Perverted Preference?: The Dark Potential of the Contemporaneous Exchange
for New Value Exception to Voidable Preferences
In re Gas-Mart USA, Inc., 613 B.R. 168, 170 (B.A.P. 8th Cir. 2020)
By Sam Brand
I. Introduction
While every area
of the law is shaped by public policy considerations, the field of bankruptcy
law tends to rely on a different policy rationale at almost every turn. The most basic goal of a successful bankruptcy
is to provide the debtor with the means to either pursue a fresh start or
reorganize their debt by creating a sustainable plan.[1] The most pervasive competing goal with that
of the debtor’s wellbeing is the preservation of value for the benefit of
creditors.[2] Put simply, bankruptcy serves primarily as a
debtor’s remedy, but the Bankruptcy Code (“Code”) attempts to prevent debtors
from devaluing the bankruptcy estate which must be used to pay off unsecured
creditors.
One way in which
the Code seeks to preserve value for the estate is through the concept of a
“voidable preference.” A voidable
preference is defined as: (1) a transfer of money or an interest in property by
the debtor to a creditor; (2) to settle an antecedent debt; (3) made while the
debtor is insolvent; (4) made within the ninety days immediately preceding the
filing of a bankruptcy petition; and (5) which enables a creditor to receive
more than it would receive under Chapter 7[3] The general rule is that any transfer the
court determines to be a voidable preference may be retracted from the
creditor, back to the bankruptcy estate.[4] The main purpose of this seemingly obscure
section is to prevent debtors from unfairly providing payment to select
creditors just before filing bankruptcy, leaving the remaining creditors to split
up the left-over scraps.[5]
While the aims of
preference law are noble, there are several exceptions to the general rule that
create problems for bankruptcy trustees trying to preserve the value of the
bankruptcy estate. Through the lens of In
re Gas-Mart, this article will discuss the “contemporaneous exchange for
new value” exception to preference law contained in § 547(c)(1). Ultimately, this article will propose that
this exception, as it has been applied in In re Gas-Mart, has the
potential to be severely abused and may defeat the principles of fairness upon
which preference law was founded.
II.
Factual Background
Prior to filing
bankruptcy in July 2015, Gas-Mart (the debtor) held deposit accounts at Wells
Fargo Bank and issued checks in excess of the balance of the accounts.[6] Gas-Mart and Wells Fargo entered into an
agreement under which Gas-Mart scheduled its repayment of the debt on the
accounts and granted Wells Fargo a security interest in all its assets.[7]
In March 2015,
Gas-Mart agreed to sell its real estate and personal property from nineteen Gas-Mart
locations for a total of $27 million; the contract, which closed on April 30,
2015, required the sold assets to be free of all liens.[8] To facilitate the requirement that the sold
assets were not subject to a lien, Gas-Mart agreed to give proceeds from the
sale to its creditors in return for lien releases.[9] Sun Life, a creditor, agreed to receive
roughly $14 million in proceeds from the sale as partial payment of Gas-Mart’s
debt in return for a lien release.[10] Wells Fargo received $1.3 million from the
sale in partial payment of its debt in return for a lien release.[11]
Additionally, Wells Fargo received a payment from Gas-Mart of $100,000 on April
29, one day before the sale closed.[12]
III.
Instant Decision[13]
Before digging
into the issues in the case, the court discussed what the contemporaneous
exchange for new value exception is.[14] This exception prevents a trustee from
avoiding a preferential transfer where the transfer was intended by the debtor
and creditor to be a contemporaneous exchange for new value given to the
debtor.[15] The key consideration, and therefore the crux
of the issue in this case, is the definition of “new value.” The court looked to existing case law to
determine that the release of a lien can constitute new value.[16] The court noted the policy rational behind
the exception: “Contemporaneous new value exchanges are excepted from avoidance
because they ‘encourage creditors to continue doing business with troubled
debtors who may then be able to avoid bankruptcy altogether,’ and ‘because
other creditors are not adversely affected if the debtor's estate receives new
value.’”[17]
As applied to the
case, the key issue for the court was whether Sun Life’s release of its liens
for less than full payment of its debt allowed Wells Fargo’s lien release to
provide Gas-Mart with new value in exchange for the $1.4 million in payment.[18] As a starting point, the court noted that
Wells Fargo’s interest in Gas-Mart’s property was junior to Sun Life’s; Sun
Life agreed to release its liens for payment of less than what it was owed, and
as a result, funds were made available to pay Wells Fargo, with the excess
returning to the debtor.[19] The trustee objected to this deal in that it
did not actually provide “new value” to the debtor. The trustee argued that if a senior creditor –
here Sun Life – “is not paid in full from the value of its collateral as the
result of a sale, that release of junior liens on the sale property should have
no corresponding value for the purposes of § 547(c)(1)”.[20]
The court
disagreed with the trustee. The court
articulated that the lien releases of Wells Fargo and Sun Life were contingent
on each other.[21] While it is true that the lien release of a
junior creditor is worthless to the debtor when the senior creditor still
possesses a lien, if both creditors release their liens for less than
full value, the debtor has acquired new value in reduced debt, despite the fact
that the junior lien would have been worthless under ordinary circumstances.[22]
As a last-ditch
effort, the trustee argued that Sun Life agreed to take less than the amount
owed because Wells Fargo impermissibly demanded payment in exchange for the
release of its junior liens.[23] The court responded that this demand merely
reflected the demands of the buyer in the overall deal and was fully
permissible.[24]
IV.
