Recent developments concerning the "subsequent advance" rule.
Not all transfers made within the preference period are avoidable. Congress has carved out seven exceptions to the trustee's recovery powers to protect transactions which replace value to the estate previously transferred. A majority of courts hold that section 547(c)(4) of the Bankruptcy Code embodies a subsequent advance rule, thereby excepting from avoidance those transfers to a creditor who subsequently extends goods or services (or credit for those goods or services) to the debtor.
For example, say on January 1 the debtor pays an unsecured creditor $10,000 for goods furnished. On February 1, the creditor provides the debtor an additional $10,000 in goods on open account (no purchase money security interest is taken in the goods). On March 1, the debtor files bankruptcy. The January 1 payment, made within 90 days before bankruptcy, is avoidable assuming that the criteria of section 547(b) were met. However, because the subsequent advance of goods replenished the estate, the subsequent advance rule permits the creditor to set off its February 1 advance against the preference. The creditor is left with an unsecured claim for $10,000.
The subsequent advance rule has its most frequent application with the pattern where a creditor provides goods or services on open account and the debtor repays at various points during the preference period. It is Congress' answer to protect the running account creditor. Under this analysis, a single transfer is not analyzed in isolation from the overall course of business between the creditor and debtor, as the basis for maintaining the open account is the debtor's entire financial picture and not the debtor's most recent payment.
The following policy objectives support the subsequent advance rule: (1) to encourage creditors to continue to extend credit to financially troubled debtors, possibly helping the debtor avoid bankruptcy; (2) to promote equality among creditors; and (3) to reward creditors who actually enhance the estate during the preference period. Without the exception, a creditor who continues to extend credit to the debtor would merely be increasing its bankruptcy loss and in effect be punished for continuing to work with the debtor.
A dispute has split courts as to whether the subsequent advance rule applies when the subsequent advance provided by the creditor has been repaid by the debtor, even if the repayment is itself an avoidable transfer. The issue breaks down to one where the debtor contends the creditor should receive subsequent advance credit only for those invoices that remain unpaid as of the bankruptcy filing, while the creditor contends it should receive credit for all subsequent advances made during the preference period, whether paid or unpaid as of the petition date.
Under the view adopted by a majority of courts, the subsequent advance must remain unpaid. The inquiry posed by these courts is whether the creditor replenished the estate after having received a preferential transfer. These courts equate replenishment with the subsequent advance providing the estate with a material benefit. A subsequent advance in an amount equal to the preference effectively returns the preference to the estate.
However, where a debtor pays the subsequent advance (or the creditor retains a security interest in the advance) there is no return of the preference and the estate is not benefitted.
Recently, a few courts have rejected the majority rule and hold that the subsequent advance need not remain unpaid to satisfy section 547(c)(4). These courts hold that section 547(c)(4) clearly requires only that the debtor not make an "otherwise unavoidable transfer" on account of that advance. Where the debtor does not make such an "otherwise unavoidable transfer," the subsequent advance should be available as a set-off against the preference. This means that a transfer could escape the definition of a voidable preference by failing to satisfy the elements of a preference or by falling within one of the seven preference exceptions. If the subsequent advance is met with a transfer to the creditor that is unavoidable, the subsequent advance is unavailable for offset.
These courts also articulate that the policy objectives supporting the subsequent advance rule are better met when the paid subsequent advance is not subject to avoidance. Providing the lenient creditor a set-off encourages the creditor to extend new credit.
Since a debtor controls the amount of a transfer made after a subsequent advance, to require that the subsequent advance remain unpaid would mean that the debtor could eliminate a section (c)(4) defense by making a large preferential transfer just prior to filing bankruptcy to pay for the subsequent advance. Moreover, under the majority rule, the trustee may recover the same amount twice; the creditor must both relinquish the payment received and lose the new credit extended.
The analysis employed by those courts adopting the minority viewpoint better meets the legislative objective of encouraging creditor support to financially strapped debtors which may permit debtors a further chance to solve their problems and possibly avoid the need of bankruptcy, while discouraging creditors from racing to the courthouse, because subsequent advances will not be penalized. Courts adopting the majority rule create a situation where a creditor extending further credit in reliance on prior payments faces an increased bankruptcy loss. The effect of this rule is that a creditor dealing with a debtor on open account will be unlikely to continue to deal with the debtor if virtually all of the debtor's payments are recoverable as preferences notwithstanding further shipments given by the creditor. For credit managers, the recent trend of courts to allow for creditors to offset their subsequent advances against preferences opens the door to limit their preference exposure.
Scott E. Blakeley is an associate in the Los Angeles office of Bronson, Bronson, & McKinnon where he practices bankruptcy and creditors' rights law. Excerpted from his article "Section 54 7(c)(4): Must the New Value Remain Unpaid?" to be published in the California Bankruptcy Journal.