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Robert J. Berens, ESQ.
Bankruptcy: Can
a Surety Be Held Liable for the Prepetition Payments Made by Its Principal?
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I. INTRODUCTION
This article
discusses an emerging issue in the law of suretyship and bankruptcy. The
emerging issue is a debtor/principal's preference action against its surety to
recover prebankruptcy payments made to laborers, subcontractors, materialmen and
other trade creditors on a project bonded by the surety. The majority of
preference actions are brought against a party that directly received payment of
funds or other transfer from the debtor. However, the debtor's preference action
does not involve the surety receiving any payments directly. Rather, the
debtor's preference action is based on the theory that its payments to project
laborers, materialmen, subcontractors and other trade creditors benefit the
surety because the surety is absolved from paying debts guaranteed under the
surety's bonds. The debtor's action against the surety is sometimes referred to
as an "indirect preference action" because the surety receives the benefit of
the debtor's payments indirectly by being relieved of bond obligations.
The issue of a
surety's liability for indirect preferences has begun to receive attention in
reported cases in the past several years. It is well established, however, that
a guarantor of a debtor's debts may be liable as a transferee of an avoidable
preference if the debtor pays the guaranteed debts ahead of other non-guaranteed
debts.
This article is not
intended to parallel in scope the various recognized bankruptcy treatises.
Instead, the purpose of this article is to explain how a surety can defend the
principal's indirect preference action. Therefore, the analysis of the debtor's
action and the various affirmative defenses that can be asserted are discussed
from the perspective of the surety. This article is further limited in that it
does not discuss every possible point of bankruptcy law that may impact the
surety. Instead, selected topics are discussed based upon the belief that they
represent emerging areas of concern in relation to an indirect preference
action.
Section II of this
article discusses the debtor/principal's burden to prove every element of its
preference action under 11 USC § 547(b). It is very possible that the debtor's
evidence is below the minimum that must be proven for a preference cause of
action to be established. For the debtor to prevail on its preference cause of
action it must prove: (1) that each alleged preferential transfer took place;
(2) that each transfer was for the benefit of the surety; (3) that each transfer
was for or on account of an antecedent debt; (4) that the payments were made
with the debtor's property; (5) that each transfer occurred during the
preference period; and (6) that the surety received more than it would in a
Chapter 7 liquidation if the transfer had not been made. If the debtor fails to
prove any of these elements of preference, then the debtor's preference action
must fail.
Section III of this
article discusses the affirmative defenses the surety may assert, under 11 USC
§§ 547(c) and 546(a), to the debtor's indirect preference action. The surety may
be able to assert one or more of the following affirmative defenses: (1) that in
exchange for the debtor's preferential payments the surety provided a benefit to
the debtor by releasing its equitable lien on bonded contract proceeds; (2) that
the debtor's payments were made in the ordinary course of business; (3) that the
debtor's trade creditors extended new unsecured credit (i.e., "new value")
subsequent to the time they received payments from the debtor; (4) that payments
to trade creditors were in satisfaction of perfected statutory liens that were
fully secured; and (5) that the limitations period to bring a preference action,
provided for in 11 USC § 546(a), applies.
Section IV of this
article discusses the possibility that even if the payments to trade creditors
are determined to be avoidable preferences, the surety may not be held liable
for these preferential payments. Various cases have held that there may be no
recovery from a party that did not receive the transfer of cash or other asset
if there was lack of intent to benefit the party by the transfer from the
debtor.
Section V of this
article discusses structuring a prebankruptcy agreement to finance the principal
to provide protection against an indirect preference action if the principal
later files for bankruptcy protection. Additionally, in a prepetition financing
arrangement, the following defenses may also be applicable: (1) that some or all
of the monies the surety advanced under the financing agreement should be
considered "new value," entitling the surety to defenses under 11 USC §
547(c)(l) and/or (4); and (2) that the payments made pursuant to the financing
agreement were not made with the debtor's property and, therefore, are not
preferential to the surety.
II. DEFEATING THE PRINCIPAL'S PRIMA FACIE ACTION
A. INTRODUCTION
The law of
bankruptcy preferences examines past transactions against standards not
necessarily intended at the time of the trans-actions. This examination is
triggered by the filing of a petition under the Bankruptcy Code.
Code § 547(b) gives
a trustee or a debtor in possession the ability to avoid prebankruptcy transfers
of the debtor's property that result in preferential treatment of a creditor.
This is a very powerful tool to recover assets for the bankruptcy estate. The
following form the necessary elements of a preference action:
(1) A transfer must
be made;
(2) The transfer
must be property of the debtor;
(3) The transfer
must be to or for the benefit of a creditor;
(4) The transfer
must be for or on account of an antecedent debt owed by the debtor before the
transfer was made;
(5) The transfer
must have been made while the debtor was insolvent;
(6) The transfer
must have been during the 90 days immediately preceding the commencement of the
bankruptcy case. If the transfer was made to an insider, the transfer may be
avoided for the period one year prior to the commencement of the bankruptcy
case; and
(7) The transfer
must enable the creditor, to or for whose benefit it was made, to receive a
greater percentage of its claim than it would receive under the distributive
provisions of the Bankruptcy Code. In other words, the creditor must receive
more than it would have received if the payments had not been made and the
creditor received what it would in a Chapter 7 liquidation.
The debtor has the
burden to establish each element of preference under Code § 547(b). If any
element of a preference is not proven, then the preference action must fail.
Accordingly, each defense the surety asserts relating to the elements of Code §
547(b) are alternative arguments which, if successful, should defeat the
debtor's indirect preference action.
B. WERE THE TRANSFERS MADE?
In the vast
majority of indirect preference actions the transfers the debtor is seeking to
recover are payments to trade creditors or laborers made by check. To prove that
preferential transfers occurred in these circumstances, the debtor must prove
that the check payments actually cleared the bank. A failure to prove that the
preferential transfer was made is fatal to the debtor's indirect preference
action.
