Are All Creditor Animals Equal Treatment of New Value Under 547

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Apr 2004

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George Orwell presaged the current plight of creditors under preference law when he stated that "All animals are
equal. But some animals are more equal than others." Even though §547(c)(4)(B) of the Code<a href="#2" name="2a">2</a> offers a defense to a
preference action where the creditor has provided "new value," not all creditors receive its benefits. Their inequality
arises because some jurisdictions require that new value remain unpaid in order to have a defense, but other
jurisdictions do not. In a national economy, that split in interpretation undermines the congressional intent that
creditors continue to do business on credit with potential debtors, confident that providing "subsequent new value"
will prevent debtors from sliding into bankruptcy. Under the current split, a creditor doing business with a
corporation that files for bankruptcy relief in Florida may find that it is later unable to protect new value shipments
that a creditor doing business with a debtor who files for bankruptcy relief in California is able to protect. Of the six
circuits that have considered this issue, three have concluded that new value must remain unpaid,<a href="#3" name="3a">3</a> two have
concluded that §547(c)(4) does not include a "remain unpaid" requirement,<a href="#4" name="4a">4</a> and one circuit has conflicting
opinions.<a href="#5" name="5a">5</a>

Strict construction of the statutory text, in conjunction with a review of the underlying congressional policy, shows
that "new value" should not have to remain unpaid in order to qualify for the statutory exception. Courts that adopt
the "remain unpaid" requirement apply an imprecise "shorthand approach" to §547(c)(4)(B), which leads to an
incomplete and inaccurate analysis. The better alternative analyzes whether the debtor has made an "otherwise
unavoidable" transfer to the creditor in exchange for the new value. If the errant circuits would adopt the latter
analysis, no creditor would be "more equal" than another.

<h3>The New Value Statute, Congressional Policy Considerations, Disagreements Among the Circuits</h3>

Section 547(b) of the Code vests the bankruptcy trustee with broad powers to avoid preferential transfers.<a href="#6" name="6a">6</a> That
section is based on two policy considerations: (1) discouraging creditors from racing to dismember a debtor
sliding into bankruptcy, and (2) promoting equality of distribution to creditors in the debtor's bankruptcy. But in
preference law, as in life, there are always competing considerations. The competing considerations are embodied in
§547(c), which creates seven exceptions to the trustee's broad avoidance powers. They stem from one policy:
encouraging creditors to continue to do business with—and to extend new credit to—financially troubled entities,
perhaps helping such entities avoid bankruptcy altogether.

The "subsequent new value" provision, §547(c)(4), is one of those exceptions. It provides:

<blockquote>
The trustee may not avoid under this section a transfer—

<blockquote>
(4) to or for the benefit of a creditor, to the extent that, after such a transfer, such creditor gave new
value to or for the benefit of the debtor—

<blockquote>
(B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit
of such creditor.

</blockquote>
</blockquote>
</blockquote>
11 U.S.C. §547(c)(4)(B) (emphasis added).

Courts and commentators generally agree that the application of the "subsequent new value exception" is contingent
on at least two requirements: (1) the creditor must have extended new value to the debtor or on debtor's behalf to a
third party, and (2) the new value must have been given after receiving the preferential transfer. Trouble surfaces,
however, with regard to a third requirement employed by some courts: Does the new value transfer have to remain
unpaid?

<h3>The Competing Schools of Thought</h3>

A. The Emerging View. The "emerging view" does not require that new value remain unpaid. The view is built on
the bedrock of the statutory language of §547(c)(4). The Ninth Circuit's holding in IRFM Inc.<a href="#7" name="7a">7</a> provides one of the
better-published analyses of the emerging view. In IRFM, the court criticized the "remains unpaid" requirement as an
"incomplete and inaccurate" analysis of statutory text of §547(c)(4)(B).<a href="#8" name="8a">8</a> The court recognized that a "more recent
trend has developed where courts and commentators have rejected the shorthand approach and have undertaken a
more thorough analysis of the language of §547(c)(4)(B)."<a href="#9" name="9a">9</a> Under that analysis, the inquiry directed by the text of
§547(c)(4)(B) is whether the new value has been paid for by "an otherwise unavoidable transfer." "[I]nstead of
barring the new value defense altogether any time new value has been repaid, this approach allows the new value
defense if the trustee can recover the repayment by some other means."<a href="#10" name="10a">10</a>

