The 547(c)(4) New Value Defense: Paid or Unpaid

The Unpaid Approach

As of this writing, there remain a select group of circuits that ostensibly require that subsequent new value remain unpaid, without exception. The leading cases in this regard are found in the Third, Seventh, and Eleventh Circuits. See generally, In re New York City Shoes, Inc. 880 F.2d 679; In re Prescott, 805 F.2d 719; In re Jet Florida Sys., Inc., 841 F.2d 1082. Although none of these cases dealt directly with the issue of paid new value, each court generally recited the same three prong test for evaluating a new value defense: 1) first, the creditor must give unsecured new value; 2) second, this new value must be given after the preferential transfer; and 3) third, the new value must remain unpaid. In re New York City Shoes, 880 F.2d at 680 (addressing timing requirements for advance of new value); In re Prescott, 805 F.2d at 731 (requiring that subsequent new value be unsecured); In re Jet Florida Sys., 841 F.2d at 1083; Kroh Bros. Dev. Co. v. Continental Constr. Eng'rs., Inc. (In re Kroh Bros. Dev. Co.), 930 F.2d 648 (8th Cir. 1991) (new value must be unpaid by the debtor.) Nonetheless, cases and decisions that have followed in these circuits have been loath to deviate from what those courts perceive to be the law of the circuit: new value must remain unpaid. See GGSI Liquidation v. Quad-tech, Inc. (In re GGSI Liquidation, Inc.), 313 B.R. 770, 777 (Bankr. N.D. Ill. 2004) (“In Prescott, the court of appeals expressly declared that 'section 547(c)(4) establishes a subsequent advance rule whereby a preferential transfer is insulated from a trustee's avoiding powers to the extent that a creditor extends new value, which is unsecured and remains unpaid.'”).

These decisions have been rightly criticized on the grounds that there is no express requirement in ' 547(c)(4) that requires subsequent new value to “remain unpaid.” Indeed, a review of the statutory language itself confirms this conclusion ' nowhere does ' 547 require that subsequent new value remain unpaid. Rather, for the defense to apply, the only statutory requirement is that any payment by the debtor on account of new value is not may not be “an otherwise unavoidable transfer.” 11 U.S.C. ' 547(c)(4)(B). Boyd v. The Water Doctor (In re Check Reporting Services, Inc.), 140 B.R. 425 (Bankr. W.D.Mich. 1992) (applying the plain meaning approach and holding that the strictly requiring subsequent new value to remain unpaid “glosses over the statutory language creating the caveat.”).

The Plain Meaning Approach

Contrary to the unpaid approach, which interprets the confusing language of ' 547(c)(4)(B) to require that new value remain unpaid, the plain meaning approach focuses solely on express language of the statute. Therefore, under the plain meaning approach, the proper inquiry is not whether the new value has been paid but, rather, “whether the new value has been paid by 'an otherwise unavoidable transfer.'” Mosier v. Ever-Fresh Food Co. (In re IRFM, Inc.) 52 F.3d 228, 231 (9th Cir. 1995) (citations omitted). “[I]nstead of barring a new value defense altogether anytime new value has been repaid, [the plain meaning] approach allows the new value defense if the trustee can recover the repayment by some other means.” Id. The approach as set for the by the Ninth Circuit in IRFM has also been adopted by the Fifth Circuit and several other bankruptcy courts. See, e.g., In re Toyota of Jefferson, Inc., 14 F.3 at 1093; Brown v. Shell Canada, Ltd. (In re Tennessee Co.), 159 B.R. 501, 518 (Bankr.E.D.Tenn.1993); Successor Comm. of Creditors Holding Unsecured Claims v. Bergen Brunswig Drug Co. (In re Ladera Heights Community Hosp., Inc.), 152 B.R. 964, 967-68 (Bankr.C.D.Cal.1993); Hyman v. Stone Lumber Co. (In re Winter Haven Truss Co.), 154 B.R. 592, 596 (Bankr.M.D.Fla.1993); Allied Companies, Inc. v. Broughton Foods Co. (In re Allied Companies, Inc.), 155 B.R. 739, 743-44 (Bankr.S.D.Ind.1992); In re Check Reporting Services, 140 B.R. at 432, 439.