C. WERE THE TRANSFERS FOR THE BENEFIT OF THE SURETY?
The debtor's
indirect preference action does not allege that the surety received any payments
directly. Rather the action is based upon the theory that the debtor's payments
to project laborers, materialmen, subcontractors and other trade creditors
indirectly benefitted the surety because the debtor paid debts covered under the
surety's bonds. In Newbery Corp. v. Fireman's Fund Ins. Co., the theory
of the indirect preference action is explained as follows:
[The principal's]
theory is based on a bankruptcy maxim that the estate may proceed directly
against a surety, instead of circuitously recouping the preference from the
creditor, forcing the creditor to proceed against the surety and then waiting
for the surety to assert a claim against the estate for reimbursement.
For the debtor's
payments to benefit the surety they must be payments of debts covered under the
surety's payment bonds. However, the debtor may not confine its indirect
preference action to obligations covered under the surety's payment bonds.
Obviously, payments made by the debtor on unbonded projects, or payments on
bonded projects for expenses not covered under the bonds, would not benefit the
surety. Therefore, these type of payments are not preferential to the surety.
The debtor may
allege that it can recover as preferential transfers all payments that were made
on bonded projects because the surety guaranteed performance of these projects
in its performance bonds. However, this argument is not consistent with the
rationale of an indirect preference action. The debtor can proceed directly
against the surety as to all transfers in which transferees receiving payments
could have recovered against the surety. The transferees could have recovered
against the surety if the expenses were covered under payment bonds. The
transferees, absent unusual circumstances, would have no right to recover under
the performance bonds because these bonds are solely for the benefit of the
named project owner/obligee. A surety is, in the vast majority of cases, not
liable for a project expense incurred by its principal unless that expense is
covered under a payment bond. The reason for this is payment bonds are
retrospective from the day of default and guarantee laborers and suppliers that
the surety will make good on the debtor's unpaid obligations. For the debtor to
sustain its burden to prove that its payments benefitted the surety, as required
under section 547(b)(1), it is essential that the debtor prove that each payment
that it made was a legitimate bond obligation.
D. WERE THE TRANSFERS FOR OR ON ACCOUNT OF AN ANTECEDENT DEBT?
The debtor is
required, under Code § 547(b)(2), to prove that each transfer was made for or on
account of a past debt. Transfers for contemporaneous or future consideration
are not preferential because they are not for an antecedent debt.
If the surety were
to sustain a loss relating to a bond issued for the debtor, the surety could
seek reimbursement from the debtor pursuant to the surety's indemnity rights.
The term "claim" means a right to payment even though such right may be
unliquidated or contingent upon a future event. The surety has an unliquidated
"claim" against the debtor that is contingent upon the surety sustaining a loss
under the bond. By reason of the surety's contingent, unliquidated claim the
surety is a "creditor" of the debtor. Conversely, since the debtor is liable for
the surety's claim the debtor owes a "debt" to the surety.
The debtor's
liability for the surety's claim does not mean that all payments made by the
debtor to legitimate bond claimants will be for or on account of the surety's
past claim. The debtor's payment history prior to filing for bankruptcy may have
led some trade creditors to require some or all sales to be made on a cash on
delivery ("COD") basis. In this type of transaction, the debtor's debt arises
and is paid upon the trade creditor delivering the goods. A payment by the
debtor on a COD basis is not a transfer for or on account of an antecedent debt;
the payment is a transfer for or on account of a present debt.
E. WERE THE TRANSFERS PROPERTY OF THE DEBTOR?
The preamble of
Code § 547(b) requires that the debtor demonstrate that any transfer be of an
"interest of the debtor in property." The Bankruptcy Code does not define the
phrase "property of the debtor" as it is used in § 547(b). "Generally, property
belongs to the debtor for purposes of § 547 if its transfer will deprive the
bankruptcy estate of something which could otherwise be used to satisfy the
claims of creditors."
The surety may
utilize a trust theory to demonstrate that the debtor's payments to trade
creditors were not transfers of the debtor's property. Under this theory, the
contract funds assume a "trust nature" until the job is complete and laborers,
materialmen, subcontractors and other trade creditors are paid. In Cooper v.
Grisofe Electric Corp., a New York Bankruptcy Court addressed the issue of a
debtor/contractor's claim that a payment to its subcontractor to pay in full all
persons who furnished material or performed labor on the property was a
preference. Pursuant to a New York lien law, funds received by a general
contractor for the improvement of real property were held in trust prior to
bankruptcy. Based upon this New York lien law the subcontractor contended that
the payment to it was from trust funds that were not the debtor's property. The
Building Dynamics court agreed and held that the prepetition payment to
the subcontractor was not preferential because the funds paid to the
subcontractor were not property of the debtor.
Payments made by a
debtor may have been from monies held in trust pursuant to a state's trust fund
statute. In states with this type of statute the surety may defend a preference
action because the monies used to pay those debts were held in trust. Thus, the
funds would not be property of the debtor and the payments would not be
preferential.
F. WERE THE TRANSFERS MADE WITHIN THE PREFERENCE PERIOD?
In the ordinary
case the transfer must have occurred within 90 days prior to the principal's
bankruptcy filing to be subject to a preference claim. However, under §
547(b)(4)(B), the preference period for an "insider," including an officer,
director, general partner, affiliate or relatives of these parties, reaches back
one year from the principal's bankruptcy filing. The extended preference period
for insiders is based upon the assumption that insiders may prefer their own
interests and they will have the information that will permit them to do so
significantly before outside creditors and third parties may be aware of the
debtor's financial difficulties.
Prior to the
enactment of the Bankruptcy Reform Act of 1994, a troublesome situation could
have occurred where a non-insider creditor received a guarantee from an insider.
Some circuits were holding that under Code § 550(a) a non-insider transferee
could be found liable for transfers that were determined to be preferential
under Code § 547(b). However, the Bankruptcy Reform Act of 1994 overturns the
line of cases beginning with Levit v. Ingersoll Rand Fin. Corp. (In re
V.N. Deprizio Constr. CO.). The Bankruptcy Reform Act of 1994 amends Code §
550 by adding a new subsection 550(c), to provide that if a transfer made
between 90 days and one year prior to bankruptcy is avoided as a preference and was made for the benefit of
an insider, the trustee may not recover the property or the value of the
property from a transferee that is not an insider. Therefore, under amended Code
§ 550 the surety would not be subject to the one-year preference period, unless
it could be demonstrated that the surety is an "insider."
