Trustee Beware The Defenses to the Preference Claim Part I

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Mar 2001

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Editor's Note:

The article is the first of a four-part series discussing four of
the seven affirmative defenses to preference action. This article covers contemporaneous
exchange. The remaining three will appear in subsequent issues of the ABI Journal.
</blockquote>

Section 547(c) of the Code provides for several affirmative defenses to a
preference action brought by a trustee or debtor-in-possession.

This series of articles will discuss only four of the seven affirmative defenses to
a preference action contained in §547: contemporaneous exchange
(§547(c)(1)), ordinary course of business (§547(c)(2)), enabling loan
(§547(c) (3)) and subsequent new value (§547(c)(4)). This paper will
also discuss the earmarking doctrine and the affirmative defense of statute of limitations
provided in §546(a).

The defenses of contemporaneous exchange, ordinary course of business, enabling loan
and subsequent new value are affirmative defenses that must be pled by the defendant.
Rule 7008, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Bankruptcy Procedure, U.S. v. Continental Illinois Nat.
Bank & Trust, 889 F.2d 1248, 1253 (2nd Cir. 1989)</a>. Otherwise,
these statutory defenses are waived. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re National Lumber and Supply Inc., 184
B.R. 74, 78 (9th Cir. BAP 1995)</a>.

<h3>Contemporaneous Exchange for New Value</h3>

"Contemporaneous new value exchanges are not preferential because they encourage
creditors to deal with troubled debtors and because other creditors are not adversely
affected if the debtor's estate receives new value." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Jones Truck Lines Inc.,
130 F.3d 323, 326 (8th Cir. 1997)</a>, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Top Ins. Co.
v. Bank of Amer. Nat'l Trust & Sav. Ass'n, 969 F.2d 321, 324
(7th Cir. 1992)</a>.

A creditor can invoke the affirmative defense of contemporaneous exchange by proving
(1) the preferred creditor extended new value to the debtor, (2) the creditor
and the debtor intended this exchange to be contemporaneous and (3) the exchange
was, in fact, contemporaneous. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Shelton Harrison Chevrolet Inc., 202
F.3d 834, 837 (6th Cir. 2000)</a>.

"New value" is defined to mean "money or money's worth in goods, services, or new
credit or release by a transferee of property previously transferred to such transferees
in a transaction that is neither void or voidable." §547(a)(2). In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Grand Chevrolet Inc., 25 F.3d 728 (9th Cir. 1994)</a>, the debtor,
Grand Motors, was in the business of buying new cars from dealers. One of the
dealers was Pacific Suzuki. The trustee sought to avoid three transfers from the debtor
to Pacific Suzuki as preferences. The Ninth Circuit affirmed the district court's
holding that the first transfer was protected by an ordinary-course-of-business defense.
The Ninth Circuit then had to consider transfers two and three. Thirty days after
delivery of two vehicles, the debtor paid for them by sending two checks directly to
the seller. Pacific Suzuki, upon receipt of the two checks, released the title
documents and security interests on the two vehicles involved in transfers two and
three. The defendant urged the contemporaneous exchange defense in connection with
transfers two and three. The Ninth Circuit found that Pacific Suzuki conferred new
value on the debtor for the purposes of the contemporaneous exchange exception to the
preference rule by releasing the title documents and security interests in connection with
transfers two and three. Grand Chevrolet at 733. The Ninth Circuit remanded that
part of the case concerning transfers two and three to the district court to determine
the amount of new value conferred by the seller.

Value should be measured at the time of the transfer. Grand Chevrolet at 733
and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re NuCorp Energy Inc., 902 F.2d 729, 733 (9th Cir.
1990)</a>.

It is not necessary that the new value go directly to the debtor. The only
requirement is that the "new value" benefits the debtor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Jones Truck Lines
Inc., 130 F.3d at 326-327</a>. In Jones Truck Lines, the debtor brought
a preference action to recover nearly $6 million in employee benefit payments paid
to Central States, which managed the debtor's employee benefit funds. The debtor paid
the benefit funds to Central States (transfers) on a past-due basis. Even though
the debtor was delinquent in making its payments, Central States continued to
administer the various employee benefit trusts. The defendant, Central States, argued
that the debtor received new value in exchange for the employee benefits in the form
of continued employee service. The Eighth Circuit reversed the holding of the lower
courts that the transfer was a preference because new value did not flow directly from
the pension funds. The Eighth Circuit stated that the word "directly" does not appear
in §547(c)(1). The fact that the new value came from the employees who
continued to work for the debtor because Central States continued to administer their
benefit funds and not directly from Central States did not negate the contemporaneous
exchange defense. Jones Truck Lines Inc. at 327.