The courts that have adopted the plain meaning approach have eschewed the unpaid requirement in deference to the plain meaning of the statute. Instead, these courts focus on the net effect of the paid new value on the estate to determine whether the new value may be used as a defense to the subject preference action. The following example highlights the differences between the two and the obvious appeal that the plain meaning approach has in such circumstances. On Jan. 1, at the beginning of the 90-day preference period, debtor D is indebted to creditor C for $100. On Jan. 15, D pays C $100 via an avoidable transfer. On Jan. 30, C advances $100 of new value to D. On Feb. 15, D pays C for the Jan. 30 transfer via a second avoidable transfer. Under the strict unpaid approach, because the new value was subsequently paid, it could not be asserted as a defense to the transfers and the C's preference exposure would be $200, notwithstanding the fact that the estate was only net depleted by $100 during the preference period. See Table 1, below. Under the plain meaning approach, the new value advanced by C on Jan. 30, although paid, is still applicable to its defense because the payment in satisfaction of that new value was itself avoidable. See Table 2, below. As a result, C's preference exposure would be $100, the exact amount that D's estate was depleted as a result of all of the transfers during the preference period.

Courts adopting the plain meaning approach have done so with the belief that requiring new value to remain unpaid regardless of the avoidability of the subsequent payment contravenes the purpose of preference statute (i.e., to ensure that the estate is not unfairly depleted for the benefit of select creditors during the run up to bankruptcy) and the purpose of the new value defense under section 547(c)(4) (i.e., to encourage creditors to continue to extend credit to financially distressed entities) and results in a windfall to the estate (i.e., preference claims that exceed the actual amount the estate has been depleted). See In re Toyota of Jefferson, Inc. at 1091.

The Replenishment Approach

The replenishment approach, similar to the plain meaning approach, also evaluates a new value defense by considering the overall effect of the preference and the subsequent new value advances on the estate. See In re Kroh Bros. Dev. Corp., 930 F.2d at 652 (“Thus, the relevant inquiry under section 547(c)(4) is whether the new value replenishes the estate.”). See also In re Florida Jet Sys., 841 F.2d at 1083 (holding that the debtor who makes a preferential transfer to a creditor who subsequently advances new value, then, has not “depleted the bankruptcy estate to the disadvantage of other creditors.”).

The replenishment approach closely resembles the plain meaning approach and when third party payments are not implicated, actually results in the same outcome. Using the example above, under the replenishment approach, C's Jan. 30 transfer of new value would be considered to have replenished the estate on account of the Jan. 15 avoidable transfer, leaving C's net preference exposure (and the net effect of the transfers on the estate) as of that date at $0.00. The subsequent Feb. 15 payment of $100 transfers would then be treated as having depleted the estate, leaving the estate depleted by $100 and C with a preference exposure of $100. See Table 3 below.

Under these circumstances, the results under the plain meaning approach and the replenishment approach are identical. Compare Table 2 and Table 3, below.

Why, then, do we need the replenishment approach? The answer is simple. The plain meaning approach cannot address the implications of new value that is paid by a party other than the debtor (such as when a buyer of operating assets pays the pre-petition debt owed to creditors with whom it will continue to do business) in a way that comports with the purposes underlying section 547. Under the plain meaning approach, the only time that new value may not be used is if “on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.” 11 U.S.C. ' 547(c)(4)(B) (emphasis added). See also In re Check Reporting Services, 140 B.R. at 434-435 (discussing at length and unwinding the “double negative” language employed in
' 547(c)(4)(B)).

Under the plain meaning approach, therefore, payments made by third parties on account of new value received by the debtor would never preclude assertion of a new value because such payments are, by definition, not made by the debtor. In this regard, the plain meaning decisions all suffer from what ails the decisions that require that new value remain unpaid: the operative facts in those cases do not implicate the issue. See In re Check Reporting Services 140 B.R. 425 at 433. By contrast, the replenishment approach does not focus on the source of the payment but on the effect of the transfers on the debtor's estate.

Expanding on the example discussed above, suppose that the Feb. 15 payment was made by a third party, T, with rights of recoupment from D, rather than D itself. Under the plain meaning approach, C would be entitled to assert a new value defense for the Jan. 30 transfer and its preference exposure would be $0.00, notwithstanding the fact that the estate has been depleted by $100 on account of T's recoupment claim. Under the replenishment approach, however, the court considers the fact that the T maintains a claim against the estate and denies C's asserted new value on the basis that the new value failed to replenish the estate. In re Kroh Bros. Dev. Corp., 930 F.2d at 652. Thus, under the same circumstances, the replenishment approach would deny C's assertion of the new value defense to the extent that T maintains a claim against the estate, resulting in a potential preference liability for C of $100 (i.e., the same amount the estate has actually been depleted). Alternatively, if the payment of the new value by T did not result in a claim against the estate, the replenishment approach would allow C to assert the new value defense because D's estate would have been replenished by the new value advanced and not otherwise depleted by T's payment.

