Section 547(c) of the Code provides for several affirmative defenses to a preference action brought by a trustee or debtor-in-possession:

This article will discuss only four of the seven affirmative defenses to a preference action contained in Section 547: contemporaneous exchange, 547(c)(1); ordinary course of business, § 547(c)(2); enabling loan, 547(c)(3); and subsequent new value, 547(c)(4). This paper will also discuss the earmarking doctrine and the affirmative defense of statute of limitations provided in Section 546(a).

The defenses of contemporaneous exchange, ordinary course of business, enabling loan, and subsequent new value are affirmative defenses which must be pled by the defendant. Rule 7008, Rules of Bankruptcy Procedure, U.S. v. Continental Illinois Nat. Bank & Trust, 889 F.2d 1248, 1253 (2nd Cir. 1989). Otherwise, these statutory defenses are waived. In re National Lumber and Supply, Inc., 184 B.R. 74, 78 (9th Cir. BAP 1995).

Contemporaneous Exchange For New Value

"Contemporaneous new value exchanges are not preferential because they encourage creditors to deal with troubled debtors and because other creditors are not adversely affected if the debtor’s estate receives new value." In re Jones Truck Lines, Inc., 130 F.3d 323, 326 (8th Cir. 1997) citing Pine Top Ins. Co. v. Bank of Amer. Nat’l Trust & Sav. Ass’n, 969 F.2d 321, 324 (7th Cir. 1992).

A creditor can invoke the affirmative defense of contemporaneous exchange by proving (1) the preferred creditor extended new value to the debtor; (2) the creditor and the debtor intended this exchange to be contemporaneous and (3) the exchange was, in fact, contemporaneous. In re Shelton Harrison Chevrolet, Inc., 202 F.3d 834, 837 (6th Cir. 2000).

"New Value" is defined to mean "money or money’s worth in goods, services, or new credit or release by a transferee of property previously transferred to such transferees in a transaction that is neither void or voidable." § 547(a)(2) In In re Grand Chevrolet, Inc., 25 F.3d 728 (9th Cir. 1994), the debtor, Grand Motors, was in the business of buying new cars from dealers. One of the dealers was Pacific Suzuki. The trustee sought to avoid three transfers from the debtor to Pacific Suzuki as preferences. The Ninth Circuit affirmed the District Court’s holding that the first transfer was protected by ordinary course business defense. The Ninth Circuit then had to consider transfers two and three. Thirty days after delivery of two vehicles, debtor paid for them by sending two checks directly to the seller. Pacific Suzuki upon receipt of two checks released the title documents and security interests on the two vehicles involved in transfers two and three. The defendant urged the contemporaneous exchange defense in connection with transfers two and three. The Ninth Circuit found that Pacific Suzuki conferred new value on the debtor for the purposes of the contemporaneous exchange exception to the preference rule by releasing the title documents and security interests in connection with transfers two and three. Grand Chevrolet at 733. The Ninth Circuit remanded that part of case concerning transfers two and three to the District Court to determine the amount of new value conferred by the seller.

Value should be measured at the time of the transfer. Grand Chevrolet at 733 and In re NuCorp Energy, Inc., 902 F.2d 729, 733 (9th Cir. 1990).

It is not necessary that the new value go directly to the debtor. The only requirement is that the "new value" benefits the debtor. In re Jones Truck Lines, Inc., 130 F.3d at 326-327. In Jones Truck Lines, the debtor brought a preference action to recover nearly $6 million in employee benefit payments paid to Central States which managed debtor’s employee benefit funds. Debtor paid the benefit funds to Central States ("transfers") on a past due basis. Even though debtor was delinquent in making its payments, Central States continued to administer the various employee benefit trusts. The defendant Central States argued that the debtor received new value in exchange for the employee benefits in the form of continued employee service. The Eighth Circuit reversed the holding of the lower courts that the transfer was a preference because new value did not flow directly from the pension funds. The Eighth Circuit stated that the word "directly" does not appear in Section 547(c)(1). The fact that the new value came from the employees who continued to work for debtor because Central States continued to administer their benefit funds and not directly from Central States did not negate the contemporaneous exchange defense. Jones Truck Lines, Inc. at 327.

