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Preventive medicine for a preference headache.

When your customer becomes a bankruptcy debtor, that debtor or its trustee may try to recover "preference" payments which were made to your company prior to the bankruptcy. A preference is a transfer of property to a creditor made by a debtor within 90 days prior to the commencement of its bankruptcy case. It allows the creditor to receive a greater recovery than would occur if the debtor were liquidated under Chapter 7 and the transfer had not been made. If the payment was made to an "insider" of the debtor, the trustee may be entitled to recover payments or transfers made up to a year prior to the bankruptcy. The best way to combat potential preference liability is to structure your pre-bankruptcy transactions with financially shaky customers so that it is more likely that your company can use one or more of the statutory preference defenses.

In the June 1993 issue of Business Credit, we discussed the "subsequent new value" preference defense, which allows creditors to reduce their preference exposure to the extent of the value of goods or services which are provided to a debtor on credit after the receipt of a preference.

The "subsequent new value" defense is codified in Section 547 (c)(4) of the Bankruptcy Code. In this article, we will focus on another defense, known as the "contemporaneous exchange for new value" defense, which allows creditors to reduce their preference exposure to the extent of the value of goods or services provided to a debtor in non-credit transactions.

Elements of the Defense

The contemporaneous exchange for new value defense is found in Section 547 (c)(1) of the Bankruptcy Code, which states:

(c) The trustee may not avoid under this section a transfer--

(1) to the extent that such transfer was--

(A) Intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange.

To invoke the contemporaneous exchange for new value defense, the creditor must prove that it provided something of value to the debtor in a transaction which involved contemporaneous payment terms. With careful planning, proper execution, and an understanding of the requirements of the defense, this need not be a difficult task.

The debtor must receive goods or services with equivalent value to the payment received by the creditor. The Bankruptcy Code contains a specific definition of "new value," as that phrase is applied to preferences. New value includes:

* money;

* money's worth in goods, services, or new credit; or

* the release (or return) by the creditor of previously repossessed property.

Thus, a transaction which involves the same day purchase by a debtor of $1,000 of goods or services for $1,000 cash will almost certainly satisfy the new value requirement. However, the defense will only apply to the extent of the actual value of the goods or services provided by the creditor.

When a debtor pays $1,000 to a creditor in payment of $500 in new goods and $500 of old debt, the creditor will only receive a "contemporaneous exchange for the new value" defense to the extent of the $500 value of the new goods delivered.

Measure "Value" at Time of Payment

For purposes of the defense, the "value" of the goods or services provided by the creditor is measured as of the time of the debtor's contemporaneous payment and not as of the time of the bankruptcy. For example, if a wholesaler delivers $1,000 of goods to the debtor, the wholesaler should receive full credit for the wholesale price of the goods even if the goods are eventually liquidated by a trustee for a fraction of wholesale value.

Goods provided at grossly inflated prices may be valued by the court at their actual market value at the time of the sale. The burden of proving the value of the goods or services provided will be on the creditor.

Forbearance Is Not New Value

Mere forbearance by a creditor from exercising rights (such as a right to reclaim goods from an insolvent customer or withdraw future credit) does not qualify as new value. However, a return or release of goods which have been successfully reclaimed (in exchange for a payment) may indeed qualify as new value. The distinction is that in the first case, the creditor who fails to reclaim goods from a debtor does not really add anything new to the debtor's estate.

But the creditor who returns or releases goods to a debtor after a successful reclamation or repossession has augmented the debtor's estate. Congress made a policy judgment that creditors who augment a debtor's estate by transferring valuable assets or services to that estate in exchange for contemporaneous payment should not be subject to preference liability for those transactions. On the other hand, creditors who fail to contribute "money or money's worth" in goods and services will not receive special or more favorable treatment once bankruptcy ensues.

Contemporaneous Transactions

To qualify for the contemporaneous exchange for new value defense, the payment at issue must have been intended to be contemporaneous with the sale or with the provision of the services. Aside from the party's intent, the payment must actually be contemporaneous in fact. Thus, if a debtor agrees and intends to pay for a shipment of goods upon delivery, but fails to do so, the defense will not apply.

As stated by the courts, the purpose of the contemporaneous exchange for new value defense is to exempt transfers "which are essentially simultaneous" from later attack as preferences (see In re Laguna Beach Motors, Inc.). Cash transactions, including c.o.d. transactions, are essentially "simultaneous" and are therefore within the scope of the defense.

Credit transactions, even if the credit terms are short, are not eligible for this defense. Breached c.o.d. transactions are also not simultaneous and are ineligible for the defense.

What if the payment is by uncertified check? If the check is promptly deposited by the creditor and honored by the debtor's bank, the payment will be deemed to be contemporaneous even if the check actually takes several days to clear through the banking system.

Congress expressly noted, in its commentary issued at the time of the enactment of the contemporaneous exchange for new value defense, that a payment by a check which "is presented for payment in the normal course of affairs" will be considered to be "in fact substantially contemporaneous" with the provision of goods or services by the creditor (see H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 373-374, 1977).

On the other hand, if the customer's check is dishonored by its bank, the defense will fail. Congress expressly noted that a payment by check which is later dishonored will not qualify for the contemporaneous exchange of new value defenses. (See Rep. No. 95-989, 95th Cong., 2d Sess. 88, 1978.) The courts have held that this rule applies even if the debtor later makes the check good (See In re Barefoot). The moral is that when your customer's check bounces, it may be time to consider implementing cash in advance terms. Cash in advance payments will usually qualify for the subsequent new value defense which was highlighted in the June 1993 issue of Business Credit.

Creditors Asked to Help Struggling Businesses

Preference defenses were enacted to encourage creditors to continue to do business with struggling debtors in the hope that with time and patience by all concerned, some bankruptcies may be avoided. Knowledge of the preference defenses which are available and an understanding of how they work are essential to any attempt to support a struggling customer, without subjecting your company to an undo amount of potential preference liability.

Any error in the pre-bankruptcy implementation of terms, which may trigger a preference defense, may be fatal to the defense. But with proper advance planning and vigilance, you can take the necessary pre-bankruptcy steps to invoke one or more of the defenses, and thereby minimize the degree of bankruptcy risk which your company may face in its commercial dealings.

Bruce Dopke concentrates his practice in commercial law and bankruptcy litigation and issues is associated with the firm of Holleb & Coff, Chicago, Ill. Pia Norman, who assisted in this article, is a third-year law student at the University of Michigan Law School.
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Title Annotation:Legal Brief
Author:Dopke, Bruce
Publication:Business Credit
Date:Sep 1, 1993
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