The "emerging view" analysis promotes the underlying congressional policy: It encourages creditors to continue to
do business with and lend new money to financially distressed debtors. Without this exception, creditors would
have a significant disincentive to continue to do business with a financially troubled debtor, because doing so
would increase a creditor's preference liability in a debtor's bankruptcy. For example, under that approach, every
time a creditor accepts payment from a debtor in exchange for continued transfers of new value, the creditors'
preference liability continues to increase without the potential for offsetting new value credits. In contrast, the
emerging view encourages the continued extension of new credit to financially troubled debtors by allowing lenient
creditors the ability to retain payments that are otherwise unavoidable. Similarly, to the extent that payments are
voidable (subject to preference liability), the creditor may use the new value transfer of services or goods as
offsetting defenses to his increasing preference liability.

B. The Majority Rule. The so-called "majority rule" holds that new value must remain unpaid in order to qualify for
the statutory exception of §547(c)(4)(B). In re Bishop initially interpreted §547(c)(4)(B) of the Code and is the
origin of the majority rule.<a href="#11" name="11a">11</a> The court noted: "[F]or §547(c)(4) to apply, three requirements must be met. First,
the creditor must extend new value as defined in §547(a)(2) as "money or...new credit" after the challenged
payment... Secondly, the new value must be unsecured... Finally, the new value must be unpaid."<a href="#12" name="12a">12</a> The In re
Bishop court arrived at this conclusion by misreading the Code. The court's third requirement, that "the new value
must be unpaid," is merely judicial gloss of the explicit statutory text, "on account of which new value the debtor
did not make an otherwise unavoidable transfer to or for the benefit of such creditor." The shortcomings of the In re
Bishop analysis have resulted in the now-familiar but inaccurate shorthand paraphrase of the Code, that the "new
value must remain unpaid."

Few courts have explained their apparent adoption of the majority rule. Instead, in what one court has called a
"comedy of errors," the adopting courts have simply relied on dicta from prior cases.<a href="#13" name="13a">13</a> The few courts that have
provided analysis have reasoned that if new value has been repaid by the debtor, then (1) 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.<a href="#14" name="14a">14</a> Additionally, these courts conclude that the majority rule is consistent with the policy considerations
underlying the preference provisions of the Bankruptcy Code. For example, in In re Braniff Inc., the court noted
that the majority rule furthered policy considerations of (1) providing a material benefit and enhancement of the
estate, (2) providing equality of treatment among the creditors and (3) encouraging creditors to continue to extend
credit to financially troubled entities.<a href="#15" name="15a">15</a> However, that reasoning is fundamentally flawed, because it fails to
recognize that a payment of the new value, which is itself an otherwise avoidable transfer (a preference), replenishes
the debtor's estate by allowing the estate newly created or increased preference liability against the creditor. This
have-your-cake-and-eat-it-too analysis allows the debtor to both keep the new value and seek to avoid the payment
of such new value. If the debtor is able to avoid the payment and keep or use the new value, the debtor receives
more than just replenishment; rather, it receives a double benefit. The text of §547(c)(4) contemplates no such
result.

<blockquote><blockquote>
<hr>
<big><center>
[O]nly the emerging view supports the congressional policy of encouraging creditors to continue doing business with financially distressed debtors.