G. WERE THE TRANSFERS PREFERENTIAL TO THE SURETY?
The final element
of a preference, contained in Code § 547(b)(5), compares whether the debtor's
payments to creditors had the effect of giving the surety more than it otherwise
would be entitled to in a Chapter 7 liquidation case. The payments that the
debtor contends are preferences to the surety should be viewed similar to
payments made to a fully-secured creditor. When a secured creditor releases
collateral in an amount equal to the payment, no preference has occurred because
the estate is enriched as much as it is depleted. In Ehring v.
Western Community Moneycenter (In re Ehring), the court held that it
is not a preference if a secured creditor forecloses on its collateral
pre-petition. As noted in Ehring, the court must consider "the reality of
the situation.”
The reality of the
situation is that if the debtor had not paid its creditors, then it would have
been in default. The funds in question would never have been available for
distribution to the other creditors because the surety holds an equitable lien
on all contract funds earned and to be earned by the debtor on each bonded
contract, to the extent necessary to fully reimburse the surety from any losses
it might suffer on each project. If the debtor had not paid its creditors on
bonded projects, the surety "had the right to step in and remove the [debtor]
from the bonded [projects]" and collect the contract proceeds that had been
earned by the debtor.
Pursuant to the
surety's equitable right of subrogation the surety would have received the
contract proceeds that the debtor paid to trade creditors to the full extent
necessary to reimburse the surety's losses. In many instances, the contract
proceeds received by the debtor may exceed the preferential payments that were
made prior to receipt of the contract proceeds. Under this scenario, the surety
will not have received more by the debtor's payment of trade creditors than the
surety would have received in a Chapter 7 liquidation.
Another facet of
section 547(b)(5) involves the debtor's payments of wages, related payroll taxes
and employee benefits. If the debtor had not made these payments prior to
bankruptcy, then the claims filed in the bankruptcy case for wages, payroll
taxes and employee benefits may have resulted in a distribution if the
bankruptcy estate was liquidated. In all likelihood at least a portion of these
claims would be priority claims in a Chapter 7 case. At the time the bankruptcy
petition is filed, the debtor's estate may have unencumbered assets (i.e., bank
account balances, rolling stock, etc.), which could be used to pay these
priority claims in a Chapter 7 liquidation. In making a liquidation
determination, a court must decide the transferee's class and determine what
distribution that class would have received in a Chapter 7 liquidation assuming
the transfer had not been made." The debtor's liquidation analysis may not
properly analyze whether these priority claimants would receive a distribution
if the estate was liquidated. The debtor, therefore, may not prove that payments
of wages, payroll taxes and employee benefits were preferential to the surety.
III. THE SURETY MAY ASSERT VARIOUS AFFIRMATIVE DEFENSES
A. INTRODUCTION
Even if the
debtor/principal has met its burden of proving the elements of a preference
action, under section 547(b), the surety should be able to assert various
affirmative defenses under section 547(c). There are seven statutory exceptions
to the Bankruptcy Code's preference-avoiding power. If a creditor can qualify
under anyone of the exceptions, then it is protected to the extent of the
applicable exception. If a creditor can qualify under several exceptions, then
it is protected by each to the extent it qualifies under each exception. The
exceptions to preference of most interest to the surety are:
(a) A payment that
was intended by all parties to be a contemporaneous exchange for "new value, and
was, in fact, substantially contemporaneous.
(b) A payment of a
debt made and incurred in the ordinary course of both the debtor's and the
transferee's business, and made according to ordinary business terms.
(c) An advance of
new unsecured credit to the debtor after the payment is made by the debtor.
(d) The fixing of a
statutory lien that is not avoidable under section 545. Payment in satisfaction
of a perfected statutory lien that is fully secured may not be a preferential
transfer.
Additionally, under
section 546(a), a preference action is subject to a limitations period. Debtors
and trustees are precluded from bringing an indirect preference action if the
limitations period has passed.
B. THE SURETY CONTEMPORANEOUSLY EXCHANGES NEW VALUE WITH ITS PRINCIPAL WHEN IT
RELEASES ITS EQUITABLE LIEN ON BONDED CONTRACT PROCEEDS
The principal's
claim against the surety is based upon the theory that, when the principal paid
creditors on bonded jobs, the payments released the surety from the contingent
liability to pay those bills under its bonds. In effect, the principal's payment
to creditors was an indirect benefit to the surety. This analysis, however, cuts
both ways. When the principal made payments to its laborers, materialmen,
subcontractors and other trade creditors on bonded projects-the payments which
the principal may argue were preferences-the trade creditors released their
claims for payment against the surety. Contemporaneously therewith, the surety
released its equitable claim to the contract funds to the extent of the payments
made and the principal was then entitled to receive the contract funds from the
owner. The surety is entitled to assert its release of its equitable claim to
contract funds as a defense to the principal's indirect preference action under
section 547(c)(1).
The surety's
equitable lien on the proceeds of bonded contracts is well established. This
doctrine, known as equitable subrogation, is recognized unanimously by
jurisdictions around the country. Regardless of whether a surety is proceeding
under a payment or performance bond, the surety's subrogation rights place it in
a priority position as to bonded contract proceeds.
In O'Rourke v.
Seaboard Surety Co. (In re E.R. Fegert, Inc.), two subcontractors
each brought suit against their general contractor and the general contractor's
surety. The general contractor eventually paid the two subcontractors and their
suits were missed and all claims against the surety were released. Subsequently,
the general contractor filed for bankruptcy. The Chapter 7 trustee of the
general contractor's bankruptcy claimed that the prepetition payments to the
subcontractors were preferences to the surety because the surety was indirectly
benefitted. The Fegert court rejected the trustee's indirect preference
claim against the surety, as follows:
In this case the
surety did not make the payments in question to the subcontractors. Instead, the
payments were made pre-petition by the Debtor as part of a tripartite agreement
under which the subcontractors released their claims against [the surety] in
exchange for payments directly from the Debtor. Under these circumstances, the
[Bankruptcy Appellate] Panel does not find that the fact that the surety did not
actually make the payments to the subcontractors requires the application of a
different equitable rule. If the Debtor had not made the payments to [the
subcontractor] then [the surety] would have been called upon to advance the
funds and then exercise its lien rights against payments due or to become due to
the Debtor. The Trustee does not dispute that the estate received post-petition
more than the total paid to both subcontractors from the White River Road
Contract. Since the Debtor's payments to the subcontractors avoided the
imposition of an equitable lien by the surety on future payments under the
contract, there was no diminution of the estate. Under these facts, the release
of the subcontractors' rights against the surety, which in turn could have
exercised its lien rights, constituted "new value" being given in a
substantially contemporaneous exchange:
Based upon the
analysis established in Fegert, the surety can move to dismiss the
debtor's indirect preference action based upon the contemporaneous exchange for
new value defense. The debtor may oppose the surety's motion on the basis that
the debtor's payments were greater than the surety's release of its equitable
lien on bonded contract proceeds. In other words, the court must measure the
amount of the "new value" the surety gives 'to the debtor to determine whether
it is equivalent to the alleged preferential transfers.
