Michael Temin writes:

Litigation DamagesOne of the commonly asserted defenses to preference avoidance actions is the “new value” defense set forth in 11 U.S.C. § 547(c)(4).  One issue considered by courts is whether the “new value” must remain unpaid.  In a recent opinion, the Eleventh Circuit joined the Fourth, Fifth, Eighth and Ninth Circuits in holding that it does not.

In Kaye v. Blue Bell Creameries, Inc., (In re BFW Liquidation, LLC), No. 17-13588, (11th Cir. Aug. 14, 2018), the Eleventh Circuit determined that section 547(c)(4) was unambiguous and that the statutory history of the section supports the conclusion that new value need not remain unpaid.

The Court acknowledged that one of the policy objectives underlying the preference provisions of the Bankruptcy Code is to encourage creditors to continue extending credit to financially troubled entities.  According to the Court, requiring new value to remain unpaid would hinder this policy objective.

To support its conclusion, the Court provided a simple illustration of why its interpretation of section 547(c)(4) encourages creditors to continue to extend credit to financially troubled entities:

A chart can perhaps best illustrate the above concepts. The following chart illustrates a scenario where the vendor-creditor ships $1,000 worth of goods to the debtor every other week, and the debtor pays for those goods one week after delivery.

Transfer from creditor to debtor Transfer from debtor to creditor
Transfer 1 $1,000 in goods
Transfer 2 $1,000 in cash
Transfer 3 $1,000 in goods
Transfer 4 $1,000 in cash
Transfer 5 $1,000 in goods
Transfer 6 $1,000 in cash
Transfer 7 $1,000 in goods
Transfer 8 $1,000 in cash
Transfer 9 $1,000 in goods
Transfer 10 $1,000 in cash

Even-numbered transfers—Numbers 2, 4, 6, 8, and 10—show five payments, in the amount of $1,000 each, by the debtor to the vendor-creditor within the 90-day preference period, meaning that each such payment is potentially avoidable by a trustee. Transfers 3, 5, 7, and 9, which show the shipment of goods by the vendor, constitute equivalent new value in the total amount of $4,000 provided by the vendor subsequent to payments 2, 4, 6, and 8, respectively. 

That being so, and under Blue Bell’s position, this $4,000 in new goods shipped would wash $4,000 of the previous payments made by the debtor, for purposes of avoidability. Yet, under the Trustee’s position, the vendor loses this new-value defense because, after conferring new value via the shipment of goods equivalent to the previous payment made by the debtor, the debtor later paid off the value of the shipped goods that constituted the new value. Specifically, Transfer 4 paid off Transfer 3; Transfer 6 paid off Transfer 5; Transfer 8 paid off Transfer 7; and Transfer 10 paid off Transfer 9. According to the position of the Trustee in this case, the vendor in the above scenario would be required to repay the entirety of the $5,000 paid to him by the debtor, even though new value was conferred on the debtor as to $4,000 of these payments.

Blue Bell argues that a subsequent payment by the debtor to the vendor-creditor for new value that was previously provided to the former does not negate the defense as to the particular new value in question. Adopting that position, the vendor in this scenario would be protected by the new-value defense as to debtor payments 2, 4, 6, and 8 because, subsequent to each of these payments by the debtor, the vendor provided new value to the debtor in the form of new goods shipped. It is only the last $1,000 payment by the debtor—Transfer 10—that Blue Bell concedes would be avoidable by the trustee because the vendor delivered no goods after this last payment by the debtor, meaning the vendor provided no subsequent new value. Because it would lack a new-value defense to the preference represented by this last payment, the vendor would have to repay the estate the $1,000; it would then have a corresponding unsecured claim against the estate for that same $1,000. But the vendor would be entitled to retain the remaining $4,000. See 11 U.S.C. §§ 547(b), 550(a), 502(h).