Conclusion

For the reasons explained above, these authors believe that, when compared with the unpaid and plain meaning approaches, the replenishment approach provides the best and most equitable method for determining the availability of subsequent new value defenses under ' 547(c)(4). The replenishment approach, by focusing on the net effect of the transfers on the estate, is the most accurate of the three alternatives to achieve the purpose behind the preference statute, to ensure the equality of treatment among similarly situated creditors, and the purpose behind the subsequent new value defense, to encourage creditors to continue to extend credit to financially troubled debtors.

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Brian L. Shaw ([email protected]) is a partner and Patrick A. Clisham ([email protected]) is an associate in the Business Insolvency Group at Chicago's Shaw Gussis Fishman Glantz Wolfson & Towbin LLC. They may be reached at 312-541-0151.

It will come as no surprise that there is a long-standing split of authorities among the courts concerning whether or not subsequent new value must remain unpaid for the purposes of ' 547(c)(4). The courts that have addressed the issue over the years have generally fallen into three categories: 1) those that steadfastly require that any new value advanced remain unpaid; 2) those that apply a plain-meaning approach to ' 547(c)(4) and thus believe that the only consideration should be whether the new value is subsequently paid by the debtor by a subsequent avoidable transfer; and 3) those that analyze the effect of the transfers and the new value on the estate to determine if the estate has actually been replenished by the asserted new value, regardless of whether the new value remains unpaid. Currently, those courts requiring that new value remain unpaid are in the majority. More recently, however, an increasing number of decisions, many of which actually analyze the issue rather than summarily reach a decision without analysis or explanation, favor the plain-meaning or replenishment approaches. The importance of the approach used by the court in which a preference defendant finds itself is emphasized by the divergent outcomes that could result under the three approaches. This article briefly reviews the three approaches and makes the case that the replenishment approach is both true to the plain language of ' 547(c)(4), and the most effective approach to accomplish the purposes underlying both ' 547 avoidance actions and the statutory defenses thereto.

Section 547(c)(4)

Section 547 of the Bankruptcy Code provides the vehicle by which a trustee or debtor in possession may avoid preferential transfers to creditors made within the 90 days immediately preceding the debtor's bankruptcy petition date. 11 U.S.C.
' 547. Section 547(c)(4) provides that:

The trustee may not avoid under this section a transfer '

(4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor ' (A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor ' 11 U.S.C. ' 547(c)(4).

Courts generally agree that the principal objectives behind ' 547 are to promote equality of treatment among similarly situated creditors and to encourage creditors to continue to extend credit to financially troubled debtors. Indeed, these underlying principals are routinely cited by courts regardless of their approach to paid new value. See New York City Shoes, Inc. v. Bentley Int'l., Inc. (In re New York City Shoes, Inc.), 880 F.2d 679, 680-681 (3d Cir. 1989); Laker v. Vellette (In re Toyota of Jefferson, Inc.) 14 F.3d 1088, 1091 (5th Cir. 1994); In re Prescott, 805 F.2d 719, 728 (7th Cir. 1986); Charisma Investment Co., N.V. v. Airport Sys., Inc. (In re Jet Florida Sys., Inc.), 841 F.2d 1082, 1083 (11th Cir. 1988). The split of authorities among the circuits has primarily resulted from the courts' interpretation of, or refusal to interpret altogether, the awkward language in 547(c)(4)(B), which requires that for the new value defense to be available “the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor” on account of such new value. 11 U.S.C. ' 547(c)(4)(B).

The Unpaid Approach

As of this writing, there remain a select group of circuits that ostensibly require that subsequent new value remain unpaid, without exception. The leading cases in this regard are found in the Third, Seventh, and Eleventh Circuits. See generally, In re New York City Shoes, Inc. 880 F.2d 679; In re Prescott, 805 F.2d 719; In re Jet Florida Sys., Inc., 841 F.2d 1082. Although none of these cases dealt directly with the issue of paid new value, each court generally recited the same three prong test for evaluating a new value defense: 1) first, the creditor must give unsecured new value; 2) second, this new value must be given after the preferential transfer; and 3) third, the new value must remain unpaid. In re New York City Shoes, 880 F.2d at 680 (addressing timing requirements for advance of new value); In re Prescott, 805 F.2d at 731 (requiring that subsequent new value be unsecured); In re Jet Florida Sys., 841 F.2d at 1083; Kroh Bros. Dev. Co. v. Continental Constr. Eng'rs., Inc. (In re Kroh Bros. Dev. Co.), 930 F.2d 648 (8th Cir. 1991) (new value must be unpaid by the debtor.) Nonetheless, cases and decisions that have followed in these circuits have been loath to deviate from what those courts perceive to be the law of the circuit: new value must remain unpaid. See GGSI Liquidation v. Quad-tech, Inc. (In re GGSI Liquidation, Inc.), 313 B.R. 770, 777 (Bankr. N.D. Ill. 2004) (“In Prescott, the court of appeals expressly declared that 'section 547(c)(4) establishes a subsequent advance rule whereby a preferential transfer is insulated from a trustee's avoiding powers to the extent that a creditor extends new value, which is unsecured and remains unpaid.'”).