In Newbery,
the District Court held that the surety was required to show the amount of new
value actually given to the debtor. It is important to recognize, however, that
the court agreed with the Fegert analysis; the court simply found that
the amount of new value must be proven.
As explained in
In re Fegert, 88 B.R. 258 (9th Cir. BAP 1988), however, in the peculiar
context of construction contracts, preferences to sureties may not be avoidable
if supported by a contemporaneous exchange for a new value given by the surety
to the debtor. The new value arises in the operation of the equitable lien
doctrine of Pearlman v. Reliance Insurance Company [citation omitted]....
This right assumes the form of an equitable lien which attaches to proceeds from
the bonded contract. Fegert at 260. Payments made by Newbery to its
suppliers, though benefiting Fireman's by reducing exposure on the bonds,
simultaneously reduced dollar for dollar the equitable subrogation lien
Fireman's would have obtained had it made the payments itself....
This court
considers Fegert soundly reasoned and adopts its holding. Under §
547(c)(l) the surety has a defense to the principal's preference claims "to the
extent" that new value is "given to the debtor." The issue is, how much new
value was given to the debtor as a result of the surety's release of its
equitable lien on contract proceeds? The answer is clear-the debtor received new
value to the extent of the contract proceeds that are actually paid to the
debtor after it makes a payment to a trade creditor. For example, if the debtor
makes a $1,000.00 preferential payment to a trade creditor and thereafter
receives $1,000.00 in contract proceeds, the surety contemporaneously released
it equitable lien on the unpaid contract proceeds to the extent of the payment,
i.e. $1,000.00. The value of this exchange is confirmed when the debtor actually
receives contract proceeds after the payment to its creditor. So long as the
debtor receives $1,000.00 in contract proceeds, the surety has given full value
in exchange for the $1,000.00 payment. Thus, the surety should have no liability
for this payment. However, if the debtor only receives $800.00 in contract
proceeds after making a $1,000.00 preferential payment, then surety has a
defense under § 547(c)(l) to the extent of the $800.00 received by the debtor.
It is imperative
that the surety determine the exact amount and date of each payment of contract
proceeds the debtor receives on each bonded job during the 90 days before
bankruptcy. With this information, it is simply a matter of then comparing the
payments to trade creditors with; the debtor's actual project receipts on a
project-by-project basis to determine the exact amount of new value given by the
surety through the release of its equitable liens.
A very useful tool
to demonstrate the application of the contemporaneous exchange for new value
defense is a spreadsheet which chronologically lists, on a project-by-project
basis, the payments the debtor claims to have made to trade creditors and the
contract proceeds the debtor received as a direct result of the surety's release
of its equitable liens. This spreadsheet should not list payments to the extent
they were made in the ordinary course of business because these type of payments
are not avoidable preferences." Since these payments are not avoidable
preferences to the trade creditors surety these' payments are not avoidable
preferences to surety.
C. TRADE CREDITORS MAY HAVE MADE SUBSEQUENT ADVANCES OF NEW VALUE
Another defense to
the debtor's indirect preference action is the "subsequent advance" preference
exception. The purpose of this preference exception is to protect creditors who,
after receiving a preferential payment, extend new unsecured credit to the
debtor.
A subsequent
advance is excepted because it is reasoned that a creditor who contributes new
value in return for payments from the incipient bankrupt, should not later be
deemed to have depleted the bankruptcy estate to the disadvantage of others. In
some situations, trade creditors extend unsecured credit to the debtor within
the 90 days before bankruptcy by supplying materials or services to the debtor.
If a trade creditor extended unsecured credit after a preferential payment was
made to the trade creditor, then the subsequent advance defense may be
applicable.
The debtor may
argue that this affirmative defense can only be asserted by the transferees
(i.e., the trade creditors) and not by the surety. The Newbery court
addressed this argument as follows:
This conclusion
assumes the payments [the principal] made to its trade creditors were to satisfy
preexisting debts. If payments were made in the ordinary course of business,
they would not be preferences to the trade creditors. 11 U.S.C. § 547(c)(2).
Neither would they be preferences to [the surety]. If the payments to the
creditor are not disgorgeable preferences, the creditor has no right to proceed
against the surety. Therefore the surety has no contingent claim against the
estate, the release of which could constitute a preference. [Citation omitted.]
Similarly, in Harrison v. Brent Towing Co., Inc. (In re H&S
Transportation Co., Inc.) a trustee brought a preference action against a
boat owner for the debtor/boat operator's payments to fuel suppliers within 90
days before bankruptcy. The trustee argued that the debtor's payments indirectly
benefitted the boat owner because the fuel supplier’s liens against the boat
were satisfied. Subsequently, the fuel suppliers sold additional fuel to the
debtor on credit. The boat owner argued that it became subrogated to the rights
of the fuel suppliers that had valid subsequent advance defenses. The H&S
Transportation court held that the boat owner, as subrogee to the rights of
the fuel suppliers, was entitled to assert a defense based upon the fuel
suppliers' subsequent advance defense. The surety should similarly be entitled
to assert the subsequent advance defense that is available to trade creditors
that extended credit to the debtor.
Three recent decisions have interpreted § 547(c) (4) and its application to a
series of alternating preferential payments and subsequent advances of new
credit by the payee. In each of these cases, the debtor made a number of
preferential payments to a single vendor and the vendor periodically extended
unsecured credit to the debtor. Each of these cases did not involve §
547(c)(4)(A) because the vendors' advances of new credit were unsecured. Each
court examined the legislative history of § 547(c)(4) as it relates to an
alternating series of preferential payments and extensions of new value. The
courts all concluded that the vendors had valid subsequent advance defenses even
though their earlier extensions of new credit were repaid by the debtor.
