chapter 11 plan in a prior case may be avoided as a preference in a subsequent bankruptcy case. The decision also fixes important guideposts on “initial transferee” liability, bank “good faith” under §550(b), insider reach-back, and the correct measure and timing of secured claim value for post-petition interest under §506(b).

Summary of the Opinion

• First-in-time holding: A payment made under a confirmed plan in a prior Chapter 11 case is a “transfer of an interest of the debtor in property” subject to attack as a preference in a new, later-filed bankruptcy case. The conversion-line cases do not shield such payments; a new case creates a new estate with full avoidance powers.
• Obligor/Guarantor characterization: The debtor remained an unlimited guarantor on the Liberty facilities; TKA was the obligor. The court refused to recharacterize the structure ex post.
• Initial transferee vs conduit: TKA was the initial transferee of the debtor’s payments; it had dominion and control and was not a mere conduit. Liberty was an immediate transferee.
• §550(b) “good faith” defense fails for the bank: Liberty did not carry its burden because it eschewed diligence (e.g., waiving a required accountant’s equity letter), had reason to know of voidability, and knew the debtor’s capital weakness; thus it was not a good-faith transferee “without knowledge.”
• Insider reach-back and insolvency: TKA and MD were insiders; the court applied the one-year reach-back and found insolvency through both going-concern and liquidation lenses, rejecting “quasi-reorganization” phantom equity and adopting a fresh-start style valuation rationale.
• Ordinary course defense fails: Debts and payments (interest upcharges, guaranty fees, premature principal prepayments, and the MD subordinated note payoff in derogation of a subordination agreement) were not ordinary between the parties nor consistent with industry norms (no credible industry evidence was offered).
• Fraudulent transfers found (actual and constructive): Multiple “badges of fraud” existed, plus unreasonably small capital; the debtor received less than reasonably equivalent value for interest upcharges, guaranty fees, and the early, excessive MD distributions.
• UCC perfection/proceeds and cross-state filings: Refiling a financing statement to add the word “proceeds” was not a new transfer; under the 1972 UCC amendments, proceeds perfection is automatic. Bankruptcy tolled the four-month refile period under former UCC §9-103(1)(d) when inventory moved to a new state; thus Liberty’s perfection held.
• Secured claim valuation/postpetition interest: Liberty’s secured claim was determined at the time of sale (the court-approved going-out-of-business asset sale), yielding a $750,000 secured claim and a $150,000 unsecured remainder. Because Liberty was undersecured at sale, it was not entitled to §506(b) post-petition interest or fees; $149,008.33 in interest and $150,000 principal were recovered as unauthorized post-petition transfers.
• Breach of the confirmed plan (contract): The plan incorporated Liberty’s commitment letter. TKA breached by failing to contribute $500,000 as equity (as the commitment required) and by charging interest on that amount. Liberty’s waiver of the equity opinion letter was a technical breach but caused no damages to the debtor; the Nintendo loan did not breach the plan.
• Fiduciary duties and corporate law: Morrow, Angle (and in part King) breached duties of care, and Morrow and Angle breached loyalty (self-dealing with the MD claims purchase and disguised distributions). The business judgment rule did not protect self-dealing. The court awarded restitutionary damages.
• Equitable subordination: Claims of TKA, MD, and King were subordinated; Liberty’s was not. The bank’s conduct was negligent but not “egregious” within the non-insider subordination standard.
• Contribution and subrogation: The estate recovered contribution from co-guarantors (Georgia law) for the debtor’s postpetition payment to Liberty and was subrogated into Liberty’s rights against guarantor collateral to satisfy those contribution claims.
• Monetary results: Net recoveries totaled $2,903,844 across preference, fraudulent transfer, overpayment of secured claim, contract damages, fiduciary breach damages, and postpetition salary overpayment.