</center></big>
<hr>
</blockquote></blockquote>

<h3>Hypothetical Application<a href="#16" name="16a">16</a>—In re Braniff, 154 B.R. 773 (Bankr. M.D. Fla. 1993)</h3>

A. Majority View. A simplified version of In re Braniff exemplifies the flaws of the majority rule's analytical
approach. Numerically, the court's holding is illustrated in Exhibit A. In that case, the debtor made a preferential
transfer to the creditor in the amount of $392,088.64. See Step #1. Subsequently, the creditor advanced new
equipment (new value) to the debtor in the amount of $87,346.59. See Step #2. The new value advanced was repaid
by the debtor. See Step #3. The debtor's preference claim increased by the amount of the repayment. See Step #4.
On the basis of the repayment, the court concluded: "[T]herefore, any material benefit which enhanced the estate by
virtue of [the new value] was extinguished when [the creditor] was paid in full for those invoices." Thus, the court
held that the creditor was unable to use the repaid new value to offset its preferential payment liability. See Step #5.

The numbers show the "absurd result" produced by the majority rule. The majority rule allows the debtor to retain
the transferred goods or services (the new value) while simultaneously increasing its preference claims against the
creditor by the amount of the repayment. Hence, the estate is unfairly enriched in the amount of the new value
transaction, $87,346.59. Through the new value transaction, the debtor's estate increased its allowable preference
claims from $392,088.64 to $479,435.23. In addition, the debtor's estate received new value goods or services in
the amount of $87,346.59. The creditor, on the other hand, loses the value of the goods or services transferred to the
debtor and is also forced to return the payment of the new value via the newly created preference liability. As a
result of the creditor's goodwill, its preference liability increased from $392,088.64 to $479,435.23. That result
comports with neither congressional policy nor common sense.

The flaw in the majority rule is that it fails to recognize that the "repayment" transfer in Step #3—itself an
avoidable transfer (a preference payment)—creates a new asset for the estate. When new value is repaid by the debtor
with a preference payment, the debtor's estate increases its preference cause of action against the creditor by the
amount of the repayment. Therefore, where the payment of new value constitutes a preference, two simultaneous and
offsetting events occur. First, the payment of the new value constitutes a depletion to the debtor's estate. See Step
#3. However, this depletion is offset by the new or increased cause of action that the debtor's estate gains against
the creditor. See Step #4. The debtor's estate is therefore replenished, and the repayment of the new value has a net
zero result. In both theory and in practical reality, repayment of new value neither replenishes nor depletes the
debtor's estate.

B. The Emerging View. Using the facts of In re Braniff, the emerging view analysis in Exhibit B shows the
better-reasoned analytical approach to new value defenses.

Under this approach, the creditor is allowed to include repaid "new value" as part of its §547(c)(4)(B) defense. As
the numbers show, this added setoff does nothing more than offset the creditors' increased preference liability.
Hence, prior to any new value transfer, the creditor's preference exposure was $392,088.64. After the new value
transfer, the creditor's preference exposure remains at $392,088.64. Similarly, the debtor's estate goes unharmed.
Although the estate is initially depleted by the repayment transfer of $87,346.59, the estate is simultaneously replenished by the $87,346.59 it gains in newly
created or increased preference claims against the creditor. See Steps #3 and #4.

<h3>Conclusion</h3>

Whether §547(c)(4) of the Code requires that new value remain unpaid in order to qualify as a preference defense has
led to a split between appellate circuits. Two schools of thought have resulted: the "majority rule" and the
"emerging view." A complete analysis of the new value defense shows that only the emerging view comports with
the text in §547(c)(4) and the congressional policy considerations supporting that defense. The emerging view
properly focuses the inquiry on whether the new value has been repaid by "an otherwise avoidable transfer." Further,
only the emerging view supports the congressional policy of encouraging creditors to continue doing business with
financially distressed debtors. Creditors' rights practitioners should continue to argue the emerging view as the
complete and accurate analytical approach to new value preference litigation. In time, we may hope that the
emerging view will return us to an environment where no creditor is more equal than others.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Jesus Batista is a third-year law student and will be an associate with Barnes & Thornburg in the fall. Scott Longman, a partner at Barnes & Thornburg, provided helpful feedback. <a href="#1a">Return to article</a>

<a name="2">2</a> 11 U.S.C. §547(c)(4)(b) (U.S. Bankruptcy Code). <a href="#2a">Return to article</a>

