Trustee Beware The Defenses to the Preference Claim - Part III

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May 2001

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A key justification for the new value exception is that while the payment of
preferences to the creditor diminished the estate, other creditors are not really worse
off, since the subsequent advance of new value replenishes the estate." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Micro
Innovations Corp., 185 F.3d 329, 336 (5th Cir. 1999)</a>.

The Fifth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Toyota of Jefferson Inc., 14 F.3d 1088
(5th Cir. 1994)</a>, had to decide whether new value had to remain unpaid if it
was to qualify as "subsequent new value" under §547(c)(4). The trustee argued
that none of the preferential payments made by the debtor could be excepted under
§547(c)(4) because the debtor paid for all of the new value accorded to it.
The Fifth Circuit disagreed with the bankruptcy trustee's interpretation of
§547(c)(4), "believing it to be contrary to the statute's plain language." Toyota
of Jefferson at 1092. The court quoted from Prof. Vern Countryman's article on
§547(c)(4), "The Concept of a Voidable Preference in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 38 Vand.
L. Rev. 713, 788 (1985)</a> at pages 1092 and 1092 of the opinion,
and summarized by saying that the debtor's payment of the new value does not preclude
the defense of subsequent new value if the payment itself is otherwise avoidable. Toyota
of Jefferson at 1093. On page 1093, the court cited the opinions of several
bankruptcy courts that adopted this approach.

The Fifth Circuit noted, however, in footnote 2 on page 1093 of the
opinion, that several circuits disagreed, and stated (in dicta) that the new value
had to remain unpaid in order to qualify as an offset under §547(c)(4)(B).
The court cited the following cases: <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kroh Brothers, 930 F.2d 648
(8th Cir. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re New York City Shoes Inc., 880 F.2d 679,
680 (3rd Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Jet Florida Sys. Inc., 841 F.2d
1082, 1083 (11th Cir. 1988)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Prescott, 805 F.2d
719, 731 (7th Cir. 1986)</a>.

The Ninth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re IRFM Inc., 52 F.3d 228 (9th Cir.
1995)</a>, also had to answer the key question concerning the application of the
"subsequent new value" defense. Does the new value have to remain unpaid for it to
qualify as "subsequent new value?" The Ninth Circuit in IRFM gives a helpful review
of the decisions of the other circuits at page 231 of the opinion:

<blockquote>
Courts and commentators agree that the exception contains two key elements.
First, the creditor must give unsecured new value, and second, this new value
must be given after the preferential transfer. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fulghum Constr.
Corp., 706 F.2d 171, 172 (6th Cir.), cert. denied, 464
U.S. 935, 104 S.Ct. 342, 343, 78 L.Ed.2d 310
(1983)</a>. The majority of courts have also adopted a shorthand approach to
§547(c)(4)(B) and hold that §547(c)(4) contains a third element—that
the new value must remain unpaid. The Eighth Circuit recently followed this
approach in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kroh Bros. Dev. Co., 930 F.2d 648, 653
(8th Cir. 1991)</a> (creditor who has been paid for the new value by the
debtor may not assert a new value defense). The rationale for this position is
(1) if new value has been repaid by the debtor, the estate has not been
replenished, and (2) the creditor is permitted the double benefit of a new
value defense and the repayment of the new value. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bros., 930
F.2d at 652</a>. However, focusing only on the issue of whether the new value
is unpaid may lead to some absurd results...As a result, an emerging trend
has developed where a few courts have reached the contrary result and hold that
new value need not remain unpaid.

</blockquote>

The Ninth Circuit in IRFM Inc. agreed with the Fifth Circuit's analysis in
Matter of Toyota of Jefferson that a new value defense is permitted when the new value
is paid unless the debtor repays the new value by a transfer that is otherwise
unavoidable. IRFM Inc. at 231-232. The court stated on page 231 of the
opinion that the court agreed with the Kroh Bros. rationale that a creditor should
not get double credit for an advance of new value. However, the court stated that
instead of barring the new value defense altogether anytime new value has been repaid,
the new value defense should be allowed if the trustee can recover the repayment by
some other means. IRFM Inc. at 231.

The Ninth Circuit in IRFM also had to decide whether the district court's formula
in calculating the new value offset was correct, and on page 232, it set out that
formula, as shown in the table below.

The Ninth Circuit accepted this formula, stating that a creditor is permitted to
carry forward preferences until they are exhausted by subsequent advances of new value.
The court stated that this approach is derived from <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Thomas W. Garland
Inc., 19 B.R. 920 (Bankr. E.D. Mo. 1982)</a>. Under the above
formula, subsequent advances of new value may be used to offset prior (and not just
immediately prior) preferences.

The court in IRFM makes it clear that the aggregate of subsequent new value
payments will be applied as an offset against the total of the preferential payments.
The court following the Garland decision refused to limit an individual shipment of
"subsequent new value" to the immediately preceding preferential payment by debtor. The
court stated on page 232:

<blockquote>
The rationale behind this method is two-fold. First, it encourages creditors
to do business with financially troubled debtors. A creditor will be more likely
to continue to advance new value to a debtor if all these subsequent advances
may be used to offset a prior preference. If a second advance of new value
carries no benefit, the creditor will be unlikely to make it. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Meredith
Manor Inc., 902 F.2d 257, 259 (4th Cir. 1990)</a>. Second,
this approach recognizes the fluid nature of ongoing commercial activity where a
creditor looks to a debtor's entire repayment history, instead of one isolated
transaction, to decide whether to advance new credit. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

A contrary approach was adopted in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Prime Leather Finishes Co.,
40 B.R. 248 (D. Maine 1984)</a>. Under this "transactional approach,"
the new value given by the creditor may be used to offset only the immediately
preceding preference...

We reject the Leathers approach. First, nothing in the language of
§547(c)(4) requires this result. The statute states only that after a
preferential transfer, new value must be given. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Holdings, 167
B.R. at 627</a>. Second, as discussed above, the Garland approach better
satisfies the purposes and goals of the preference section.

</blockquote>

Both the Fifth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Micro Innovations Corp., 185 F.3d
337 (5th Cir. 1999)</a>, and the Fourth Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Meredith Manor
Inc., 902 F.2d 257, 259 (4th Cir. 1990)</a>, rejected the
"transactional approach" approved in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Prime Leathers Finishes Co., 40
B.R. 248 (D. Maine 1984)</a>, and followed the Garland rule described by
the Ninth Circuit in IRFM Inc. in the above quotation.

Journal Authors

Keith M. Baker

Journal Date

Tuesday, May 1, 2001 - 12:00

Bankruptcy Rule

2001