Analysis

Precedents and Authorities Applied

• Preferences and transferee liability:
  • Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890 (7th Cir. 1988): “Dominion and control” test for initial transferee; only the party free to use funds is the initial transferee. Applied to hold TKA was not a conduit.
  • Nordberg v. Societe Generale (IN RE CHASE SANBORN CORP.), 848 F.2d 1196 (11th Cir. 1988): Bank as conduit when it merely passes funds; contrasted with TKA’s control here.
  • C-L Cartage Co., 899 F.2d 1490 (6th Cir. 1990): Payments to insider/affiliate on unsecured intercompany debt are preferences; used to frame TKA’s status as unsecured recipient.
  • UNION BANK v. WOLAS, 502 U.S. 151 (1991): Ordinary-course defense can apply to long-term debt; court nonetheless required objective industry proof, which TKA/MD failed to provide.
  • Craig Oil, 785 F.2d 1563 (11th Cir. 1986); Advo-System v. Maxway, 37 F.3d 1044 (4th Cir. 1994): Ordinary course requires subjective consistency and objective industry norms; defense failed for lack of credible industry evidence and because of unusual collection/payment patterns.
• Fraudulent transfer standards:
  • Grissom v. Johnson, 955 F.2d 1440 (11th Cir. 1989), and BFP v. RESOLUTION TRUST CORP., 511 U.S. 531 (1994): Reasonably equivalent value totality test; BFP inapposite to non-foreclosure. The court used a totality approach to interest upcharges and guaranty fees.
  • Levine v. Weissing, 134 F.3d 1046 (11th Cir. 1998): Adopted Florida’s badges of fraud; applied to insider transfers, concealment, inequivalent value, and insolvency.
• Confirmed plan payments and subsequent case preferences (first-impression holding):
  • Conversion-line cases such as Chattanooga Wholesale Antiques, 930 F.2d 458 (6th Cir. 1991) and Kaleidoscope, 56 B.R. 562 (Bankr. M.D.N.C. 1986), distinguish conversions (no estate to reach back). The court explained why a new case creates a new estate with full avoiding powers – a critical doctrinal clarification.
  • Jartran, 886 F.2d 859 (7th Cir. 1989); White Farm Equipment, 943 F.2d 752 (7th Cir. 1991): Successive-case treatment of earlier plan claims; rationale that earlier unpaid plan claims become general unsecured debts in the later case; dovetails with preference reach.
• §550(b) “good faith” defense:
  • Bonded, 838 F.2d at 897–98: “Good faith” requires more than absence of intent; facts sufficient to oblige diligence defeat the defense; applied to Liberty (waived CPA equity opinion; knew of capital shortfall and reliance materials).
• UCC perfection and proceeds:
  • Former UCC §9-306 (1972 amendments): Proceeds are perfected automatically; no need to check a box; refiling to add “proceeds” does not create a new transfer.
  • Former UCC §9-103(1)(d): Cross-state perfection survives for up to four months; adopting In re Halmar Distributors, 968 F.2d 121 (1st Cir. 1992): bankruptcy filing tolls the four-month refiling period; vivid practical rule for nationwide retailers and their lenders.
• Secured claim valuation and §506(b) interest:
  • Ford Motor Credit v. Dobbins, 35 F.3d 860 (4th Cir. 1994): Post-petition interest turns on being oversecured at time of disposition; using sale price to gauge; applied to disallow §506(b) interest because the collateral sold for less than the claim.
  • T–H New Orleans, 116 F.3d 790 (5th Cir. 1997): Secured claimant bears burden to prove oversecured status and duration; Liberty failed.
• Fiduciary duties and equitable subordination:
  • PEPPER v. LITTON, 308 U.S. 295 (1939): Officers/directors owe highest fiduciary obligations; cannot prefer themselves; the court invoked and applied Pepper to insider self-dealing.
  • Mobile Steel, 563 F.2d 692 (5th Cir. 1977): Three-prong test for equitable subordination; applied to subordinate insiders’ claims; not satisfied as to non-insider Liberty (no egregious conduct).
  • Papercraft, 160 F.3d 982 (3d Cir. 1998): Insider claims-trading and fiduciary duty; court analogized to Morrow/Angle’s discounted purchase of the First Union claims as an usurped corporate opportunity.

