On June 7, 2007, the U.S. Court of Appeals for the Third Circuit issued a decision in the In re Hechinger Investment Company case holding that the "contemporaneous exchange for new value" defense to preference claims can apply even if the payments were made in the context of a credit arrangement. The key is whether the parties intended the payments involved to be contemporaneous exchanges for new value, the linchpin of this particular preference defense. A copy of the Third Circuit’s decision is available here.

Bankruptcy Preferences. As a reminder, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

The Contemporaneous Exchange Defense. This defense, found in Section 547(c)(1) of the Bankruptcy Code, is short and to the point:

(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.

In interpreting this language, the Bankruptcy Court held that a "credit relationship is inconsistent with the intent required in order to sustain" the defense. Essentially, under its view the defense would presumably be limited to situations in which no credit was allowed to remain outstanding but instead a C.O.D. purchase or other similarly immediate "goods for cash" swap was involved.

The Third Circuit’s Focus On Intent. The Third Circuit reversed the Bankruptcy Court’s ruling, explaining its reasoning as follows:

The Bankruptcy Court found that the disputed transfers were not intended by the parties to be contemporaneous exchanges because the transfers were credit transactions. In reaching this result, the Court relied upon several factually distinguishable cases, none of which stand for the proposition that parties can never intend credit transactions to be contemporaneous exchanges under § 547(c)(1)(A). We disagree with the Bankruptcy Court’s conclusion. Indeed, it would appear that § 547(c)(1) covers little other than credit transactions. The § 547(c)(1) defense applies only to transfers that the debtor has shown are payments on an “antecedent debt” under § 547(b). See 11 U.S.C. § 547(b)(2) (definition of avoidable transfers). If there is no delay between when the debt arises and payment of the obligation, then the transfer is outside the scope of § 547(b), and § 547(c)(1) is not implicated. The existence of a delay between the creation of a debt and its payment is a hallmark of a credit relationship, which is, by definition, a relationship in which the creditor entrusts the debtor with goods without present payment. OXFORD ENGLISH DICTIONARY (2d ed. 1989) (defining “credit” as “[t]rust or confidence in a buyer’s ability and intention to pay at some future time, exhibited by entrusting him with goods, etc. without present payment.”).

We do not think that the District Court’s interpretation of the Bankruptcy Court’s order – namely, as concluding that the parties intended to have a credit relationship – necessarily resolves the question. The inquiry still remains: even if a credit relationship was intended, was it nonetheless their intent that the ongoing payments would be contemporaneous exchanges for new value? A court may find the parties intended a contemporaneous exchange for new value even when the transaction is styled as a “credit” transaction. See In re Payless Cashways, Inc., 306 B.R. 243 (8th Cir. BAP 2004), aff’d, 394 F.3d 1082 (8th Cir. 2005). The question is one of intent, and although a delay between the incurrence of the debt and its payment can evidence that the exchange was not intended to be contemporaneous, the passage of time does not necessarily negate intent.

(Footnotes omitted.)

The Bottom Line. Under this decision, a contemporaneous exchange defense to a preference is available even if the defendant has extended credit to the debtor. Nevertheless, to prevail the defendant will have to prove that it and the debtor actually intended the payments to be contemporaneous exchanges for new value and they were, in fact, substantially contemporaneous with the exchange of goods or services.

A Final Note. The Third Circuit decision covered other issues as well, including the ordinary course of business defense and whether prejudgment interest is available for preference claims. For more on those issues, plus a copy of the Bankruptcy Court’s decision below, be sure to read the detailed post on the case by the Delaware Business Bankruptcy Report.

On June 4, 2007, the U.S. Court of Appeals for the Ninth Circuit brought some additional clarity to the earmarking defense to preference claims in its decision in Metcalf v. Golden, an adversary proceeding within the In re Adbox, Inc. Chapter 7 case. In this post, I’ll give a little background on preferences and the earmarking defense and then discuss how the defense works in the Ninth Circuit.

Preferences And Earmarking. Before reaching its decision on the earmarking issues, the Court set the legal context by discussing what preferences are and how earmarking can sometimes be a defense to a preference claim.

Under 11 U.S.C. § 547 the bankruptcy trustee may recover certain transfers made by the debtor within 90 days before filing for bankruptcy, if the trustee proves:

(1) a transfer of an interest of the debtor in property;

(2) to or for the benefit of a creditor;

(3) for or on account of an antecedent debt;

(4) made while the debtor was insolvent;

(5) made on or within 90 days before the date of the filing of the petition; and

(6) one that enables the creditor to receive more than such creditor would receive in a Chapter 7 liquidation of the estate.