The debtor may
argue that the subsequent advance defense requires that the creditors' advances
of unsecured credit must remain unpaid. The court in Matter of Bishop
interpreted § 547(c)(4)(B) as requiring the creditors' extension of unsecured
credit remain unpaid. However, it can be argued that nothing in the language of
§ 547(c)(4) or the statute's legislative history requires that the new value
remain unpaid.
The surety should
prepare a spreadsheet, similar to the one utilized by the Check Reporting
Services Court, on a vendor-by-vendor basis. For example, if ABC Company
received a series of payments from the debtor and ABC Company periodically
extended unsecured credit to the debtor, then a spreadsheet should list
chronologically each preferential payment and extension of credit between ABC
Company and the debtor. The preference exposure column of the spreadsheet will
increase with each preferential payment and decrease with each subsequent
extension of unsecured credit. However, since the subsequent advance defense
requires that new credit be advanced after a preferential payment, credit
extended in excess of the preference exposure column may not be carried forward
as a defense to later preferential payments. Therefore, the preference exposure
column can never go below zero.
The surety should
prepare the spreadsheet separately analyzing the advances made by each trade
creditor that allegedly received preferential payments. The reason the
spreadsheet must be prepared on a vendor-by-vendor basis is because the surety
is subrogated to each trade creditors' subsequent advance defense. If the debtor
could not avoid its payments to the trade creditors due to the subsequent
advance defense available to these transferees, then the debtor cannot recover
the alleged preferential payments from the surety. Thus, the trade creditors'
subsequent advances of new value to the debtor may be asserted by the surety as
an affirmative defense to the debtor's preference action.
D. THE DEBTOR'S PAYMENTS MAY BE PAYMENTS MADE IN THE ORDINARY COURSE OF BUSINESS
1. INTRODUCTION
The debtor's
preference claims may logically be divided into two· categories, payments to
laborers (i.e., payroll) and all other payments (i.e., non-payroll). Even if the
debtor's payments to trade creditors on bonded jobs are preferential, the
payments may fall within the safe harbor of § 547(c)(2) as payments made in the
ordinary course of business.
The purpose for the
ordinary course of business preference exception is to allow a financially
troubled entity to continue in business and attempt to resolve its financial
problems without filing for bankruptcy. Section 547(c)(2) is intended to
"protect recurring, customary credit transactions that are incurred and paid in
the ordinary course of business of the debtor and the transferee. "Thus,
payments made by a debtor to employees, suppliers, landlords and utility
companies, and other similar operating expenses or trade credit transactions,
were intended by Congress to be exempt from recovery as preferences."
2. PAYROLL PAYMENTS
In most situations
in the construction industry laborers receive payroll on the same day each week
for the work performed during the preceding work week. This practice of making
weekly payroll payments is typical in the construction industry. This type of
payroll payments to a debtor's laborers are the type of payments that are
intended to be protected by the ordinary course of business exception to
preference. Thus, if the payroll obligations are incurred and paid by the debtor
in the ordinary course of its business with its employees and are typically made
in the industry, then the payroll payments should be insulated from the debtor's
preference attack under section 547(c)(2).
The debtor's
payroll payments may not be recoverable for another reason. The debtor's
laborers continued to work each week after receiving their weekly payroll. In
all likelihood the laborers would have left the project if the debtor stopped
paying its weekly payroll. The laborer's continued services after being paid may
be considered subsequent advances of new value. Thus, payroll payments may be
further protected from the debtor's preference attack under section 547(c)(4).
3. NON-PAYROLL
PAYMENTS
The debtor's
non-payroll payments may also be incurred and made in the ordinary course of
business. However, in a situation where the principal has defaulted under its
construction contracts, it is likely that the principal has not made payments in
the ordinary course of business to its trade creditors other than payroll
payments. Nonetheless, when analyzing the principal's non-payroll payments, it
should be noted that late payments are not per se excluded from being considered
payments made in the ordinary course of business. Section 547(c)(2) has been
found applicable to late payments when these type of payments are the standard
practice between the parties and are not outside industry standards. However, if
payments are so late as to be inconsistent with prior transactions between the
parties or not according to industry standards, the ordinary course of business
exception will not provide a defense.
E. THE DEBTOR'S PAYMENTS MAY BE IN SATISFACTION OF PERFECTED STATUTORY LIENS
Some of the
debtor's preference claims may be for payments made to parties that held
perfected statutory liens prior to receiving payment. Code § 547(c)(6) provides
a preference exception if the transfer is the "fixing" of a statutory lien that
is not avoidable under Code § 545. If the holder of an unavoidable statutory
lien is a fully secured creditor (i.e., the lienholder's claim is fully
supported by the value of property subject to the lien), then payment in
satisfaction of such lien is not preferential because the lienholder received no
more than it would have in a Chapter 7 liquidation. Thus, the debtor's payments
to a holder of a fully secured statutory lien that was perfected prior to
bankruptcy are not preferential and should not be avoidable.
A minority of
courts has extended the statutory lien exception to the debtor's payments to a
lienholder that did not perfect its statutory lien. For example, in Cimmaron
Oil Co., Inc. v. Cameron Consultants, Inc., the debtor made prepetition
payments for geological consulting work prior to the consultant perfecting its
lien. The consultant contended that under a Texas statute it had six months from
the date the consultant performed work to perfect a lien on the debtor's oil
well, and if the consultant was not paid it could have perfected its lien.
Additionally, the Texas statute provided that the lien would have related back
to the date of the last delivery of the material or services provided. The
Bankruptcy Court concluded that the debtor's payments to the consultant and the
consultant's waiver of its right to file a valid oil and gas lien was intended
to be a contemporaneous exchange for new value and was a substantial
contemporaneous exchange. The District Court affirmed the result reached by the
Bankruptcy Court, but under a different defense. The District Court, noting that
a split in authority exists,83 held that § 547(c) (1) does not protect payments
to holders of unperfected liens from being avoided as preferences. The District
Court did hold, however, that the payments to the consultant were excepted from
avoidance under § 547(c)(6). The court stated that the legislative history
reflects Congress' intent that this statute also exempt "transfers in
satisfaction of such liens," as follows:
This interpretation
of § 547(c)(6), while faithful to congressional intent, obviates the
commercially unreasonable consequences that could result if the trustee were
permitted to pay for a lienor's services, thereby precluding the perfecting of
the lien, and later avoid the payments as preferences."
