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WHAT YOU CAN DO TO RECOVER A DEBT WHEN YOUR CUSTOMER FILES BANKRUPTCY; The New Value Exception to the Preference Statute

Contact: Matthew Cox

It is anticipated that a wave of bankruptcy and insolvency proceedings – including an increase in preference lawsuits – is coming from the economic fallout due to the COVID-19 pandemic.

Most businesses have a vague understanding that certain payments they may have received in the days before a bankruptcy filing are subject to demands that the payments be turned over to a bankruptcy trustee or returned to the debtor that made the payment. These payments are referred to as a ‘preference.’ If you provided goods or services after receiving payment, you may have a defense.

For example, many months ago, you received a payment from a vendor paying you the amount owed under your contract and due upon receipt of an invoice you sent.  After receiving payment, you shipped more product to your customer.  Then nothing, no further payments were received.  The customer informed you that they cannot pay and they have filed bankruptcy and are shutting down the company.  A year goes by without a thought of these transactions until you receive a letter from a Chapter 7 Trustee demanding payment for the payments you received from your customer, a customer that still owes you money.

Do you have any recourse?  The answer is if you provided goods or services after receiving payment, you may have a defense.  There may be other possible defenses but are not the subject of this article.  Under § 547 of the Bankruptcy Code, a Trustee may avoid any transfer of an interest of the debtor in property—(1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent;(4) made on or within 90 days before the date of the filing of the petition; and (5) that enables such creditor to receive more than such creditor would receive if the case was a case under Chapter 7.

Under § 547 (c)(4), the Trustee may not avoid a transfer to or for the benefit of a creditor if:  (1) new value was given to the debtor after the preferential transfer; (2) the new value was unsecured; and (3) the new value remained unpaid.  In re Eleva, Inc., 235 B.R. 486, 488-89 (B.A.P. 10th Cir. 1999), citing, Mosier v. Ever–Fresh Food Co. (In re IRFM, Inc.), 52 F.3d 228 (9th Cir. 1995).  “New value” is defined as:

[M]oney or money’s worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee under any applicable law, including proceeds of such property, but does not include an obligation substituted for an existing obligation.
Eleva at 489.

A preferential transfer may be set off against new value advanced after the preference is received.  In re Eleva, Inc., 235 B.R. 486, 488-89 (B.A.P. 10th Cir. 1999); In re Vaso Active Pharmaceuticals, Inc., 500 B.R. 384, 396; 58 Bankr. Ct. Dec. (CRR) 159 (Bankr. D. Del. 2013).

The new value exception to the preference statute, sometimes referred to as the subsequent new value exception, is meant to encourage creditors to work with companies on the verge of insolvency, and is also designed to ameliorate unfairness of allowing trustee to avoid all transfers made by debtor to creditor during preference period without giving any corresponding credit for advances of new value that benefited debtor.  See, Vaso Active Pharmaceuticals at 396.   “[T]he exceptions enumerated in [§] 547(c) [are] designed to rescue from attack in bankruptcy those kinds of transactions, otherwise fitting the definition of a preference, that are essential to commercial reality and do not offend the purposes of preference law, or that benefit the ongoing business by helping to keep the potential bankrupt afloat.” In re PMC Mktg. Corp., 518 B.R. 150, 156 (B.A.P. 1st Cir. 2014), citing, Official Comm. of Unsecured Creditors of Maxwell Newspapers, Inc. v. Travelers Indem. Co. (In re Maxwell Newspapers, Inc.), 192 B.R. 633, 635 (Bankr.S.D.N.Y.1996) (internal quotations and citation omitted).

Under  § 547(c)(4) where there have been multiple extensions of new value and multiple payments by debtor, the creditor is entitled to a set off from the preferential transfer of all subsequent advances, up to the amount of new value given.  See In re Meredith Manor, Inc., 103 B.R. 118 (S.D. W. Va. 1989), aff’d, 902 F.2d 257, 23 Collier Bankr. Cas. 2d (MB) 629, Bankr. L. Rep. (CCH) ¶73414 (4th Cir. 1990).  In Meredith Manor, the court held that a creditor who has received a preferential transfer may retain that transfer to the extent that, after such transfer, it gave new value to or for the benefit of debtor, and the creditor is entitled to dollar-for-dollar offset up to date of bankruptcy, regardless of intervening payments.  Id. at 120 (citing Garland v. Union Electric Co., 19 B.R. 920 (Bankr.E.D.Mo.1982)).  The court rejected the notion that the new value set-off is only available for a preferential transfer made immediately before the new value was given, stating:

“… Garland urges that section 547(c)(4) be interpreted to allow set-off only of new value provided immediately after one preferential transfer and prior to the next preferential transfer. I hereby reject Garland’s suggested interpretation of section 547(c)(4). Such an interpretation places limitations on the creditor’s right to set off not found in the statutory language. In addition, this suggested interpretation, if applied, would be tantamount to treating the preferential transfer and subsequent unsecured advances as a substantially contemporaneous exchange, coverage of which is already provided for in section 547(c)(1).”
Garland at 926.

This was also the court’s finding in In re Smith Min. and Material, LLC, 405 B.R. 589, (Bankr. W.D. Ky. 2009) when the court held in a case involving preferential transfers for fuel supplied after payment that “[i]n calculating new value for purposes of new value defense to preferential transfer claim, the proper approach is to offset each advance of new value against all prior preferential transfers”.  Id. at 594.  Similarly, in In re Moltech Power Systems, Inc., 326 B.R. 179 (Bankr. N.D. Fla. 2005), the court held that “the defense of new value is available where the new value ‘effectively repays the earlier preference, and offsets the harm to the debtor’s other creditors.’”  Id. at 184, (Savage & Assocs., P.C. v. Level(3) Communications (In re Teligent), 315 B.R. 308, 315 (Bankr.S.D.N.Y.2004).  In short, the Trustee’s claims against you should be offset to the extent that BHA provided new value during the preference period.

For example, in In re Smith Mining, the court found that the trustee’s claims were offset by the new value of the fuel supplied by the defendant.  The court found that during the 90 days prior to the petition date, the debtor paid the defendant $85,984.88.  Also, during the preference period, the defendant shipped $73,800.08 of fuel to the debtor.  The court found that the debtor was therefore entitled to only recover $13,184.90, the difference between the amount paid by the debtor and the value of the fuel it received.

In your case, you have an argument that any product shipped or services rendered during the 90-day preference period should be offset from the total amount the Trustee is claiming.  If that amount is more than the Trustee claims, it may be a complete defense.  Beware, there are courts and Trustee’s that take the position that only the last new value is a defense, but the cases cited herein provide ammunition to challenge that assertion.

There are other available defenses not addressed in this article. You should consult an attorney if faced with a demand letter requesting the return of funds or property transferred to you by a debtor to determine if you have any available defenses to the alleged preference, and if so, how strong those defenses are.

P. Matthew Cox is a lawyer at Snow Christensen & Martineau – Utah’s bedrock business, litigation and trial law firm since 1886 – and is a trusted advisor and litigator in bankruptcy and creditors’ rights. His practice focuses on representing financial institutions and other lenders in efforts to protect their collateral and loan rights in federal and state courts, including bankruptcy court. He provides creditor and debtor representation in bankruptcy, receiverships, foreclosures, workouts, loan documentation, and collections.

For questions about this blog post, about bankruptcy and creditors’ rights, or other legal services we offer please visit our website scmlaw.com or contact Matt personally at pmc@scmlaw.com.

P. Matthew Cox