The Fifth Circuit reached the same conclusion in Matter of Fuel Oil Supply & Terminaling, Inc., 837 F.2d 224 (5th Cir. 1988). In Fuel Oil Supply, (1) debtor paid creditor; (2) creditor as a result released letters of credit securing the loan; (3) the bank that had issued the letters of credit then released its lien on debtor’s collateral given to the bank. The Fifth Circuit held that new value did not have to come directly from the creditor who received the preference, but may be provided by a fully secured third party. Fuel Oil Supply at 231. The Fifth Circuit further held that the bank conferred new value on the debtor by releasing its lien on debtor’s collateral, and debtor-in-possession was not entitled to recover the transfers.

A preference defendant must prove the specific valuation of the new value given by the defendant to the debtor. Section 547(c)(1) protects preferential transfers only to the extent of the amount of new value. In re Jet Florida Systems, Inc., 861 F.2d 1555, 1559 (11th Cir. 1988).

The second element of a contemporaneous exchange is the intent of debtor and creditor that the transaction be a substantially contemporaneous exchange. This rule was first established in National City Bank of New York v. Hotchkiss, 231 U.S. 50, 34 S. Ct. 20 (1913). In the Hotchkiss case the bank made an unsecured loan in the morning and then learned later in the day that the borrower was having financial difficulties. During the afternoon of the same day, the bank requested and got from the borrower a security interest in property to secure the loan. The court found that the transfer of the security interest was not a contemporaneous exchange because the lender did not originally intend the loan to be secured. The Hotchkiss case was decided in 1913, but "intent" is still a necessary element in proving a contemporaneous exchange defense to a preference action.

The Court In re Wadsworth Bldg. Components, Inc., 711 F.2d 122, 124 (9th Cir. 1983) stated at page 124: "The critical inquiry in determining whether there has been a contemporaneous exchange for new value is whether the parties intended such an exchange." See also In re Spada, 903 F.2d 971, 975 (3rd Cir. 1990) and Matter of Prescott, 805 F.2d 719, 727 (7th Cir.1986); In re Gateway Pacific Corp., 153 F.3d 915, 918 (8th Cir. 1998). In Wadsworth, the debtor was required to pay past debts before the creditor would receive further credit. The court held that since the creditor conditioned the future shipment of goods on payment by debtor, the parties lacked the intent of a contemporaneous exchange even though the actual transaction was contemporaneous. Wadsworth, 711 F.3d at 124. In In re Filter Corp., Inc., 163 F.3d 570 (9th Cir. 1998), the creditor loaned money to debtor during the 90-day preference period, but did not file its financing statement until five days after the date of security interest agreement. The Ninth Circuit affirmed the bankruptcy court’s finding that the parties intended a contemporaneous exchange, and the transfer took effect at the same time as the loan because the financing statement was filed within 10 days as provided in Section 547(e)(2)(A); In re Filter Corp., 163 F.3d at 584-590.

The third element is that the exchange must be in fact a contemporaneous exchange. Dean v. Davis, 242 U.S. 438, 37 S. Ct. 130 (1917). In Dean v. Davis, the parties intended to make a secured loan, but the mortgage on debtor’s real property was not signed until one week after the note was signed. The Supreme Court found that the parties intended a contemporaneous exchange, and that the interval of one week did not preclude an actual contemporaneous exchange. The Fifth Circuit in Matter of Lockin, 101 F.3d 435, 443 Ftn. 10 (5th Cir. 1996) held that the time difference between the date the creditor receives a check and the date the check clears the debtor's bank does not defeat the defense of contemporaneous exchange - assuming the check is promptly deposited and cleared.

The existence of intent, contemporaneous of the exchange and new value are questions of fact. In re Lewellyn & Co. Inc., 929 F.2d 424, 426 (8th Cir. 1991); In re Spada, 903 F.2d at 975.

