One Preference Won’t Prevent Another from Being a Preference

Upheld in district court, an opinion by Bankruptcy Judge Brian F. Kenney of Alexandria, Va., stands for three important propositions regarding preference law: (1) One preference cannot save another preference from being a preference; (2) a joint check agreement isn’t always a defense to a preference; and (3) a joint check agreement itself can be a preference.

The facts were not uncommon in the construction industry. The prime contractor had a $273 million contract to perform renovations on the Washington, D.C., subway system. The prime contractor entered into a subcontract with an electrical subcontractor. In turn, the subcontractor had a $17 million contract with second-tier subcontractor to provide electrical equipment.

The electrical subcontractor ran into financial problems and fell behind in payments to the second-tier equipment supplier, who refused to deliver more equipment without being paid.

Previously, the prime contractor had been paying the subcontractor, who in turn was to pay the equipment supplier. The three parties agreed to modify how they had been doing business by signing a joint check agreement.

About three weeks after signing the joint check agreement, the prime contractor wrote a $2.1 million check jointly payable to the subcontractor and the equipment supplier, in accordance with the joint check agreement. The subcontractor endorsed the check and returned it to the prime contractor, who in turn delivered the check to the equipment supplier.

The subcontractor ended up filing a chapter 7 petition. The execution of the joint check agreement and the $2.1 million payment both fell within the 90-day preference window.

You guessed it. The trustee sued the equipment supplier for receipt of a $2.1 million preference. In July 2018, Bankruptcy Judge Kenney found the supplier liable for receipt of a preference under Section 547. Gold v. Myers Controlled Power LLC (In re Truland Group Inc.), 588 B.R. 447 (Bankr. E.D. Va. 2018).

The equipment supplier appealed, but District Judge Leonie M. Brinkema upheld the judgment, employing Judge Kenney’s rationale.

There were two transfers: the execution of the joint check agreement and the payment by check. In her May 24 opinion, Judge Brinkema was tasked with deciding whether either or both represented “a transfer of an interest of the debtor in property” and therefore qualified as preferences under Section 547.

Contending that the check did not represent the debtor’s property as a consequence of the joint check agreement, the equipment supplier relied on the Fourth Circuit’s decision in Mid-Atlantic Supply Inc. of Virginia v. Three Rivers Aluminum Co., 790 F.2d 1121 (4th Cir. 1986). There, the parties also had a joint check agreement, but it had been signed outside of the preference window.

The Fourth Circuit ruled in Mid-Atlantic that the subcontractor held the check in constructive trust under Virginia law. There was no preference because the check did not represent a transfer of an interest of the debtor in property.

The facts in the case on appeal were different, however. Judge Brinkema agreed with Bankruptcy Judge Kenney that the joint check agreement itself was a voidable preference because it occurred within the preference window. The agreement was a transfer because the subcontractor gave up the right to receive payment from the prime contractor.

Paraphrasing Judge Kenney in her May 24 opinion, Judge Brinkema said that one preference (the joint check agreement) could not prevent another transfer (the check) from being a preference. Judge Brinkema relied upon bankruptcy court decisions from Connecticut and Pennsylvania for the proposition that a joint check agreement signed within the preference period is a preference.

In other words, “one preference cannot save another,” Judge Brinkema said.

Judge Brinkema also upheld Judge Kenney’s finding that there was no substantially contemporaneous exchange for new value, giving rise to a defense under Section 547(c)(1). The equipment supplier had delivered equipment 45 days and 23 days before the check was issued.

Judge Brinkema upheld Judge Kenney’s finding that the intervals between delivery and payment were too long to be considered contemporaneous.

Observation: Proper structuring would have saved the equipment supplier $2.1 million. Had the check gone out immediately after delivery of the equipment, the supplier would have been entitled to the contemporaneous exchange defense. The joint check agreement would have remained a preference but would not have mattered in view of the contemporaneous exchange.