December 30, 2005

Should the Minority Rule: Must New Value Under Section 547(c)(4) Remain Unpaid?

Holland & Knight Newsletter
Richard E. Lear

Section 547(b) of the Bankruptcy Code, 11 U.S.C. §§ 101 et seq., accords a bankruptcy trustee broad authority to avoid as a preference a wide array of transfers made by a debtor to a creditor on or within 90 days prior to the filing of the debtor’s bankruptcy case if the debtor was insolvent and so long as the other requirements of section 547(b) are satisfied. A transfer of the debtor’s property may not be avoided as a preference, however, if the trustee is unable to prove that the requirements of section 547(b) are met or if one of the nine exceptions under section 547(c) applies. One of the affirmative defenses to avoiding a transfer of a debtor’s interest in property as a preference is the subsequent new value defense under section 547(c)(4).

Subsequent New Value Under Section 547(c)(4)

Section 547(c)(4) of the Bankruptcy Code provides that a bankruptcy trustee may not avoid a transfer of a debtor’s interest in property if, after receipt of the allegedly preferential transfer, the creditor gave new value to or for the benefit of the debtor which new value was not secured by an otherwise unavoidable security interest and “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) (emphasis added).

This section was clearly intended by Congress to apply to revolving credit relationships. See Nimmer, Security Interests in Bankruptcy: An Overview of Section 547 of the Code, 17 HOUS.L.REV. 289, 299 (1980). Two policy considerations support this exception to preferences: (i) without the exception, a creditor who extends credit to the debtor, perhaps in implicit reliance on prior payments, would merely be increasing its bankruptcy loss; and (ii) the limited protection provided by the subsequent advance rule encourages creditors to continue their revolving credit arrangements with financially troubled debtors, potentially helping the debtor to avoid bankruptcy altogether. Id. at 300-01.

This seemingly straightforward policy has proven to be complicated in application. That this section contains a double-negative has, in the view of some, led to confusion in applying the exception. See Boyd v. The Water Doctor (In re Check Reporting Srvs., Inc.) 140 B.R. 425, 434 (Bankr. W.D. Mich. 1992). Although the reason for the confusion may not be clear, it is clear that a dispute has split the circuit courts as to whether the subsequent new value must remain unpaid in order for the creditor to avail itself of the subsequent new value defense. The majority of circuit courts and the lower courts considering the issue have determined that if the new value is subsequently paid for by the debtor, the creditor may not assert section 547(c)(4) in defense of the preference. Kroh Bros. Dev. Co. v. Continental Constr. Eng’rs, Inc. (In re Kroh Bros. Dev. Co), 930 F.2d 648, 653 (8th Cir. 1991)1; New York City Shoes, Inc. v. Bentley Int’l, Inc. (In re New York City Shoes, Inc.), 880 F.2d 679, 680 (3d Cir. 1989); Charisma Invest. Co., N.V. v. Airport Sys., Inc. (In re Jet Florida Sys., Inc.), 841 F.2d 1082, 1083 (11th Cir. 1988) (per curiam); In the Matter of Prescott, 805 F.2d 719, 731 (7th Cir. 1986); GGSI Liquidation, Inc. v. Quad-Tech, Inc. (In re GGSI Liquidation, Inc.), 313 B.R. 770, 778 (Bankr. N.D. Ill. 2004). More recently, there is an emerging trend of courts, including three circuits, the Fourth, Fifth and Ninth, which have rejected the majority view, resulting in a split of the circuits on this issue. Chrysler Credit Corp. v. Hall (In re JKJ Chevrolet, Inc.), 412 F.3d 545, 552 (4th Cir. 2005); Mosier v. Ever-Fresh Food Co. (In re IRFM, Inc.), 52 F.3d 228, 232 (9th Cir. 1995); Laker v. Vallette (In the Matter of Toyota of Jefferson, Inc.), 14 F.3d 1088, 1093 (5th Cir. 1994).

The Majority View

In the view of the courts espousing the majority view, by advancing new value, the creditor has replenished the debtor’s estate so that there has been no overall diminution of the estate to the prejudice of other creditors. Kroh Bros. Dev., 930 F.2d at 652. In the view of these courts, however, if the debtor pays for the new value, the creditor has not replenished the estate but has unfairly diminished the debtor’s estate. See id. at 652-53. Consequently, those courts following the majority view have taken a shorthand approach to section 547(c)(4), stating that “[t]his section has generally been read to require: (1) that the creditor must have extended the new value after receiving the challenged payments; (2) that the new value must have been unsecured; and (3) that the new value must remain unpaid.” Jet Florida, 841 F.2d at 1083 (emphasis added).