Ordinary Course Of Business

The purpose of the ordinary course of business defense is to protect credit transactions that are paid and received in the ordinary course of the business of the debtor and the debtor’s transferee. In re Energy Co-op. Inc., 832 F.2d 997, 1004 (7th Cir. 1987). Such transactions do not detract from the general policy of Section 547 of discouraging unusual action by either the debtor or creditors during the debtor’s slide to bankruptcy.

The affirmative defense of ordinary course of business has three elements:

  1. The debt on which the payment was made must have been incurred in the ordinary course of business or financial affairs of both the debtor and the transferee § 547(c)(2)(A).
  2. The transfer must have been made in the ordinary course of business or financial affairs of the debtor and the transferee § 547(c)(2)(B).
  3. The transfer must have been made according to ordinary business terms. § 547(c)(2)(C).

See In re R. M. Taylor, Inc., 245 B.R. 629, 637 (Bankr. W. D. Mo. 2000).

Ordinary Course Of Business Between Debtor And Creditor; The Subjective Prong, Subsections (c)(2), (A)-(B)

The courts have used the "baseline of dealings" between the parties in applying the subjective test for determining if the debt and the transfer was made in the normal course of business between the debtor and creditor. In re Lan Yik-Foods Corp., 185 B.R. 103, 113 (Bankr. E.D. N.Y. 1995). The "baseline of dealings" approach is fairly simple: The court in applying the "baseline of dealings" between the parties will examine the course of dealings between the debtor and the creditor in the period before the 90-day preference period and compares that "baseline" with the dealings between creditor and debtor during the 90-day period. In re Healthco Intern. Inc., 132 F.3d 104, 110 (1st Cir. 1997). If the debtor’s payments made during the 90-day preference period were in accordance with the baseline of dealings established by parties in the pre- 90-day period, they are protected by subsection (c)(2)(B) because they are recurring, customary credit transactions. In re A. W. & Associates, Inc., 136 F.3d 1439, 1441 (11th Cir. 1998); In re T.B. Home Sewing Enterprises, Inc., 173 B.R. 782, 789 (Bankr. N.D. Ga. 1993). Payment made by the debtor during the preference period that are inconsistent with debtor’s history of payment preceding the preference period, were not made in the ordinary course of business of the debtor and are avoidable preferences. In re Healthco Intern. Inc., 132 F.3d at 110.

A late payment is considered "ordinary" within the meaning of subsection (c)(2)(B) if the "baseline of dealings" between the parties shows that the creditor accepted late payments from debtor. In re Grand Chevrolet, Inc., 25 F.3d 728, 733 (9th Cir. 1994); Matter of Tolona Pizza Products, 3 F.3d 1029, 1033 (7th Cir. 1993); In re Fred Hawes Organization, Inc., 957 F.2d 239, 244 (6th Cir. 1992).

In In re Gateway Pacific Corp., 153 F.3d 915, 917-918 (8th Cir. 1998), the debtor had consistently made tardy payments without penalty before and during the preference period. The payments during the preference period, however, were significantly later than the late payments made in the nine months preceding the preference period. During the nine month period preceding the preference period, the median time that elapsed between the date of invoice and date of payment was 35 days. During the preference period, this median time increased to 54 days or a 54% increase. Gateway Pacific at 918. Also, during the nine months preceding the preference period, only nine of approximately 155 payments were 50 days old, while 24 of the 28 payments during the preference period were at least fifty or more days old. Gateway Pacific at 918. The Eighth Circuit affirmed the bankruptcy court’s holding that the late payments made during the preference period were not exchanges protected by Section 547(c)(2). Gateway Pacific at 919.

If payments are made somewhat sooner during the preference period, they are not preferential payments if they "were sufficiently consistent with the payment times during the prior 12 months". Lovett v. St. Johnsbury Trucking, 931 F.2d 494, 498 (8th Cir. 1991).