It is the author's
belief that the better reasoned cases only permit the statutory lien exception
as a valid defense to payments made to holders of a fully secured statutory lien
that were perfected prior to the petition date. However, if a lien holder
receives payment in satisfaction of its claim prior to perfecting its lien, the
surety should check the decisions in its jurisdiction to determine if a defense
may be asserted under Cimmaron Oil.
F. THE INDIRECT PREFERENCE ACTION IS SUBJECT TO A LIMITATIONS PERIOD
The indirect
preference action against the surety may be barred pursuant to the statute of
limitations in Code § 546(a). Prior to the Bankruptcy Reform Act of 1994 this
section provided that a preference action may not be brought after the earlier
of two years after the appointment of a trustee or the closing or dismissal of
the bankruptcy case. There was a split in authority whether a Chapter 11 debtor
in possession could file a preference action if the bankruptcy case was filed
more than two years prior to the action being filed. The Bankruptcy Reform Act
of 1994 amends Code § 546(a)(l) to provide that an avoidance proceeding may not
be commenced later than two years after the entry of the order for relief or one
year after the appointment or election of the first trustee if the appointment
or election occurs before the expiration of the initial two-year limitations
period. Under the recently amended Code § 546, in a Chapter 11 proceeding where
a trustee has not been appointed, the two-year limitations period applies if the
preference action was filed more than two years after the debtor voluntarily
filed for bankruptcy. If a trustee is appointed or elected prior to the
expiration of two years from the petition date, the one-year limitations period
applies if the preference action was filed more than one year after the
appointment or election of the first trustee. In both of these situations, the
limitations period in Code § 546(a) clearly bars the preference action.
IV. THE SURETY MAY
NOT BE A PARTY FROM WHOM
PREFERENTIAL PAYMENTS MAY BE RECOVERED
The discussion
above involved an analysis of section 547 to determine whether the
debtor/principal's prepetition payments on bonded projects were avoidable as
preferences to the surety. However, even if a court were to conclude that the
debtor's payments were preferences to the surety, the surety may not be liable
for the preferential payments made to trade creditors. This is so because
section 550, the Code section
that dictates the party from whom a preferential payment may be recovered, may
not include the surety under certain circumstances. To determine preference
liability, the following two-step analysis must be made: (1) Has there been an
avoidable transfer (section 547)? and; (2) From whom may the transfer be
recovered (section 550)?
The Code
specifically 'separates the identification of avoidable transfers (§ 547) from
the identification of those who must pay (§ 550) [citation omitted].' ... If it
is determined that the transfer is a preference under 11 USC § 547(b) and none
of the exceptions under 11 USC § 547(c) apply, we then look to section 550(a) to
determine to whom the trustee may look for recovery of the property.
Under § 550(a)(l)
the debtor can recover a preferential transfer from the surety only if the
debtor can prove that the surety was either: (1) the initial transferee of the
preference or (2) the entity for whose benefit the initial transfer was made.
Alternatively, under § 550(a)(2) the debtor can recover from the surety only if
the surety was a subsequent transferee of the initial transfer.
The term
"transferee" is not defined within the Code. To determine whether an entity is a
transferee for section 550 purposes, the majority of courts analyzes whether the
entity had dominion over the money and had the right to put the money to its own
purposes, as follows:
[T]he minimum
requirement of status as a 'transferee' is dominion over the money or other
asset, the right to put the money to one's own purposes.
[A]n entity does
not have 'dominion over the money' until it is, in essence, 'free to invest the
whole [amount] in lottery tickets or uranium stocks.
In the vast
majority of situations the surety will not exercise any dominion over the funds
the debtor paid to trade creditors. Rather, laborers, suppliers, subcontractors
and other trade creditors are the parties that receive payments directly from
the debtor and maintain dominion and control over the funds. In an indirect
preference action, the allegation is that the debtor's payments were
preferential to the surety, not because the surety receives the payments, but
because the payments relieve the surety of obligations under its bond(s). Thus,
the surety is neither an initial transferee nor a subsequent transferee, under
sections 550(a) (1) or 550(a)(2), respectively.
If the surety is
not a "transferee" of the indirect preferences, the only way the surety can be
held liable for the preferential payments, under section 550(a)(1), is if the
surety is held to be an "entity for whose benefit [the initial] transfer was
made." This phrase of section 550(a)(1) was analyzed in Danning v. Miller
(In re Bullion Reserve of North America). In this case, the parties
stipulated that a $1.5 million transfer from the debtor to its president was a
fraudulent conveyance under section 548. The sole issue was whether the
fraudulent conveyance could be recovered from Miller, a party involved with this
transaction. The court held that Miller was not an initial or subsequent
transferee because he never had dominion over the funds. More importantly, the
Bullion Reserve court held that for an individual or entity to be an
"entity for whose benefit such transfer was made" the initial transfer must have
been made with an intent to benefit the individual or entity. Since the initial
transfer was not made for Miller's benefit, the court held that the Chapter 7
trustee could not recover the fraudulent conveyance from Miller.
In most situations
prior to bankruptcy, it will be possible to show that the principal's intent
when paying its trade creditors was to keep the business "afloat" or otherwise
benefit itself rather than to benefit the surety. In these situations, section
550 may provide the surety with a defense to an indirect preference action.
V. DRAFTING A PREPETITION FINANCING AGREEMENT
TO INSULATE THE SURETY FROM AN INDIRECT PREFERENCE ATTACK
A. INTRODUCTION
This section
suggests various provisions the surety should include in a prepetition financing
agreement to protect the surety, to the extent possible, from the effects of an
indirect preference action if the principal files for bankruptcy after the
financing agreement is executed. This article does not promote or discourage
financing the principal's completion of bonded work. Instead, it is assumed that
the decision to finance has been made.