By paraphrasing section 547(c)(4), the courts following the majority view are both reading the word “paid” into the statute, which is not there, and they are eliminating language from the statute that, although unclear, expresses a concept which is being ignored in these courts’ shorthand approach to section 547(c)(4). Section 547(c)(4)(B) does not provide that the new value remain unpaid, but, instead, requires that the debtor “not make an otherwise unavoidable transfer” on account of the new value. 11 U.S.C. § 547(c)(4)(B). By taking this approach, the courts espousing the majority view are ignoring the binding requirement that they must apply the plain meaning of the statutory language, unless doing so “will produce a result demonstrably at odds with the intentions of its drafters.” United States v. Ron Pair Enters., Inc., 489 U.S. 235, 242, 109 S.Ct. 1026, 1031 (1989). For the reasons stated below, a literal application of section 547(c)(4)(B) would not produce such a result.

The Emerging View, or a Vote for Plain Meaning

The Fourth Circuit is the latest circuit to take a position on whether new value must remain unpaid in order for section 547(c)(4) to be applicable as a defense against an effort to avoid a transfer as a preference. In JKJ Chevrolet, the Fourth Circuit agreed with the district court (which had reversed the bankruptcy court) and concluded that “[a] creditor is entitled to offset preference payments through the extension of new value to the debtor so long as the debtor does not make an otherwise unavoidable transfer on account of the new value.” JKJ Chevrolet, 412 F.3d at 552 (emphasis in original). In so ruling, the Fourth Circuit agreed with the Fifth Circuit and the Ninth Circuit that the issue in applying section 547(c)(4) was not whether the new value remained unpaid, but rather, whether the new value has been paid for by “an otherwise unavoidable transfer.” See IRFM, 52 F.3d at 231; Toyota of Jefferson, 14 F.3d at 1093 n.2. This inquiry follows the same rationale taken by the courts following the majority view, but instead of barring the defense if the new value is repaid, “this approach allows the new value defense if the trustee can recover the repayment by some other means.” IRFM, 52 F.3d at 231. As explained by the Ninth Circuit, this approach fully comports with the statute’s plain language. Id. “While the phrase ‘the debtor did not make an otherwise unavoidable transfer’ is complicated, it is not ambiguous and its meaning is easily discernible.” Id.

As one noted commentator has explained:

If the debtor has made payments for goods or services that the creditor supplied on unsecured credit after an earlier preference, and if these subsequent payments are themselves voidable as preferences (or on any other ground), then under section 547(c)(4)(B) the creditor should be able to invoke those unsecured credit extensions as a defense to the recovery of the earlier voidable preference. On the other hand, the debtor’s subsequent payments might not be voidable on any other ground and not voidable under section 547, because the goods and services were given C.O.D. rather than on credit, or because the creditor has a defense under section 547(c)(1), (2) or (3). In this situation, the creditor may keep his payments but has no section 547(c)(4) defense to the trustee’s action to recover the earlier preference. In either event, the creditor gets credit only once for goods and services later supplied.

Countryman, The Concept of a Voidable Preference in Bankruptcy, 38 Vand.L.Rev. 713, 788 (1985) (emphasis added and footnotes omitted).

The circuit courts that disagree with the majority view not only follow the Supreme Court’s directive that they apply the plain meaning of section 547(c)(4), but also thoughtfully consider how following the plain meaning of the statutory language will be consistent with the purpose of the statute. See, e.g., IRFM, 52 F.3d at 232; Toyota of Jefferson, 14 F.3d at 1091-92. In contrast, the decisions of the circuits which follow the majority rule state the axiom “new value must remain unpaid” as shorthand for the statutory language, in dicta, or to the extent these decisions represent the holdings of the circuits, without an application of the plain meaning of the statutory language. See Kroh Bros. Dev., 930 F.2d at 651-52; New York Shoes, 880 F.2d at 680; Jet Florida at 1083; Prescott, 805 F.2d at 728.