"Ordinary Business Terms"; The Objective Prong, Subsection (c)(2)(C)

The Seventh Circuit in Matter of Tolona Pizza Products Corp., 3 F.3d at 1031 stated that it was easy to understand the first two requirements of the ordinary course of business defense: the debt must have been incurred in the ordinary course of debtor and creditor, and the payment on the debt must also have been made and received in the ordinary course of their business. This "baseline" approach is simple and easy to understand. The court stated that the third element, "ordinary business terms," is more difficult to understand. Tolona Pizza at 1031. Does it refer to what is "ordinary" between the debtor and the creditor or does it refer to what is ordinary in the market or industry in which they operate? The Seventh Circuit stated that the circuits were divided on this point. The Seventh Circuit, however, found that if Section 547(c)(2)(C) referred only to the dealing between the creditor and debtor, then it added nothing to 547(c)(2)(B). Tolona Pizza at 1032. The court after some additional analysis concluded that a creditor "must show that the payment he received was made in accordance with the ordinary business terms in the industry (emphasis supplied)." Tolona Pizza at 1033. The court formulated what has become the "objective" standard of 547(c)(2)(C) at page 1033 of the opinion:

We conclude that "ordinary business terms" refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary and therefore outside the scope of subsection C.

The above test for the third element of the ordinary course of business defense is often referred to as the "objective" test. The Seventh Circuit revisited this issue two years later in Matter of Midway Airlines, Inc., 69 F.3d 792 (7th Cir. 1995). The court stated that in order to sustain the ordinary course of business exception, the creditor must prove by a preponderance of the evidence that the transaction (1) was ordinary as between the parties, subsection (c)(2)(A)-(B), and (2) ordinary in the industry examined as a whole, subsection (c)(2)(C). Matter of Midway Airlines, Inc. at 797.

In Tolona Pizza, the creditor-defendant introduced evidence of industry sales terms through the testimony of its own executive vice-president, a person with extensive experience in the industry. The Seventh Circuit found this evidence sufficient. Tolona Pizza at 1033. The court in Midway found, however, that the creditor had tried to satisfy subsection (c)(2)(C) indirectly by testimony on its own relationship with the debtor and the creditor’s other customers. The Court found that the creditor had not met its burden of proof. The creditor had failed to prove an industry standard. The court stated at pages 797-798 of the opinion:

Reliance solely on the experience of the creditor renders ineffectual the important dichotomy between the subjective requirements of 11 U.S.C. Section 547(c)(2)(A)-(B) which can be satisfied through the proof of the parties own dealings, and the objective requirement imposed by 11 U.S.C. § 547(c)(2)(C) which requires reference to some external datum.

See also In re Weilert R. U. Inc., 245 B.R. 377 (Bankr. C. D. Cal. 2000).

The U.S. Courts of Appeals that have considered this matter during the 1990's have, after much effort, arrived at the same conclusion reached by the Seventh Circuit in Tolona Pizza, but with some variations.

The Eighth Circuit in In re U.S.A. Inns of Eureka Springs, Arkansas, 9 F.3d 680, 684 (8th Cir. 1993) adopted the Tolona Pizza "objective" test in applying Section 547(c)(2)(C). The Eighth Circuit in Eureka Springs stated that subsection (c)(2)(C) "does not require a creditor to establish the existence of some uniform set of business terms within the industry in order to satisfy its burden. It requires evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems." Eureka Springs at 685. The Eighth Circuit went on to review the Tolona Pizza decision and adopted its "objective test".

The Tenth Circuit in In re Meredith Hoffman Partners,12 F.3d 1549, 1553 (10th Cir. 1993) cited the Tolona Pizza decision and adopted a variation of it. The court stated that "ordinary business terms" are "the kinds of terms that creditors and debtors use in ordinary circumstances, when debtors are healthy (emphasis supplied)." Meredith Hoffman at 1553. This formulation raises a difficult obstacle for defendants because it precludes them from using proof of how similar businesses in the industry treat delinquent customers who are having financial problems.

The Third Circuit in In re Molded Acoustical Products, Inc.,18 F.3d 217 (3rd Cir. 1994) adopted a modified version of the Tolona Pizza objective test for subsection (c)(2)(C), at page 225 of the opinion:

[T]he more cemented (as measured by its duration) the pre-insolvency relationship between the debtor and the creditor, the more the creditor will be allowed to vary its credit terms from the industry norm yet remain within the safe harbor of §547(c)(2).