<a name="3">3</a> The Third Circuit, In re New York Shoe Inc., 880 F.2d 679 (3rd Cir. 1989); the Seventh Circuit, In re Prescott, 805 F.2d 719 (7th Cir. 1986); and the Eleventh Circuit, In re Jet
Florida, 841 F.2d 1082 (11th Cir. 1988), have held that new value must remain unpaid in order to qualify under the statutory exemption of §547(c)(4) of the Code. <a href="#3a">Return to article</a>

<a name="4">4</a> The Fifth Circuit, In re Toyota of Jefferson, 14 F.3d 1088 (5th Cir. 1994), and the Ninth Circuit, In re IRFM Inc., 52 F.3d 225 (9th Cir. 1995), have concluded that no such
"remain unpaid" requirement is imposed by the statue. <a href="#4a">Return to article</a>

<a name="5">5</a> In In re Jones, 130 F.3d 323 (8th Cir. 1997), the Eighth Circuit noted "we agree with courts that have construed our reference to 'remaining unpaid' as an adequate shorthand
description of §547(c)(4)(B) of the Code." However, the court did not explicitly reject its previous holding in In re Kroh Brothers, 930 F.2d 648 (8th Cir. 1991), where it noted
that "the majority of courts...hold that a creditor who has received payment from the debtor for new value cannot rely on §547(c)(4)." Id. at 652. <a href="#5a">Return to article</a>

<a name="6">6</a> In general, an avoidable preferential transfer is a transfer of the debtor's property, to or for the benefit of a creditor, on account of the debtor's antecedent debt, made less than
90 days before bankruptcy while the debtor is insolvent, that enables the creditor to receive more than it would otherwise receive in a chapter 7 liquidation. In re Jones Truck
Lines Inc., 130 F.3d 323, 326 (8th Cir. 1997). <a href="#6a">Return to article</a>

<a name="7">7</a> In re IRFM Inc., 52 F.3d 288 (9th Cir. 1995). <a href="#7a">Return to article</a>

<a name="8">8</a> Id. at 231. <a href="#8a">Return to article</a>

<a name="9">9</a> Id. <a href="#9a">Return to article</a>

<a name="10">10</a> Id. <a href="#10a">Return to article</a>

<a name="11">11</a> In re Bishop, 17 B.R. 180 (Bankr. N.D. Ga. 1982). <a href="#11a">Return to article</a>

<a name="12">12</a> Id. at 183. <a href="#12a">Return to article</a>

<a name="13">13</a> For example, in In re New York City Shoes Inc., 880 F.2d 679, 680 (3rd Cir. 1989), in dicta, the court cites In re Almarc Manufacturing Inc., 62 B.R. 684, 686 (Bankr. N.D. Ill.
1986), for the proposition that new value must remain unpaid, but the court fails to provide any explanation for its deviation from the statutory text. Similarly, in In re Prescott,
805 F.2d 719, 728 (7th Cir. 1986), the court cites In re Saco Local Development Corp., 30 B.R. 859 (Bankr. D. Me. 1983), and in In re Jet Florida System Inc., 841 F.2d 1082
(11th 1988), the court cites In re Fulgham Const. Corp., 45 B.R. 112 (Bankr. M.D. Tenn. 1984), for the same proposition that new value must remain unpaid without providing
any explanation. <a href="#13a">Return to article</a>

<a name="14">14</a> In re IRFM Inc., 52 F.3d 228, 231 (9th Cir. 1995). <a href="#14a">Return to article</a>

<a name="15">15</a> In re Braniff Inc., 154 B.R. 773, 785 (Bankr. M.D. Fla. 1993). <a href="#15a">Return to article</a>

<a name="16">16</a> This hypothetical is a simplified version of the more complicated fact pattern in In re Braniff. <a href="#16a">Return to article</a>

Journal Authors

Deborah L. Thorne

Jesus Batista

Journal Date

Thursday, April 1, 2004 - 12:00

Bankruptcy Rule

2004