Once a principal
files for bankruptcy, the possibility exists that various transfers of property
by the principal to its creditors within 90 days of bankruptcy might be avoided
or undone under the preference provision of the Bankruptcy Code. The payments
made pursuant to a financing agreement between the surety and its principal may
be the target of an indirect preference attack. The target may be made more
difficult to hit if certain provisions are inserted into the financing
agreement. Obviously, no agreement can be made one hundred percent
preference-proof.
The bankrupt
principal may argue that assignments of bonded contract proceeds to the surety
and/or transfers of security interests to the surety were preferences. This
article does not address these potential preference attacks that might be
brought by the principal. Rather, the scope of this article is to suggest
financing provisions and other actions that may insulate the surety from its
principal's indirect preference action that may be brought if the principal
files for bankruptcy after the financing agreement is executed.
B. SUGGESTED PROVISIONS TO BE INCLUDED IN THE FINANCING AGREEMENT
The financing
agreement should contain the ordinary clauses identifying the parties,
identifying each bond and each project bonded by the surety, and contain a
general provision including within its scope any bonds and projects
inadvertently omitted. The financing agreement should identify the sources of
funds to be deposited into the joint control trust accounts, including all the
principal's accounts receivable, the principal's current funds and the surety's
advances.
All indemnity
agreements should be identified and the principal should acknowledge the
agreements' continued validity. Further, the financing agreement should state
that all funds advanced by the surety will be losses covered by the indemnity
agreements. All indemnitors should sign the financing agreement beneath language
acknowledging the principal's assent to the agreement and affirming the validity
of the existing indemnity obligation. The agreement should provide that any
rights the surety obtains under the agreement are in addition to, and not in
replacement of, any rights the surety has under the indemnity agreements.
The agreement
should contain an acknowledgement by the principal that money is currently owed
to laborers, materialmen, subcontractors and other trade creditors on the bonded
projects. The principal should state that it is financially unable to complete
the projects or pay the bills without the surety's financial assistance, and
that the principal has requested the surety's financial assistance. Further, if
any projects had a formal default declared by an obligee, the financing
agreement should identify each project and the dates of each notice of default.
The agreement
should recite the benefits the principal will receive from the surety's
agreement to finance. These benefits include avoidance of financial defaults and
the preservation of goodwill and favorable trade terms on existing contracts.
These admissions should aid the surety's contention that at least some of the
financing provided by the surety was "new value" to its principa1.
The principal
should acknowledge that the surety has an equitable lien on bonded contract
proceeds. This admission should aid the surety's defense of an indirect
preference action relating to the debtor's payment of bills that would be
covered by the surety's bond obligations.
The agreement must
contain limitations on the surety's duty to finance, but the limits should not
overshadow the duty. The agreement may limit the term of the financing, with
extensions to be agreed upon by the parties in writing. Such a clause will
permit periodic reassessment of the decision to finance and protect against
runaway liability. Some commentators have recommended that the surety retain
absolute discretion concerning the advancement of funds under a financing
agreement.77 However, the retention of absolute discretion severely
weakens a preference defense. The principal may argue that the surety did not
provide "new value" because the surety was not legally obligated to make any
advances under the agreement.
C. THE SURETY'S ADVANCES MAY FURNISH THE BASIS FOR NEW VALUE DEFENSES
The surety may
defend the principal's preference action, under section 547(c)(1), by
demonstrating that the debtor's payments were a contemporaneous exchange for the
surety's giving new value (i.e., the surety's financing). A creditor may be
excepted from preference liability if the creditor gives new value to the
debtor. The new value may simply be a modification of debt terms, or some other
substantial concession by the creditor. For example, in Creditors' Committee
v. Spada, (In re Spada), a preference action was brought against a
bank alleging that the debtor's conveyance of a mortgage was preferential.
Before the mortgage was conveyed, the debtor was obligated to the bank on three
separate unsecured loans. The debtor requested that the bank consolidate the
loans and reduce the interest payments under the loans. In return for the
mortgage, the bank gave new value by reducing the interest rate and agreeing to
accept payments of interest only during the first year of the loan. The Spada
court concluded that the bank's modification of the existing loans and the
conveyance of the mortgage by the debtor was a "contemporaneous exchange for new
value" under section 547(c)(1).
In a typical
financing situation, the surety will wire money into the joint control accounts
to be used to pay specific creditors and invoices. The surety wires monies into
the accounts with the intent that they be immediately paid to specific
creditors. If a court were to conclude that the surety gave new value to the
debtor and that the surety's advancement of funds and the principal's payments
to trade creditors were a "substantially contemporaneous" exchange for new
value, then section 547(c)(1) would provide a defense. Conversely, if a court
were to conclude there was not a substantially contemporaneous exchange for new
value, then the "subsequent advance" exception in section 547(c)(4) may apply.
Illustrative of this preference exception is the decision of Amarex, Inc. v.
Marathon Oil Co. (In re Amarex, Inc.). In this case, the debtor
entered into an agreement with a group of creditors, under which the debtor made
payments to these creditors within 90 days of filing bankruptcy. The Amarex
court concluded that the creditors' payments to third party vendors, made on
behalf of the debtor, were a subsequent advance of new value each time the
creditors paid the debtor's vendors.
Similarly, the
surety's commitment to finance and a portion of its cash advances may be
determined to be "new value" under § 547(a)(2). If the surety's new value is
perceived as being substantially contemporaneous with or subsequent to the
debtor's payments to trade creditors, then the exceptions to preference in
section 547(c)(1) or 547(c)(4) should apply to defeat at least a portion of the
debtor's indirect preference action.
The bankrupt
principal may argue that the surety's finance money, to be used to pay expenses
on the bonded projects, is not "new value" because the surety had a pre-existing
duty under its bonds to pay these expenses. It should be explained to the court
that financing the principal goes significantly beyond the surety's bond
obligations. A performing surety is not required to finance its principal to
complete the bonded projects. A surety is entitled to decide how to best
complete bonded projects upon the principal's default. Furthermore, the surety's
financing may protect the principal's reputation, preserve favorable credit
terms and relationships with suppliers and subcontractors and provide other
benefits to the principal. Financing may also require the surety to cover a
portion of the principal's overhead or other expenses not covered under the
surety's bonds. These benefits to the debtor should constitute new value.