This Third Circuit approach which adjusts the objective test based on the length of the parties relationship has been referred to as the "sliding scale standard" or "sliding scale window". The "sliding scale standard" of the Third Circuit in Molded Acoustical means that the longer the duration of the parties pre-insolvency relationship, the more the creditor will be allowed to vary its terms from the industry norm by the customary terms between the parties if those terms did change significantly during the pre-insolvency period. Molded Acoustical at 225. This "sliding scale" variation on the Tolona Pizza test seems to inject a "subjective" element into a supposedly "objective" test.

The Fourth Circuit in Advo-System Inc. v. Maxway Corp., 37 F.3d 1044, 1050 (4th Cir. 1994) adopted the Tolona Pizza rule "modified by and embellished" by the Third Circuit’s "sliding scale" of Molded Acoustical. Advo-System Inc.

The Sixth Circuit in In re Carled, Inc., 91 F.3d 811, 818 (6th Cir. 1996), the Second Circuit in In re Roblin Industries, Inc., 78 F.3d 30, 41 (2nd Cir. 1996) and the Eleventh Circuit in In re A. W. & Associates, 136 F.3d 1439, 1442 (11th Cir. 1998) adopted the Tolona Pizza interpretation of Subsection (c)(2)(C) after reviewing the decisions of the other circuits set out above. See also In re Food Catering & Housing, Inc., 971 F.2d 396, 398 (9th Cir. 1992) which required payment to be ordinary (1) in relation to past practices between the debtor and the particular creditor; and (2) in relation to "prevailing business standards."

Enabling Loan Defense

Section 547(c)(3) of the Code exempts a transfer of a security interest in property acquired by the debtor to the extent that the security interest secures new value given by a secured party to enable the debtor to acquire property. The security interest must be perfected on or before 20 days after the debtor received possession of the property.1 The new value cannot be given prior to the execution of a security agreement containing a description of the property as collateral. This provision of Section 547 is referred to as the "enabling loan" defense. All of the circuit courts that have considered the issue have agreed that a purchase money security interest that is not sheltered under the enabling loan defense of Section 547(c)(3) cannot have alternative shelter under the contemporaneous exchange defense of subsection (c)(1). Matter of Locklin, 101 F.3d 435, 443 (5th Cir. 1996); In re Holder, 892 F.2d 29, 31 (4th Cir. 1989); In re Tressler, 771 F.2d 791, 794 (3rd Cir. 1985); In re Davis, 734 F.2d 604, 607 (11th Cir. 1984), and In re Vance, 721 F.2d 259, 262 (9th Cir. 1983). The Fifth Circuit in Locklin at page 443 stated that such a holding best accorded the legislative intent and policies underlying the enactment of Section 547(c)(3). The Honorable Emilio M. Garza, writing for the Fifth Circuit in Locklin, summed up the Court’s position in Latin: Expressio unius est exclusio alterius. Locklin at 444.

The courts, however, are divided in the application of Section 547(c) to non-purchase money security interests. The Ninth Circuit Bankruptcy Appellate Panel (BAP) in In re Marino, 193 B.R. 907 (9th BAP 1996) found that the creditor had taken all steps necessary to timely perfect its non-purchase security interest, but the recording clerk failed to timely record the interest. The court held that when the delay in recording the security interest can be explained, the transfer can be protected as a contemporaneous exchange. Marino at 916. See also In re Pine Top Ins. v. Bank of America Nat. Trust & Sav., 969 F.2d 321, 328-329 (7th Cir. 1992). The Sixth Circuit, however, in In re Arnett, 731 F.2d 358, 363 (6th Cir. 1984) held that a secured creditor who did not timely perfect its non-purchase security interest as required by Section 547(c)(3) cannot use the affirmative defense of contemporaneous exchange.