Legal Reasoning

1. Plan distribution exposure in a later case. The court’s most consequential holding squarely rejects the premise that prior plan payments are sacrosanct in a later case. It carefully distinguished conversion cases—where a confirmed plan revests property and leaves no estate— from a new case, which creates a new estate that inherits full avoidance powers. Treating plan payments as ordinary transfers balances preference policy: it discourages “grabs” by savvy creditors (especially insiders) anticipating a second filing and preserves pro rata equality for similarly situated creditors in the subsequent estate.

2. Initial transferee and the failed conduit defense. Applying Bonded/Chase Sanborn, the court asked who had dominion and control. TKA received checks directly from the debtor, booked them to its own unsecured notes, controlled timing (often delaying remittance to Liberty/CS and charging more interest), and could spend the money as it wished. That ended the conduit argument; TKA was the initial transferee, exposing it to strict §550(a)(1) liability and stripping it of §550(b)’s “good faith” defense.

3. Bank’s §550(b) “good faith” defense—what diligence demands. Liberty argued it simply collected payments on antecedent debt. The court drilled into the equity covenant and the bank’s own commitment letter: Liberty waived a CPA attestation of $2 million equity even as the debtor’s balance sheets reflected “phantom equity” via quasi-reorganization accounting and obvious mid-year losses. Given the bank’s knowledge of going-concern risk (including Touche Ross’s going-concern qualification), its awareness that trade creditors would rely on the pro forma and commitment letter, and its own knowledge of the debtor’s inability to hit the equity target, the bank had facts requiring investigation; it failed to show “good faith” or lack of knowledge of voidability for payments received after insolvency was evident.

4. Insolvency and insider reach-back. The opinion carefully reevaluates balance sheets: it removes the stock-subscription receivable and “quasi-reorganization” paid-in capital; halves inventory values based on credible valuation testimony and retail realities; and recognizes understated liabilities and unearned discounts. It also offers a “fresh start” lens to test reasonableness, concluding insolvency from confirmation forward. As TKA and MD were insiders, the one-year reach-back applied.

5. Ordinary course defense fails on both prongs. Subjectively, payments timed to match the parent’s bank maturities, paid in advance of due dates on demand notes, and including “guaranty fees” (even when no CS debt was outstanding) were not ordinary. Objectively, defendants offered no credible industry evidence; testimony from their own principals and banker was too self-referential. MD’s subordinated note payoff violated its subordination agreement and prepayment constraints, removing it from any “ordinary course” safe harbor.

6. Fraudulent transfers: badges and inequivalent value. Transfers to insiders, concealment through misleading financials, inequivalent value (interest upcharges, guaranty fees, overpayment to MD), and pervasive insolvency established actual intent; alternatively, “unreasonably small capital” supported constructive fraud. The court was particularly troubled by the July 6, 1989 “interest/profit” distribution to MD (within 90 days of confirmation, not permitted under the plan) and the December 29, 1989 prepayment of the subordinated MD note in derogation of its subordination.

7. UCC perfection: proceeds and interstate moves. The court dispelled two common traps. First, refiling to add “proceeds” is not a preference because proceeds coverage is automatic under the 1972 Article 9 amendments unless expressly excluded. Second, adopting Halmar’s logic, a bankruptcy filing within the four-month window under §9-103(1)(d) tolls the period for refiling in the new state; Liberty’s security interest remained continuously perfected even though Mississippi filings were missing.