These decisions have been rightly criticized on the grounds that there is no express requirement in ' 547(c)(4) that requires subsequent new value to “remain unpaid.” Indeed, a review of the statutory language itself confirms this conclusion ' nowhere does ' 547 require that subsequent new value remain unpaid. Rather, for the defense to apply, the only statutory requirement is that any payment by the debtor on account of new value is not may not be “an otherwise unavoidable transfer.” 11 U.S.C. ' 547(c)(4)(B). Boyd v. The Water Doctor (In re Check Reporting Services, Inc.), 140 B.R. 425 (Bankr. W.D.Mich. 1992) (applying the plain meaning approach and holding that the strictly requiring subsequent new value to remain unpaid “glosses over the statutory language creating the caveat.”).

The Plain Meaning Approach

Contrary to the unpaid approach, which interprets the confusing language of ' 547(c)(4)(B) to require that new value remain unpaid, the plain meaning approach focuses solely on express language of the statute. Therefore, under the plain meaning approach, the proper inquiry is not whether the new value has been paid but, rather, “whether the new value has been paid by 'an otherwise unavoidable transfer.'” Mosier v. Ever-Fresh Food Co. (In re IRFM, Inc.) 52 F.3d 228, 231 (9th Cir. 1995) (citations omitted). “[I]nstead of barring a new value defense altogether anytime new value has been repaid, [the plain meaning] approach allows the new value defense if the trustee can recover the repayment by some other means.” Id. The approach as set for the by the Ninth Circuit in IRFM has also been adopted by the Fifth Circuit and several other bankruptcy courts. See, e.g., In re Toyota of Jefferson, Inc., 14 F.3 at 1093; Brown v. Shell Canada, Ltd. (In re Tennessee Co.), 159 B.R. 501, 518 (Bankr.E.D.Tenn.1993); Successor Comm. of Creditors Holding Unsecured Claims v. Bergen Brunswig Drug Co. (In re Ladera Heights Community Hosp., Inc.), 152 B.R. 964, 967-68 (Bankr.C.D.Cal.1993); Hyman v. Stone Lumber Co. (In re Winter Haven Truss Co.), 154 B.R. 592, 596 (Bankr.M.D.Fla.1993); Allied Companies, Inc. v. Broughton Foods Co. (In re Allied Companies, Inc.), 155 B.R. 739, 743-44 (Bankr.S.D.Ind.1992); In re Check Reporting Services, 140 B.R. at 432, 439.

The courts that have adopted the plain meaning approach have eschewed the unpaid requirement in deference to the plain meaning of the statute. Instead, these courts focus on the net effect of the paid new value on the estate to determine whether the new value may be used as a defense to the subject preference action. The following example highlights the differences between the two and the obvious appeal that the plain meaning approach has in such circumstances. On Jan. 1, at the beginning of the 90-day preference period, debtor D is indebted to creditor C for $100. On Jan. 15, D pays C $100 via an avoidable transfer. On Jan. 30, C advances $100 of new value to D. On Feb. 15, D pays C for the Jan. 30 transfer via a second avoidable transfer. Under the strict unpaid approach, because the new value was subsequently paid, it could not be asserted as a defense to the transfers and the C's preference exposure would be $200, notwithstanding the fact that the estate was only net depleted by $100 during the preference period. See Table 1, below. Under the plain meaning approach, the new value advanced by C on Jan. 30, although paid, is still applicable to its defense because the payment in satisfaction of that new value was itself avoidable. See Table 2, below. As a result, C's preference exposure would be $100, the exact amount that D's estate was depleted as a result of all of the transfers during the preference period.