The grace period provided for in Section 547(c)(3) pre-empts any state law that provides a different period. Fidelity Financial Services, Inc. v. Fink, 522 U.S. 211, 118 S. Ct. 651 (1998); Matter of Hamilton, 892 F.2d 1230, 1234-1235 (5th Cir. 1990).

Subsequent New Value

"A key justification for the new value exception is that while the payment of preferences to the creditor diminished the estate, other creditors are not really worse off since the subsequent advance of new value replenishes the estate." In re Micro Innovations Corp., 185 F.3d 329, 336 (5th Cir. 1999).

The Fifth Circuit in Matter of Toyota of Jefferson, Inc., 14 F.3d 1088 (5th Cir. 1994) had to decide whether new value had to remain unpaid if it was to qualify as "subsequent new value" under Section 547(c)(4). The trustee argued that none of the preferential payments made by the debtor could be excepted under Section 547(c)(4) because the debtor paid for all of the new value accorded to it. The Fifth Circuit disagreed with bankruptcy trustee’s interpretation of Section 547(c)(4) "believing it to be contrary to the statute’s plain language." Toyota of Jefferson at 1092. The Court quoted from Professor Vern Countryman’s article on Section 547(c)(4), The Concept of a Voidable Preference in Bankruptcy, 38 Vand. L. Rev. 713, 788 (1985) at pages 1092 and 1092 of the opinion, and summarized by saying that the debtor’s payment of the new value does not preclude the defense of subsequent new value if the payment itself is otherwise avoidable. Toyota of Jefferson at 1093. The Court at page 1093 cited the opinions of several bankruptcy courts that adopted this approach.

The Fifth Circuit noted, however, in footnote 2 on page 1093 of the opinion that several circuits disagreed and stated (in dicta) that the new value had to remain unpaid in order to qualify as an offset under Section 547(c)(4)(B). The court cited the following cases: In re Kroh Brothers, 930 F.2d 648 (8th Cir. 1991); In re New York City Shoes, Inc., 880 F.2d 679, 680 (3rd Cir. 1989); In re Jet Florida Sys., Inc., 841 F.2d 1082, 1083 (11th Cir. 1988); In re Prescott, 805 F.2d 719, 731 (7th Cir. 1986).

The Ninth Circuit in In re IRFM, Inc., 52 F.3d 228 (9th Cir. 1995) also had to answer the key question concerning the application of the "subsequent new value" defense. Does the new value have to remain unpaid for it to qualify as "subsequent new value"? The Ninth Circuit in IRFM gives a helpful review of the decisions of the other circuits at page 231 of the opinion:

Courts and commentators agree that the exception contains two key elements. First, the creditor must give unsecured new value and, second, this new value must be given after the preferential transfer. See In re Fulghum Constr. Corp., 706 F.2d 171, 172 (6th Cir.), cert. denied, 464 U.S. 935, 104 S. Ct. 342, 343, 78 L.Ed.2d 310 (1983). The majority of courts have also adopted a short hand approach to section 547(c)(4)(B) and hold that section 547(c)(4) contains a third element, that the new value must remain unpaid. The Eighth Circuit recently followed this approach in In re Kroh Bros. Dev. Co., 930 F.2d 648, 653 (8th Cir. 1991) (creditor who has been paid for the new value by the debtor may not assert a new value defense). The rationale for this position is (1) if new value has been repaid by the debtor, the estate has not been replenished and; (2) the creditor is permitted the double benefit of a new value defense and the repayment of the new value. See Kroh Bros., 930 F.2d at 652. However, focusing only on the issue of whether the new value is unpaid may lead to some absurd results . . . . As a result, an emerging trend has developed where a few courts have reached the contrary result and hold that new value need not remain unpaid.

The Ninth Circuit in IRFM, Inc. agreed with the Fifth Circuit’s analysis in Matter of Toyota of Jefferson that a new value defense is permitted when the new value is paid unless the debtor repays the new value by a transfer which is otherwise unavoidable. IRFM, Inc. at 231-232. The Court stated at page 231 of the opinion that the court agreed with the Kroh Bros. rationale that a creditor should not get double credit for an advance of new value. The Court, however, stated that instead of barring the new value defense altogether anytime new value has been repaid, the new value defense should be allowed if the trustee can recover the repayment by some other means. IRFM, Inc. at 231.