8. Secured claim valuation and §506(b) interest. Because the collateral was sold under court auspices, the court used the sale date and sale price to peg the secured amount under §506(a), consistent with Dobbins and similar cases. The sale yielded only $750,000 for inventory; Liberty’s claim (then $900,000) was undersecured. No §506(b) postpetition interest or fees were allowed, and the debtor’s postpetition payments of $150,000 principal and $149,008.33 interest were avoided under §549 and recovered. The estate then pursued contribution from co-guarantors (Georgia §10-7-50) and subrogation to Liberty’s collateral (Georgia §§10-7-56, -57) to collect those amounts.

9. Plan as contract; breaches and limits. The plan incorporated Liberty’s commitment letter. TKA’s failure to inject $500,000 as equity was a clear breach; its charging the debtor interest on that money compounded the harm. Liberty’s failure to obtain the Touche Ross opinion breached the commitment but did not cause the debtor contract damages. The Nintendo loan violated none of the plan’s terms and did not harm the debtor on a contract theory (though portions of those funds were later recovered as preferences/fraudulent transfers).

10. Fiduciary duties; business judgment limits; subordination. As the debtor was insolvent, duties ran to creditors. Morrow and Angle usurped a corporate opportunity by purchasing First Union’s claims at a steep discount via MD and then orchestrated preferential/fraudulent distributions to MD and to themselves disguised as “guaranty fees” and “interest/profit.” The business judgment rule did not protect self-dealing. The court awarded damages (including the “profit” MD extracted) and subordinated any claims of TKA, MD, and King to the general unsecured class, but declined to subordinate Liberty’s claim because its conduct, while imprudent, was not egregious within the non-insider standard.

Impact and Practice Implications

• Confirmed-plan payments are not immune in a later case. Creditors who receive distributions under a plan remain exposed to preference risk if the debtor later files a new bankruptcy. Conversion cases do not insulate such payments. This shifts leverage to committees and trustees in serial filings and counsels caution in insider-directed plan payments near or within a year of a later filing.
• Conduit doctrine is narrow; dominion and control controls. Affiliates that take debtor checks, book their own unsecured notes, and control onward flows are initial transferees. Structuring flows through a parent will not shield the parent (or its immediate transferee) from liability.
• Bank “good faith” under §550(b) is a diligence standard in substance. Where a lender knowingly waives equity covenants, ignores going-concern warnings, and knows trade creditors will rely on its commitment/pro forma, it risks losing the §550(b) shield. “Good faith” is not a rubber stamp; it requires prudent inquiry.
• Insider reach-back and “ordinary course” require real, objective proof. Insiders should expect a one-year clawback window. To meet §547(c)(2), defendants need credible industry evidence; insider affidavits will not do. Prepayments timed to insiders’ bank obligations and non-arm’s-length “fees” are red flags.
• UCC house-keeping:
  • Do not refashion filings to “add proceeds”—the law already covers them; such refilings do not create avoidable transfers.
  • Bankruptcy tolls the four-month interstate perfection grace period; still, prudent lenders should calendar and file in new states quickly.
• Secured claim valuation timing matters. If collateral is sold during the case, expect sale-date valuation; a creditor oversecured at filing may become undersecured by sale and lose §506(b) interest and fees. Draft cash-collateral orders accordingly and monitor collateral value.
• Plan commitments bind insiders and lenders. A plan incorporating commitment-letter terms is a contract enforceable against all bound parties. Insiders must deliver equity contributions; failures can generate contract and fiduciary damages.
• Corporate governance in distress: Officers and directors of insolvent companies owe duties to creditors; insider claim purchases are corporate opportunities and must be disclosed and handled loyally. Disguised dividends (guaranty fees, interest upcharges) invite avoidance, damages, and equitable subordination.
• Contribution/subrogation strategy: Where an estate has paid a guaranteed debt postpetition, trustees should consider state-law contribution rights and subrogation into the lender’s collateral to collect from co-guarantors.