Notably, this is the same situation the vendor would have found itself in had it simply stopped doing business with the debtor after Transfer 2: it would have had to return that $1,000, and it would have had a $1,000 unsecured claim against the estate based on Transfer 2. It would have owed the estate no additional moneys as a clawback by the trustee for any preferences. Yet, the debtor (and the estate it leaves behind) would be in a worse position had the vendor decided to abandon the debtor after Transfer 2. Had that been the case, the debtor would not have received the $4,000 worth of future shipments of goods. With those additional shipments, however, the debtor had additional goods that it could sell to its customers, and thereby potentially increase the size of the estate available at the time of the later bankruptcy filing.

Consider, moreover, the strong disincentives for a vendor to continue supplying an ailing customer with goods if the Trustee’s position wins out. Under the interpretation the Trustee gives the new-value defense, the vendor would have to return all of the payments it subsequently received for the new value it provided the debtor. Were this the rule, a prudent vendor, sensing financial problems by the debtor, would be foolish to continue delivering goods to the debtor following Transfer 2. Cf. Laker v. Vallette (In re Toyota of Jefferson, Inc.), 14 F.3d 1088, 1091 (5th Cir. 1994) (noting that, without the protection of § 547(c)(4), “a creditor who continues to extend credit to the debtor, perhaps in implicit reliance on prior payments, would merely be increasing his bankruptcy loss”). Indeed, focusing on post-Transfer 2 events set out in the chart, not only would the vendor have to return the entirety of the payments it had received for goods it had delivered under the Trustee’s interpretation, but it would also be out $4,000 in the value of the goods it had provided the debtor: $4,000 worth of goods that it could have to sold to another grocery store.

In short, were the Trustee’s approach applicable, a sensible vendor should immediately cut off the debtor, which would likely hasten the latter’s financial demise and his ensuing bankruptcy. Yet, the bankruptcy estate would almost always be better off if a vendor continues to supply the debtor with goods to sell, and the new-value defense, as interpreted by Blue Bell, would encourage it to do so.

Read the full opinion here.

Michael L. Temin is senior counsel in Fox’s Financial Restructuring & Bankruptcy Department, based in its Philadelphia office.

In an appeal from the U.S. Bankruptcy Court for the District of Hawaii, the U.S. District Court for the District of Hawaii determined when the date of the transfer occurred for the purposes of a preferential transfer asserted by a trustee pursuant to 11 U.S.C. §547.  See Coulson v. Kane (In re Price), Civ. No. 17-00437-LEK-KSC (D. Hi June 29, 2018).  Generally, a preferential transfer under Section 547 of the Bankruptcy Code involves a transfer of the debtor’s funds or property shortly before filing for bankruptcy (within 90 days) and such a transfer can be avoided (and the funds/property returned to the bankruptcy estate) if certain conditions are met.

In this case, the Appellant was sued by a bankruptcy trustee for receipt of funds out of escrow that occurred during the 90 days immediately preceding the debtor’s bankruptcy filing. The appellant argued, among other things, that the transfer actually occurred outside the 90-day period because the transfer occurred at some earlier time when the funds were put into escrow because bankruptcy courts have previously held that escrow funds are not property that vests in the bankruptcy trustee.  Id. at 16.

Honolulu, Hawaii
Honolulu, Hawaii

The Court explained that “[t]o prevail on his escrow theory, Appellant must show the ultimate transfer of funds to him, which occurred outside the preference period, did not ‘deplete the assets of the estate available for distribution,'” or, in other words, that the “Escrow Instructions diminished the Debtor’s interest in the escrowed funds sufficiently so that they were not property of the bankruptcy estate.”  Id. at 17 (citations omitted).

For example, escrow instructions that have left a debtor with only a “contingent right” to the funds might sufficiently diminish the debtor’s interest in escrow funds such that the funds are no longer estate property.  Id.  Here, however, the Escrow Instructions at issue did not contain any particular terms that caused the Debtor’s interest to be “without value to the bankruptcy estate.”  Id. at 18.

Accordingly, the Hawaii District Court affirmed the Bankruptcy Court’s ruling that the trustee could recover the transfer of the escrowed funds to appellant because that transfer occurred within the 90-day preference period.  Although sometimes receipt of a preferential transfer can’t be avoided, this case serves as an important reminder to review escrow instructions carefully to the extent they could be used as a defense.