The Ninth Circuit in IRFM also had to decide whether the district court’s formula in calculating the new value offset was correct, and at page 232, it set out that formula:

Check Date

Payment Amount ($)

Goods Shipped ($)

Preference ($)

April 25








May 2








May 11








May 16








May 23








May 30








June 6








June 13








June 20








June 22








The Ninth Circuit accepted this formula at page 232 of the opinion stating that under this formula a creditor is permitted to carry forward preferences until they are exhausted by subsequent advances of new value. The Court stated that this approach is derived from In re Thomas W. Garland, Inc., 19 B.R. 920 (Bankr. E.D. Mo. 1982). Under the above formula, subsequent advances of new value may be used to offset prior (and not just immediately prior) preferences.

The Court in IRFM makes it clear that the aggregate of subsequent new value payments will be applied as an offset against the total of the preferential payments. The Court following the Garland decision refused to limit an individual shipment of "subsequent new value" to the immediately preceding preferential payment by debtor. The Court stated at page 232:

The rationale behind this method is two-fold. First, it encourages creditors to do business with financially troubled debtors. A creditor will be more likely to continue to advance new value to a debtor if all these subsequent advances may be used to offset a prior preference. If a second advance of new value carries no benefit, the creditor will be unlikely to make it. In re Meredith Manor, Inc., 902 F.2d 257, 259 (4th Cir. 1990). Second, this approach recognizes the fluid nature of ongoing commercial activity where a creditor looks to a debtor’s entire repayment history, instead of one isolated transaction, to decide whether to advance new credit. Id.

A contrary approach was adopted in Leathers v. Prime Leather Finishes Co., 40 B.R. 248 (D. Maine 1984). Under this "transactional approach," the new value given by the creditor may be used to offset only the immediately preceding preference. . . .

We reject the Leathers approach. First, nothing in the language of section 547(c)(4) requires this result. The statute states only that after a preferential transfer, new value must be given. See PNP Holdings, 167 B.R. at 627. Second, as discussed above, the Garland approach better satisfies the purposes and goals of the preference section.

Both the Fifth Circuit in In re Micro Innovations Corp., 185 F.3d 337 (5th Cir. 1999) and the Fourth Circuit in In re Meredith Manor, Inc., 902 F.2d 257, 259 (4th Cir. 1990) rejected the "transactional approach" approved in Leathers v. Prime Leathers Finishes Co., 40 B.R. 248 (D. Maine 1984), and followed the Garland rule described by the Ninth Circuit in IRFM, Inc. in the above quotation.

Statute Of Limitations

Section 546(a) of the Code currently provides that a preference action (among others) may not be commenced after the earlier of:

  1. the later of –
  1. 2 years after the entry of the order for relief; or
  2. 1 year after the appointment or election of the first trustee under section 702, 1104, 1163, 1202 or 1302 of this title if such appointment occurs before the expiration of the period specified in subparagraph (a); or
  1. the time the case is closed or dismissed.

Section 546(a) of the Code makes it clear that limitation of two years begins to run on the filing of the Chapter 7, 13, or 11. If a trustee is appointed, then it begins anew with the appointment of the first trustee under Section 702 (election of trustee by creditors in Chapter 7 cases) Section 1104 (appointment of trustee in Chapter 11 cases), Section 1163 (appointment of trustee in railroad reorganization), Section 1202 (appointment of trustee in Family Farmer Chapter 12 cases), or Section 1302 (appointment of trustee in Chapter 13 cases). § 546(a)(1)(b) The closing or dismissal of a bankruptcy case bars any preference adversary proceeding. § 546(a)(2)

The Ninth Circuit in a decision dated before the 1994 amendment of Section 546(a) Bankruptcy Code, In re Software Centre. Intern. Inc., 994 F.2d 682 (9th Cir. 1993), held that Section 546(a), which provides that a trustee may not commence a preference action after the running of the statute of limitations, applies to an adversary proceeding filed by a debtor-in-possession. The Fifth Circuit in In re CompuAdd Corp., 137 F.3d 880, 881-882 (5th Cir. 1998) also held that the two-year statute of limitation applies to debtors-in-possession in the same manner that Section 546(a) applies to trustees. The Fifth Circuit in CompuAdd had to apply the pre-1994 version of Section 546(a) since the Chapter 11 was filed in 1993.