Complex Concepts, Simplified

1. Preference basics

A preference is a payment or transfer made before bankruptcy that gives one creditor more than it would receive under a Chapter 7 liquidation. The trustee must show a transfer to a creditor, on an antecedent debt, while the debtor was insolvent, within 90 days (or one year if the creditor is an insider), that improved the creditor’s recovery. Defenses include the “ordinary course” of business and subsequent new value.

2. Initial transferee vs conduit (who gets sued under §550)

The law imposes strict liability on the “initial transferee” and allows a limited “good faith” defense to later transferees. The “initial transferee” is the one with dominion and control over the funds—the party free to use the money. A bank that simply passes funds on instruction is a conduit and not liable; an affiliate that books the payment, sets terms, and controls remittance is an initial transferee.

3. Ordinary course of business defense

This defense has two dimensions: a subjective inquiry (were the debt and payments consistent with the parties’ own course of dealing?) and an objective inquiry (were they consistent with ordinary business terms in the relevant industry?). Both must be satisfied; insider arrangements and unusual fees/prepayments rarely qualify without solid, independent industry proof.

4. Actual vs constructive fraudulent transfers

Actual fraud focuses on intent, inferred via “badges of fraud,” such as transfers to insiders, concealment, lack of equivalent value, and insolvency. Constructive fraud does not require intent; it looks for transfers for less than reasonably equivalent value when the debtor was insolvent or left with unreasonably small capital.

5. Quasi-reorganization vs fresh-start accounting (why “equity” wasn’t real)

“Quasi-reorganization” accounting can present canceled liabilities as equity—phantom equity that doesn’t add cash or assets. “Fresh-start” accounting values the reorganized entity’s assets at what a new owner would pay. The court rejected phantom equity and instead looked at real assets and liabilities to test solvency.

6. §506 valuation and postpetition interest

A secured creditor receives postpetition interest only if the claim is oversecured—i.e., the collateral’s value exceeds the claim. If collateral is sold, courts commonly use the sale value at the time of disposition to decide whether the creditor is oversecured; if undersecured, no §506(b) interest or fees are allowed.

7. UCC proceeds and interstate perfection

Under Article 9 (1972 amendments), perfection in proceeds is automatic; a financing statement need not list “proceeds.” When a debtor moves collateral across state lines, prior perfection remains effective for four months; if the debtor files bankruptcy in that window, courts (as here) may treat the bankruptcy as tolling that deadline.

Conclusion

Toy King delivers a set of practical, clarifying rules across multiple bankruptcy and commercial-law seams:

• Payments made under a confirmed plan in a prior case are not inherently immune in a later case; they are ordinary transfers subject to avoidance.
• Affiliates who receive debtor checks and set their own loan terms are initial transferees, not conduits. A downstream bank must prove both “value” and true “good faith” under §550(b), including diligence and the absence of facts requiring inquiry.
• Insiders face a one-year look-back and must support ordinary-course defenses with credible industry-wide evidence; insider fees, prepayments, and subordination violations will rarely survive scrutiny.
• Secured creditors should expect sale-date valuation to control §506(b) interest rights; oversecured status at filing can evaporate by disposition.
• Plan commitments bind; equity-infusion promises are enforceable, and failures can spawn contract damages and fiduciary liability.
• UCC proceeds coverage is automatic; bankruptcy can toll cross-state perfection deadlines.

The court’s thorough factual reconstruction—dissecting “phantom equity,” rejecting recharacterization, and parsing insider self-dealing—grounds a coherent body of doctrine that balances transactional certainty with bankruptcy’s foundational principle of equal treatment. Going forward, lenders should tighten diligence around equity covenants and opinion letters; insiders must avoid hidden fees and disclose conflicts; and committees should consider preference exposure of prior-plan distributions in serial filings. Toy King thus stands as a detailed, influential map for navigating the interstices of preference avoidance, fraudulent transfer law, secured claim valuation, and fiduciary accountability in serial Chapter 11 landscapes.