Recoupment Affirmative Defense Not Extinguished by Debtor’s 363(f) Sale

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On March 30, 2012, Judge Sidney H. Stein of the District Court for the Southern District of New York held that a claimant’s affirmative defense of recoupment was not extinguished by the debtor’s section 363(f) sale.  Hispanic Independent Television Sales LLC v. Kaza Azteca America Inc., 10 Civ. 932 (SHS), 2012 U.S. Dist. LEXIS 46239 (S.D.N.Y. Mar. 30, 2012).

Background

In December 2005, Interep National Radio Sales and one of its wholly owned subsidiaries entered into a national television sales representation agreement with Kaza Azteca America Inc..  As part of the agreement, Kaza retained Interep to sell television spots to be aired during Kaza’s television programming, and Interep agreed to serve as “Kaza’s exclusive national representative” for the sale of the national television spot advertising time.  The contract also required that Interep maintain a sales force of 20 salespersons.

Interep and its subsidiaries filed for chapter 11 protection in the Bankruptcy Court for the Southern District of New York on March 30, 2008.  The case was later converted to chapter 7 in October 2008.  Kaza filed a proof of claim in the bankruptcy proceeding asserting that Interep breached its contract with Kaza and that it was entitled to liquidated damages totaling $522,536 as a result of Interep’s breach.  Subsequently, the Trustee, as seller, and Hispanic Independent Television Sales LLC (“HITS”), as purchaser, entered into an asset purchase agreement pursuant to section 363(f), whereby the Trustee assigned to HITS its right to all of Interep’s accounts receivable. Kaza objected to this sale.  The Bankruptcy Court held that the trustee could sell Kaza’s accounts receivable to HITS free and clear of interests in the property; however, the Bankruptcy Court also held that the Kaza agreement could not be assumed and assigned to HITS.

Interep and the Trustee subsequently moved to disallow Kaza’s proof of claim, and on January 26, 2011, the Bankruptcy Court granted the motion.  Kaza did not object to the disallowance of its proof of claim.  In March 2011, Kaza filed a motion for reconsideration requesting that the Bankruptcy Court set aside the order disallowing Kaza’s claim.  Kaza stated that it intended to withdraw its proof of claim if its motion was granted, and did so to preserve its recoupment claim against HITS and to avoid a successful collateral estoppel challenge to its claims by HITS.  In September 2011, the Bankruptcy Court granted Kaza’s motion for reconsideration on the condition that Kaza’s claim be withdrawn against the debtor.

In 2010, HITS commenced an action in New York state court seeking to recover the accounts receivable from Kaza that it had acquired from Interep.  The action was subsequently removed to the District Court for the Southern District of New York.  In its answer to HITS’ complaint, Kaza filed what it referred to as a “counterclaim,” asserting that Interep breached its exclusivity provision in its agreement with Kaza and by failing to maintain the contractually required sales force.  HITS, in turn, moved to dismiss the counterclaim pursuant to Rule 12(b)(6) contending that the bankruptcy proceedings and section 363(f) sale collaterally estopped Kaza from asserting its recoupment counterclaim.

The District Court’s Kaza Azteca Decision

The District Court held that Kaza adequately pled a recoupment defense and examined whether its counterclaim was a legally subsisting claim.  Recoupment is an equitable defense that provides the defendant with a right to demand deduction from the amount from a money claim brought by a plaintiff through a process whereby cross demands arising out of the same transaction are allowed to compensate one another.

The District Court ruled that Interep’s section 363(f) sale of its accounts receivable did not extinguish Kaza’s legally subsisting recoupment defense.  Section 363(f) authorizes a trustee to sell property free and clear of any claim or interest that any entity has in such property.  The District Court, however, found that a right of recoupment is a defense and does not constitute an interest within the meaning of the Bankruptcy Code.  A recoupment defense does not constitute a claim or interest under the Bankruptcy Code because it has no independent value separate and apart from the debtor’s or purchaser’s claim.  Furthermore, a recoupment defense simply does not constitute an interest in the right to payment under the contract, and instead, it serves only to define and limit that right.  Id. (citing  Folger Adam Sec., Inc. v. DeMatteis/MacGregor, J.V., 209 F.3d 252, 267 (3d Cir. 2000).   Consequently, the Court found that a recoupment defense cannot be extinguished by a section 363(f) sale.  Id.  Similarly, the District Court found that New York precedent supported the conclusion that a recoupment claim is not extinguished by the assignment of claim.

After determining that its recoupment claim had not been extinguished, the District Court examined whether the recoupment defense arose out of the same transaction as the HITS’ claim.  It found that that it did because the plaintiff sued to recover past-due damages for telecommunication services rendered under a contract, and the defendant’s recoupment defense alleged a breach of that same contract.  Consequently, Kaza had a legally subsisting recoupment claim because it would be “difficult, if not impossible to separate [plaintiff’s] claims from [defendant’s] counterclaim.”  Id. at *20.  Therefore, the District Court held that the recoupment defense survived the bankruptcy sale and consequently, the District Court denied HITS’ motion to dismiss.

Conclusion

In light of the Kaza Azteca decision, assignees and purchasers in a section 363(f) sale should bear in mind that a sale free and clear of interests does not encompass nor extinguish affirmative defenses by those holding an interest in the sold property.  Consequently, a sale free and clear of interests would not preclude a third party with an interest in the debtor’s property from asserting a recoupment defense should the assignee initiate collateral litigation against that party.