The appointment of an estate representative under Section 1123(b)(3) to retain and enforce any claim or interest belonging to the debtor or to the estate does not restart the running of the two-year statute of limitations; the limitation period begins running on the date a Chapter 11 petition is filed. In re DeLaurentiis Entertainment Group, Inc., 87 F.3d 1061, 1064 (9th Cir. 1996); Starzynski v. Sequoia Forest Industries, 72 F.3d 816, 822 (10th Cir. 1995).

Earmarking Doctrine

On occasion a third party lends money to a debtor for the purpose of paying a specific creditor. Under the earmarking doctrine, the loan is not a preferential transfer because the third party is simply substituted for the original creditor. In re Heitkamp,137 F.3d 1087, 1089 (8th Cir. 1998); In re Interior & Wood Products Co., 986 F.2d 228, 231 (8th Cir. 1993); In re Kelton Motors, Inc., 97 F.3d 22, 28 (2nd Cir. 1996).

In Heitkamp, a bank, the preference action defendant advanced money to the debtor to pay the obligations of debtor to certain subcontractors who had furnished labor and material in the construction of a house. The debtor, in consideration of the loan, granted a second mortgage to secure the loan to the bank. The subcontractors released their mechanic’s liens, after they received payment from the debtor. The trustee sought to have the second mortgage voided as a preferential transfer. The Eighth Circuit rejected the trustee’s effort to void the second mortgage stating that under the earmarking doctrine, there is no avoidable transfer when (1) a new lender and debtor agree to use the loaned funds to pay a specific antecedent debt, (2) the agreement terms are actually performed, and (3) the transaction viewed as a whole does not diminish the debtor’s estate. Heitkamp at 1088-1089. The Court held there was no preference because the loan funds never become property of the estate; instead a new creditor stepped into the shoes of an old creditor. Heitkamp at 1089. The earmarking doctrine does not apply when a new creditor is not substituted for an old creditor. In re Interior Wood Products Co., 986 F.2d at 232.

The earmarking doctrine is not limited to the protection of guarantors. In re Kemp Pac. Fisheries, Inc., 16 F.3d 313, 316 N2 (9th Cir. 1994).

Bad Checks

The "contemporaneous exchange" defense is not available to a creditor who is given a bad check by the debtor and the debtor subsequently makes good on the check by a subsequent payment; the dishonor of the check creates an antecedent debt. In re Barefoot, 952 F.2d 795, 800 (4th Cir. 1991); In re Car Renovators, 946 F.2d 780, 782 (11th Cir. 1991); In re Standard Food Services, Inc., 723 F.2d 820, 821 (11th Cir. 1984). Payment by a bad check and subsequent payment by the debtor to the creditor also strips the creditor of the ordinary course of business defense. In re Barefoot at 801. In re Federated Marketing Inc., 123 B.R. 265, 270 (Bankr. S.D. Ohio 1991). In re Kroh Bros. Development Co., 115 B.R. 1011, 1020 (Bankr. W.D. Mo. 1990). Some courts hold that a replacement check does not relate back to the date of the bad check. In re So Good Potato Chip Co.,137 B.R. 330, 331 (Bankr. E.D. Mo. 1992). Other courts, however, hold that if the debtor subsequently honors the bad check within a reasonable time, then the transfer date will relate back to the delivery date of the dishonored check. In re Kenitra Inc., 797 F.2d 790, 791 (9th Cir. 1986).


1Prior to the 1994 amendments to the Bankruptcy Code, the period was ten days. Congress expanded the period to 20 days to conform with most state law.

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