The Fifth Circuit reached the same conclusion in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Fuel Oil Supply &
Terminaling Inc., 837 F.2d 224 (5th Cir. 1988)</a>. In Fuel Oil
Supply, (1) the debtor paid the creditor; (2) as a result, the creditor
released letters of credit securing the loan; and (3) the bank that had issued the
letters of credit then released its lien on the debtor's collateral given to the bank.
The Fifth Circuit held that new value did not have to come directly from the
creditor that received the preference, but may be provided by a fully secured third
party. Fuel Oil Supply at 231. The Fifth Circuit further held that the bank
conferred new value on the debtor by releasing its lien on debtor's collateral, and
the debtor-in-possession was not entitled to recover the transfers.

A preference defendant must prove the specific valuation of the new value given by
the defendant to the debtor. Section 547(c)(1) protects preferential transfers
only to the extent of the amount of new value. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Jet Florida Systems Inc.,
861 F.2d 1555, 1559 (11th Cir. 1988)</a>.

The second element of a contemporaneous exchange is the intent of the debtor and
creditor that the transaction be a substantially contemporaneous exchange. This rule was
first established in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… City Bank of New York v. Hotchkiss, 231 U.S.
50, 34 S.Ct. 20 (1913)</a>. In the Hotchkiss case, the bank made an
unsecured loan in the morning and then learned later in the day that the borrower was
having financial difficulties. During the afternoon of the same day, the bank
requested and got from the borrower a security interest in property to secure the
loan. The court found that the transfer of the security interest was not a
contemporaneous exchange because the lender did not originally intend the loan to be
secured. The Hotchkiss case was decided in 1913, but "intent" is still a
necessary element in proving a contemporaneous exchange defense to a preference action.

The court <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Wadsworth Bldg. Components Inc., 711 F.2d 122, 124
(9th Cir. 1983)</a>, stated on page 124: "The critical inquiry in determining
whether there has been a contemporaneous exchange for new value is whether the parties
intended such an exchange." See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Spada, 903 F.2d 971, 975
(3rd Cir. 1990)</a>, and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Prescott, 805 F.2d 719, 727 (7th
Cir.1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gateway Pacific Corp., 153 F.3d 915, 918 (8th
Cir. 1998)</a>. In Wadsworth, the debtor was required to pay past debts before
the creditor would receive further credit. The court held that since the creditor
conditioned the future shipment of goods on payment by the debtor, the parties lacked
the intent of a contemporaneous exchange, even though the actual transaction was
contemporaneous. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 711 F.3d at 124</a>. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Filter Corp.
Inc., 163 F.3d 570 (9th Cir. 1998)</a>, the creditor loaned money to
the debtor during the 90-day preference period, but did not file its financing
statement until five days after the date of security interest agreement. The Ninth
Circuit affirmed the bankruptcy court's finding that the parties intended a
contemporaneous exchange, and the transfer took effect at the same time as the loan
because the financing statement was filed within 10 days as provided in
§547(e)(2)(A); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Filter Corp., 163 F.3d at 584-590</a>.

The third element is that the exchange must be in fact a contemporaneous exchange.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Davis, 242 U.S. 438, 37 S.Ct. 130 (1917)</a>. In Dean
v. Davis, the parties intended to make a secured loan, but the mortgage on the
debtor's real property was not signed until one week after the note was signed. The
Supreme Court found that the parties intended a contemporaneous exchange, and that the
interval of one week did not preclude an actual contemporaneous exchange. The Fifth
Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Lockin, 101 F.3d 435, 443 Fn. 10 (5th Cir.
1996)</a>, held that the time difference between the date the creditor receives a
check and the date the check clears the debtor's bank does not defeat the defense of
contemporaneous exchange—assuming the check is promptly deposited and cleared.

The existence of intent, contemporaneous of the exchange and new value, are
questions of fact. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lewellyn & Co. Inc., 929 F.2d 424, 426
(8th Cir. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Spada, 903 F.2d at 975</a>.

Journal Authors

Keith M. Baker

Journal Date

Thursday, March 1, 2001 - 12:00

Bankruptcy Rule

2001