In addition to its consistency with the plain language of section 547(c)(4), the emerging view better satisfies the policy considerations supporting this exception to preferences. While considering the trustee’s argument for the majority view, the Ninth Circuit observed that:

The rule for which [the Trustee] argues would discourage creditors from having any dealings with a financially troubled debtor. For instance, [Creditor] could have sold the goods to another purchaser and been able to retain the payment for those goods. Instead, [Creditor] would not only be required to forfeit all payments made by IRFM during the preference period, but [Creditor] would also lose the new value extended to the debtor. [The Trustee’s] rule also makes the creditor worse off vis-à-vis the other creditors. By refusing to permit the creditor to receive some benefit for the transfer of new value, the [majority view] would put the creditor in a worse position than those creditors who chose not to deal with the debtor.

IRFM, 52 F.3d at 233 (emphasis in original); see also JKJ Chevrolet, 412 F.3d at 553 (“A creditor is entitled to offset preference payments through the extension of new value to the debtor so long as the debtor does not make an otherwise avoidable transfer on account of the new value.”) (emphasis in original).

Further, under the majority rule, the bankruptcy trustee recovers the same amount twice; the creditor loses both the payment received and the new value. This double-hit is illustrated by the following hypothetical.

Assume that a debtor pays a creditor $50,000 on open account. Subsequently, the creditor ships $20,000 in goods to debtor on an unsecured basis. Thereafter, debtor pays creditor $20,000. After this second payment, creditor advances additional new value to debtor in the form of another $30,000 in goods. After receipt of this second shipment, debtor files bankruptcy. All of the foregoing transactions occurred within the 90-day preference period.

Under the majority view, because the new value must remain unpaid under section 547(c)(4), the $20,000 shipment can not be used to offset the $50,000 payment because the debtor paid for that shipment. Because the second shipment of $30,000 worth of goods was not paid for, this shipment would qualify as subsequent new value available to reduce the preference. Accordingly, the amount of the preference would be $40,000 (($50,000 + $20,000) - $30,000). Under the majority view, the creditor losses both the $20,000 that debtor paid and the $20,000 in goods shipped to debtor.

Under the emerging view, the creditor can assert subsequent new value as a defense even if the new value is paid for so long as that payment is subject to being avoided as a preference (or otherwise). Accordingly, the amount of the preference would be $20,000 (($50,000 + $20,000) – ($20,000 + $30,000)), assuming that the $20,000 payment made by debtor is subject to being avoided, although it need not actually be avoided as long as the payment could have been avoided. See JKJ Chevrolet, 412 F.3d at 552. Here, because the $20,000 payment is avoidable, the creditor is entitled to claim the new value as a setoff against the preference. If the $20,000 payment was not avoidable, the creditor is allowed to keep the $20,000 payment, but the creditor would have no subsequent new value defense to the earlier preference.


Of the seven circuit courts to consider the issue, four circuits (the Third, Seventh, Eighth and Eleventh) have pronounced a rule that subsequent new value must remain unpaid in order for section 547(c)(4) to be available as a preference defense while three circuits (the Fourth, Fifth and Ninth) have concluded that the issue is not whether the new value remains unpaid, but whether the payment of the new value is, itself, avoidable. Although the minority view, the position advanced by the Fourth, Fifth and Ninth Circuits is more consistent with the plain language of the statute and supports the policy considerations underlying section 547(c)(4). In contrast, the circuit court decisions which promote the majority view’s axiom that “new value must remain unpaid” enunciate this standard as inexact shorthand for section 547(c)(4)(B), generally expressed in dicta without the benefit of any analysis or consideration of either the plain language of the statute or the underlying policies supporting the subsequent new value defense. Although the existing dispute among the circuits may not be resolved, if ever, until the Supreme Court considers the requirements of section 547(c)(4), there can be no doubt as to which view better abides by the Supreme Court’s admonition on statutory construction and better carries out the policies underlying Congress’ enactment of the statute.

1 In a subsequent decision, Jones Truck Lines, Inc. v. Central States, Southeast and Southwest Areas Pension Fund (In re Jones Trucking Lines, Inc.), 130 F.3d 323, 328-29 (8th Cir. 1997), the Eighth Circuit distinguished its prior decision in Kroh Bros. Dev., while stating in dicta that new value that had been repaid by debtor by avoidable transactions could be used to offset a preference under section 547(c)(4).

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