D. ESTABLISHMENT OF JOINT CONTROL ACCOUNTS WITH STRICT CONTROLS OVER
DISBURSEMENT OF FUNDS
1. INTRODUCTION
The principal's
indirect preference action may allege that monies paid from a joint control
account to trade creditors on bonded projects were preferential to the surety.
The surety may defend this portion of the indirect preference action by
demonstrating: (1) that the monies paid to trade creditors were held in trust
for the surety's benefit, or (2) that payments to trade creditors were made with
funds "earmarked" to be paid to specific creditors. Under either scenario, the
requisite element that a preferential transfer be of "an interest of the debtor
in property" will be lacking.
2. DEBTOR'S
PAYMENTS OF TRUST FUNDS
New bank accounts
should be opened and specifically designated as the principal's accounts held in
trust for the benefit of the surety. Although the principal may prefer to keep
using existing bank accounts, the surety should insist that new accounts be
opened. New accounts are more consistent with the "trust" purpose of the
accounts.
Bankruptcy Courts
look to state law to determine whether a valid trust was created. In most
states, the essential elements of a trust are: A competent settlor and trustee,
an intent to create a trust, ascertainable trust property and an identifiable
beneficiary. For a surety/principal joint control account, the trust property is
the monies in the joint control account, the settlors are both the surety and
the principal and the trustee is the bank where the joint control account is
located. The element of trust that must be given special attention is the intent
of the parties to create a trust. The financing agreement must have very
specific provisions that leave no doubt that an express trust is being created
for the benefit of the surety.
Explicit procedures
for funding the completion of the bonded projects should be set forth in the
financing agreement. If broad latitude is granted to the principal to use the
surety's funds, it may indicate the funds are not held "in trust," but were
merely loaned to the principal. However, if specific procedures are observed
during the financing period, the surety can effectively argue that it had no
intention of giving its principal the beneficial interest to any funds paid from
the account. This may demonstrate that the surety is the beneficiary to the
funds in the joint control account. If a court determines that the debtor did
not own the equitable interest to the funds in the account the debtor's claim
that payments from the account were preferential must fail.
A case involving
explicit procedures for funding a construction project is Askew v. Resource
Funding Ltd. In this case an agreement created a project account, and
contemplated that the funds would be spent on a specific project. The court held
that a trust relationship was created because the agreement, between the
transferor and the transferee of funds, provided for various safeguards and
restrictions on the use of those funds by creating a committee which oversaw and
approved expenditures before permitted withdrawals from the project account. The
Askew court stated:
We thus conclude
that the language of the Agreement makes it clear that the transferor. NePA, did
not intend the transferee, RGL, to have the beneficial interest in the property
transferred, i.e., the $837,500, much less the "ownership" thereof. Seemingly,
it would be difficult to draw a document with terminology more manifest as to
the purpose of the funds in question than the Agreement before us.·
If specific
procedures are established and observed during the term of the financing
agreement, a court may determine that the funds advanced into and paid out of
the joint control account are funds held in trust for the surety's benefit. The
debtor's prepetition payments of trust funds from the joint control account are
not payments of the debtor's property. Thus, the debtor's argument that payments
from the joint control account were preferential should fail.
3. DEBTOR'S
PAYMENTS OF EARMARKED FUNDS
Another defense the
surety may assert to the claim that payments of funds from the joint control
account were preferential to the surety is the Earmarking Doctrine. This
doctrine becomes applicable where a "lender" transfers funds to the' debtor that
are intended and directed by the new lender to be used to pay the debtor's
obligation to another creditor. The rule originated where the new "lender" was a
guarantor or a surety of the debtor's obligation to the "old creditor." The
equities of the doctrine protect a surety against the risk of his having to pay
twice if the first payment is held to be an avoidable preference.90
The Earmarking
Doctrine requires the following:
(1) the existence
of an agreement between the new lender and the debtor that the new funds will be
used to pay a specified past debt;
(2) performance of
that agreement according to its terms; and
(3) the transaction
viewed as a whole (including the transfer in of the new funds and the transfer
out to the old creditor) does not result in any diminution of the estate.
It is imperative
that the financing agreement contain very strict controls designed to ensure
that the surety's advances are used to pay specific creditors exactly as the
surety intends. The surety or a designated agent should review and agree to pay
specific invoices owed by the debtor to its trade creditors. The surety's
deposit of funds into the designated account(s) should be in an amount
sufficient to cover the intended payments. The surety or designated agent should
then direct the bank to honor the specific checks drawn to cover the approved
invoices. It is important that the surety and bank enter an agreement that
without the surety's approval of each specific payment, the bank will not honor
any checks drawn on the account. Payments made under these strict controls
should be determined to be earmarked payments.
If the joint
control account is properly established and operated, the monies paid from the
account should be determined to have been funds held in trust for the surety's
benefit. Additionally, since the monies were advanced by the surety under very
strict controls specifically to enable the debtor to satisfy claims of
designated trade creditors, the payments should be determined to be subject to
the Earmarking Doctrine. If a court were to conclude that the payments of funds
from the account were held in trust or were "earmarked" funds, then the debtor
will not be able to demonstrate that the payments were property of the debtor.
Accordingly, the portion of the debtor's preference action to recover payments
made from the joint control account should fail.
VI. CONCLUSION
The
debtor/principal's indirect preference action to recover prepetition payments
made to trade creditors is a matter the surety must take very seriously. If the
debtor's preference action is not properly defended, the surety could be held
liable for the prepetition payments the debtor made to laborers, subcontractors,
materialmen and other trade creditors on projects bonded by the surety.
To properly defend
an indirect preference action the surety should carefully examine and challenge
the debtor's proof relating to each element of the debtor's preference action.
If the debtor fails to prove any element of its preference action, then the
action must fail. The surety should also assert all applicable affirmative
defenses, namely the exceptions to preference provided for in section 547(c)(1),
(2), (4) and (6), and the limitations period to bring a preference action
provided for in section 546(a). Finally, even if the debtor's payments to trade
creditors are determined to be avoidable preferences, under section 550(a) the
surety may not be held liable for these preferential payments. If the surety
challenges the debtor's proof of its indirect preference action and the surety
asserts all applicable defenses, then the surety may successfully defend itself
from the debtor's preference attack.
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