Courts adopting the plain meaning approach have done so with the belief that requiring new value to remain unpaid regardless of the avoidability of the subsequent payment contravenes the purpose of preference statute (i.e., to ensure that the estate is not unfairly depleted for the benefit of select creditors during the run up to bankruptcy) and the purpose of the new value defense under section 547(c)(4) (i.e., to encourage creditors to continue to extend credit to financially distressed entities) and results in a windfall to the estate (i.e., preference claims that exceed the actual amount the estate has been depleted). See In re Toyota of Jefferson, Inc. at 1091.

The Replenishment Approach

The replenishment approach, similar to the plain meaning approach, also evaluates a new value defense by considering the overall effect of the preference and the subsequent new value advances on the estate. See In re Kroh Bros. Dev. Corp., 930 F.2d at 652 (“Thus, the relevant inquiry under section 547(c)(4) is whether the new value replenishes the estate.”). See also In re Florida Jet Sys., 841 F.2d at 1083 (holding that the debtor who makes a preferential transfer to a creditor who subsequently advances new value, then, has not “depleted the bankruptcy estate to the disadvantage of other creditors.”).

The replenishment approach closely resembles the plain meaning approach and when third party payments are not implicated, actually results in the same outcome. Using the example above, under the replenishment approach, C's Jan. 30 transfer of new value would be considered to have replenished the estate on account of the Jan. 15 avoidable transfer, leaving C's net preference exposure (and the net effect of the transfers on the estate) as of that date at $0.00. The subsequent Feb. 15 payment of $100 transfers would then be treated as having depleted the estate, leaving the estate depleted by $100 and C with a preference exposure of $100. See Table 3 below.

Under these circumstances, the results under the plain meaning approach and the replenishment approach are identical. Compare Table 2 and Table 3, below.

Why, then, do we need the replenishment approach? The answer is simple. The plain meaning approach cannot address the implications of new value that is paid by a party other than the debtor (such as when a buyer of operating assets pays the pre-petition debt owed to creditors with whom it will continue to do business) in a way that comports with the purposes underlying section 547. Under the plain meaning approach, the only time that new value may not be used is if “on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.” 11 U.S.C. ' 547(c)(4)(B) (emphasis added). See also In re Check Reporting Services, 140 B.R. at 434-435 (discussing at length and unwinding the “double negative” language employed in
' 547(c)(4)(B)).

Under the plain meaning approach, therefore, payments made by third parties on account of new value received by the debtor would never preclude assertion of a new value because such payments are, by definition, not made by the debtor. In this regard, the plain meaning decisions all suffer from what ails the decisions that require that new value remain unpaid: the operative facts in those cases do not implicate the issue. See In re Check Reporting Services 140 B.R. 425 at 433. By contrast, the replenishment approach does not focus on the source of the payment but on the effect of the transfers on the debtor's estate.

Expanding on the example discussed above, suppose that the Feb. 15 payment was made by a third party, T, with rights of recoupment from D, rather than D itself. Under the plain meaning approach, C would be entitled to assert a new value defense for the Jan. 30 transfer and its preference exposure would be $0.00, notwithstanding the fact that the estate has been depleted by $100 on account of T's recoupment claim. Under the replenishment approach, however, the court considers the fact that the T maintains a claim against the estate and denies C's asserted new value on the basis that the new value failed to replenish the estate. In re Kroh Bros. Dev. Corp., 930 F.2d at 652. Thus, under the same circumstances, the replenishment approach would deny C's assertion of the new value defense to the extent that T maintains a claim against the estate, resulting in a potential preference liability for C of $100 (i.e., the same amount the estate has actually been depleted). Alternatively, if the payment of the new value by T did not result in a claim against the estate, the replenishment approach would allow C to assert the new value defense because D's estate would have been replenished by the new value advanced and not otherwise depleted by T's payment.

Conclusion

For the reasons explained above, these authors believe that, when compared with the unpaid and plain meaning approaches, the replenishment approach provides the best and most equitable method for determining the availability of subsequent new value defenses under ' 547(c)(4). The replenishment approach, by focusing on the net effect of the transfers on the estate, is the most accurate of the three alternatives to achieve the purpose behind the preference statute, to ensure the equality of treatment among similarly situated creditors, and the purpose behind the subsequent new value defense, to encourage creditors to continue to extend credit to financially troubled debtors.

[IMGCAP(1)]

[IMGCAP(2)]

Brian L. Shaw ([email protected]) is a partner and Patrick A. Clisham ([email protected]) is an associate in the Business Insolvency Group at Chicago's Shaw Gussis Fishman Glantz Wolfson & Towbin LLC. They may be reached at 312-541-0151.