Southern California Bankruptcy Law Blog

Preferential Transfers IV: Defenses to Preference Avoidance Actions (Part IV)

Posted in Chapter 11, Chapter 13, Chapter 7

Here is the fourth defense against preference avoidance actions, the so-called net result defense.

Defenses To Preference Avoidance Actions, Part IV:

The Net Result Defense

Suppose you borrowed $10,000 from ABC Bank.  After paying back ABC Bank the $10,000, you borrowed another $7,000 from ABC Bank.  And suppose you filed for bankruptcy protection less than ninety days after repaying the $10,000 to ABC Bank.  Can the trustee assigned to your case avoid the $10,000 payment as a preference?  The answer to this question is the point of § 547(c)(4):

The trustee may not avoid under this section a transfer — . . . 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.

Based on our discussion of § 547(b), we might conclude that the trustee can recover the entire $10,000.  However, § 547(c)(4) limits the recover to the net preference, which is $3,000.  Thus, while you repaid $10,000, the net benefit that ABC Bank derived from the transaction was only $3,000 because it gave you $7,000 after the repayment.

Put another way, when you paid the bank $10,000, your subsequent bankruptcy estate was diminished by $10,000.  When the bank later gave you $7,000, the subsequent bankruptcy estate was replenished by $7,000, leaving a net shortfall of $3,000.  Therefore, the trustee would only be able to recover $3,000 rather than the entire $10,000.

There are two key elements in the statutory language of § 547(c)(4):  “First, the creditor must give unsecured new value and, second, this new value must be given after the preferential transfer.”  In re IRFM, Inc., 52 F. 3d 228, 231 (9th Cir. 1995) (emphasis in original).

In light of § 547(c)(3), the unsecured status requirement avoids turning § 547(c)(4) into vacuity.  Otherwise, § 547(c)(3)’s secured interest defense would control.  The “after the preferential transfer” requirement reduces the risk to the creditor of making the new transfer, thus encouraging it to continue to do business with a debtor in financial difficulty.

Although it is not explicitly found in the text of § 547(c)(4), the Ninth Circuit Court of Appeals has added an implied third element to the analysis:  “We . . . hold that a new value defense is permitted unless the debtor repays the new value by a transfer which is otherwise unavoidable.”  Id. at 232.  This additional requirement takes into account the phrase “otherwise unavoidable transfer” in the statute.  The IRFM Court explained the rationale by quoting Vern Countryman, The Concept of a Voidable Preference in Bankruptcy, 38 Vand. L. Rev. 713, 788 (1985):

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 a 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.

Id. at 231-232.

If you’re facing a preference avoidance action, and need an analysis of your case and the possible application of the net result defense to your case, contact a highly skilled bankruptcy attorney to help you.