Comment
On its surface, In
re Gas-Mart looks like a relatively cut-and-dry case. It is hard to argue with the court’s finding
that new value was added to the bankruptcy estate based on the lien releases of
both Sun Life and Wells Fargo. Yet, when
considering the motivations of the parties, the facts do not seem to add
up. The biggest question this case
raises is why Sun Life agreed to release its liens in the first place. As a secured creditor, Sun Life was guaranteed
to receive payment in bankruptcy up to the value of the secured collateral.[25] Therefore, when Sun Life released its liens
for far less than their face value, it presumably took on a substantial loss in
order to ensure the sale went through. This
begs the question: why?
The most likely
answer is that Sun Life intentionally overvalued its liens, so that when it released
the liens in return for a kickback from the sale, it was not actually taking a
loss. This theory is nearly impossible
to prove, but it is perhaps the only explanation for Sun Life’s bizarre
behavior in this case. In the grander
scheme, it does not matter whether this theory is true, but In re Gas-Mart
illustrates a way in which a creditor can use the contemporaneous exchange for
new value exception to circumvent preference law entirely.
Valuation of
assets in bankruptcy is a notoriously tricky business, so much so that each
party usually acquires a separate appraisal, leaving the judge to determine a fair
appraisal.[26] If a creditor succeeds in convincing the
court that the value of its lien is greater than the actual value of the asset,
a wily creditor could abuse the contemporaneous exchange for new value
exception in much the same way as Sun Life.
Rather than waiting for the slow process of bankruptcy to take its
course, this creditor could simply agree to release its overvalued lien in
exchange for a payment from the debtor for less than the full value of the
lien. When all is said and done, the
creditor will have gotten far more than it would likely have received had it
merely acquired the property in bankruptcy.
V.
Conclusion
While it is
unclear if this is what happened in In re Gas-Mart, judges must be wary
of attempts to malign the bankruptcy process through inaccurate valuation
practices. This warning may not shock
bankruptcy judges who deal with valuation issues on a near daily basis, but it
serves as another reminder that the Bankruptcy Code is not perfect. While the contemporaneous exchange for new
value exception provides room for debtors to bargain with creditors, judges
must remain vigilant in order to preserve the value of the bankruptcy estate
for the sake of the bankruptcy trustee and any unsecured creditors.
[1] Elizabeth Warren et al., The Law of Debtors and Creditors 6–7
(2014).
[2] Id.
at 7.
[3] 11
U.S.C. § 547(b).
[5]
Robert Weisberg, Commercial Morality, the Merchant Character, and the
History of the Voidable Preference, 39
Stan. L. Rev. 3 (1986).
[6] In
re Gas-Mart USA, Inc., 613 B.R. 168, 170–71 (B.A.P. 8th Cir. 2020).
[7] Id.
at 171.
[8] Id.
[9] Id.
at 171, 174. This case also involved a
tax lien by the IRS, but for the purposes of this article, the tax lien release
operated in much the same way as the Wells Fargo release. For the sake of
clarity and conciseness, the issue of the tax lien will not be addressed
herein.
[10] Id.
at 171.
[11] Id.
[12] Id.
[13]
This case addressed other issues in addition to what is discussed here. This
article focuses on the “new value” issue and does not address the issues
related to flexibility of the contemporaneous exchange requirement.
[14] In
re Gas-Mart, 613 B.R. at 172.
[15] 11
U.S.C. § 547(c)(1); In re Gas-Mart, 613 B.R. at 172.
[16] In
re Gas-Mart, 613 B.R. at 172 (first citing Velde v. Kirsch, 543 F.3d 469,
474 (8th Cir. 2008) (recognizing new value under § 547(c)(1) by release of
a lien on debtor's assets); then citing Velde v. Reinhardt, 294 Fed. Appx.
242, 243 (8th Cir. 2008) (same)).
[17]
Id. (citing Dietz v. Calandrillo (In re Genmar Holdings, Inc.), 776
F.3d 961, 963 (8th Cir. 2015) (quoting Jones Truck Lines, Inc. v. Central
States, S.E. and S.W. Areas Pension Fund (In re Jones Truck Lines,
Inc.), 130 F.3d 323, 326 (8th Cir. 1997))).
[18] Id.
at 173.
[19] Id.
[20] Id.
[21] Id.
[22] Id.
[23] Id.
[24] Id.
[25] 11
U.S.C. § 506(a).
[26] Douglas
G. Baird, Donald S. Bernstein, Absolute Priority, Valuation
Uncertainty, and the Reorganization Bargain, 115 Yale L.J. 1930-33 (2006).
