Floating Lien Defense does not actually float on waterHere is the fifth defense against preference avoidance actions, the so-called floating lien defense.

Defenses To Preference Avoidance Actions, Part V:

The Floating Lien Defense

In my last post I discussed the security interest defense, and noted that § 547(c)(3) requires that the security agreement must clearly identify the collateral securing the debt.  The example that set the stage for the discussion of § 547(c)(3) was of the purchase of a car.  The debtor took possession of the car and at the same time transferred a security interest in the car to the creditor.  Thus, the debtor had the car at the time of the transfer.

However, a lien can be created even before the debtor has the collateral, or even before the collateral comes into existence.  Such a lien is called a floating lien.

For example, suppose the debtor is a business that  regularly purchases widgets from a supplier, and then resells them at its retail outlets.  The parties can create a lien that specifies that all future deliveries of widgets become collateral securing a floating debt the debtor has to the supplier.  As the inventory is sold, the debt is paid from the proceeds, with the unsold inventory serving as collateral for the unpaid portion of the debt.

A business with this sort of arrangement is typically buying inventory and reselling it on an ongoing basis.  Therefore, if the business files for bankruptcy protection, there may have been many payments to the supplier during the relevant prepetition period (ninety days for an ordinary creditor and one year for an insider creditor.  Cp. § 547(b)(4)).  Each of these payments could be viewed as a preference to be avoided by the Trustee.  However, in certain circumstances § 547(c)(5) affords the supplier a defense:

The trustee may not avoid under this section a transfer — . . . that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent that the aggregate of all such transfers to the transferee caused a reduction, as of the date of the filing of the petition and to the prejudice of other creditors holding unsecured claims, of any amount by which the debt secured by such security interest exceeded the value of all security interests for such debt on the later of —


(i) with respect to a transfer to which subsection (b)(4)(A) of this section applies, 90 days before the date of the filing of the petition; or

(ii) with respect to a transfer to which subsection (b)(4)(B) of this section applies, one year before the date of the filing of the petition; or

(B) the date on which new value was first given under the security agreement creating such security interest.

Although this language is a bit confusing the basic idea behind is fairly simple.  The first thing to observe is that this subsection deals only with inventory, accounts receivable, and the proceeds of inventory and accounts receivable.

Next, rather than having to trace through every transaction during the relevant prepetition period, according to § 547(c)(5) things can be viewed in the aggregate.  The test is this:  if the transfers during the prepetition period did not reduce the shortfall between the value of the collateral and the debt owed to the supplier (i.e., did not reduce the amount by which the supplier/creditor was undersecured) to the prejudice of the general unsecured creditors, then the transfer is not avoidable by the Trustee.  To the extent that the transfers do reduce the shortfall, they are avoidable.

The underlying idea here is this:  the shortfall in question is a measurement of the amount of unsecured debt the debtor owes the supplier/creditor because it is the amount by which the total debt to the supplier/creditor exceeds the value of the collateral.  If that shortfall is reduced from the beginning to the end of the relevant preference period, then to that extent the supplier/creditor has been paid the unsecured portion of the debt it is owed.  Therefore, in its role as an unsecured creditor its position has improved.  Since the other unsecured creditors didn’t get paid, their rights were prejudiced because the supplier/creditor qua unsecured creditor received more favorable treatment.

Since this analysis is done in the aggregate, the calculation is straightforward.  First,  determine the total debt owed to the supplier at the beginning of the relevant prebankruptcy period.  Give the result the symbol D1.  Second calculate the aggregate value of the collateral securing the debt as of the same date.  Give the result the symbol V1.  The difference, S1 = D1 – V1, is the shortfall between the value of the collateral and total debt (i.e., the amount the supplier/creditor is undersecured) at that date.  Third, perform the same calculation on the petition date to get, S2 = D2 – V2, the shortfall on that date.  If S2 is less than S1, then the shortfall has been reduced and the supplier/creditor is better off than it was at the beginning of the preference period.  To that extent, i.e., the difference between S1 and S2, the transfers may be avoided.  If S2 is larger than or equal to S1 then the supplier/creditor is either worse off than, or in the same position as, it was at the beginning of the preference period and the transfer cannot be avoided.

The final provision in the statute covers the situation where the security agreement was initiated after the inception of the relevant prebankruptcy period.  In that case the calculation of S1 is done for the date the agreement was entered instead of the date of the beginning of the relevant prebankruptcy period.

Unsurprisingly, much of the battle in the application of the floating lien defense is over the value of the collateral, especially at the beginning of the preference period.

If you’re facing a preference avoidance action, and need an analysis of your case and the possible application of the floating lien defense to your case, contact a California Board Certified Bankruptcy Law Specialist to help you.



Image courtesy of Flickr (Licensed) by Chris Gladis