In re Superior Stamp & Coin Co., Inc., 223 F.3d 1004, 1007 (9th Cir. 2000) (citing 11 U.S.C. § 547(b)). Such a transfer is known as an ‘avoidable preference’ or a ‘preferential transfer.’ Id. at 1007-09. The ‘earmarking doctrine’ is a courtmade exception to this rule that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor. Id.; In re Sierra Steel, Inc., 96 B.R. 271, 274 (B.A.P. 9th Cir. 1989). In such circumstances, the funds are deemed ‘earmarked’ and are not considered part the debtor’s estate. Sierra Steel, 96 B.R. at 274.

For more information on preferences, and some tips on how creditors can protect themselves when dealing with a financially troubled customer, you may find this post of interest.

Is Earmarking An Affirmative Defense? One previously unresolved issue involving the earmarking defense was whether it is a true "affirmative defense," which would mean that to assert it a preference defendant would have to include it in its answer to the preference complaint. In Metcalf, the Ninth Circuit said no:

Earmarking is not one of the affirmative defenses enumerated in Rule 8, and we decline to construe it as such under Rule 8’s residuary clause for ‘any other matter constituting an avoidance or affirmative defense.’ Properly understood, the earmarking doctrine is not an affirmative defense under Rule 8, but rather a challenge to the trustee’s claim that particular funds are part of the bankruptcy estate under 11 U.S.C. § 547. See Libby Int’l., 247 B.R. at 467 [In re Libby Int’l., Inc., 247 B.R. 463 (B.A.P. 8th Cir. 2000)]. Thus, the Metcalfs did not waive their earmarking defense by failing to plead it in their answer in the preference action.

Who Has The Burden Of Proof? With the affirmative defense issue out of the way, the Ninth Circuit then tackled the even more important question of whether the trustee or the defendant has the burden of proof on the earmarking defense. The Court held that although the trustee has the burden to prove that the funds at issue came from the debtor’s account, the real burden of proof to establish the actual earmarking defense shifts back to the defendant:

As the district court noted, there is ‘substantial confusion’ over who bears the burden of proof on an earmarking defense. The Ninth Circuit Bankruptcy Appellate Panel addressed this question in Sierra Steel, where it denied an earmarking defense because the defendant ‘ha[d] not traced the funds to money received by the debtor from [the lender].’ 96 B.R. at 275. While the Sierra Steel court started from the general principal that the trustee has the burden of establishing that property is part of the bankruptcy estate, it also noted that the funds in question were disbursed from the defendant’s general account. Id. at 274 n.5. The source of the funds raised the presumption that the funds were property of the bankruptcy estate and the burden of proof accordingly shifted from the trustee—to establish that the funds were part of the estate —to the defendant—to show that they were not. Id. (citing In re Bullion Reserve of N. Am., 836 F.2d 1214, 1217 n.3 (9^th Cir. 1988)).

We follow well-established law in holding that the trustee bears the initial burden of establishing that a transfer is an avoidable preference under § 547. See Sierra Steel, 96 B.R. at 274. If, however, the trustee establishes that the transfer of the disputed funds was from one of the debtor’s accounts over which the debtor ordinarily exercised total control, we follow the approach of Sierra Steel and find that the trustee makes a preliminary showing of an avoidable transfer “of an interest of the debtor” under § 547(b). The burden then shifts to the defendant in the preference action to show that the funds were earmarked.

In the Metcalf case, the Court ultimately held that the defense was not established. The defendants could not prove the existence of an agreement between the debtor and the lender that had advanced the funds requiring them to be paid to the defendants. Since the debtor could have used those funds for another purpose, the payment to the defendants was a preferential transfer from the debtor’s estate.

Where Does This Leave The Earmarking Defense? The Ninth Circuit’s decision reaffirmed the existence of the earmarking defense and resolved two important procedural questions about how the defense may be asserted. The decision also highlighted the level of proof needed to make a successful earmarking defense. If a creditor is getting paid with loaned funds and hopes to use the defense, it should make sure that there is an actual agreement requiring the debtor to use the newly loaned funds to pay that creditor. Without proof of such an actual agreement, the earmarking defense will fail.