Restructuring

The Fourth Circuit Court of Appeals recently had occasion to consider the frequently asserted earmarking and contemporaneous exchange for new value defenses to preference actions.  By a 2-1 majority decision, the appellate panel found that a debtor’s use of loan proceeds to cash collateralize a letter of credit was not subject to avoidance as a preference because the beneficiary of the letter of credit showed that the transfer did not diminish the bankruptcy estate.  In doing so, the appellate panel clarified the evidentiary burden of a transferee invoking the contemporaneous exchange for new value defense.
Background
ESA Environmental Specialists, Inc. was a construction, architectural, and industrial engineering firm that performed services for federal agencies.  ESA was required to obtain both a performance and a payment bond in connection with its federal construction jobs.  ESA requested one of its existing surety bond companies, Hanover, to issue performance bonds on certain federally funded construction projects.  Hanover, however, refused to issue any new bonds unless ESA provided to Hanover a $1.375 million irrevocable letter of credit to collateralize the new performance bonds as well as all of Hanover’s existing guarantees and surety obligations on behalf of ESA.  ESA obtained the LC through a fairly circuitous route — it obtained a loan from Prospect Capital, used the proceeds from the Prospect loan to purchase a certificate of deposit from SunTrust, and then pledged the CD to SunTrust to secure its reimbursement obligations under the LC issued by SunTrust to Hanover.  Hanover then delivered the performance bonds, which ESA in turn tendered to the governmental agencies for final award of the new government contracts.
Within three months, ESA filed a voluntary chapter 11 petition.  After ESA’s filing, Hanover drew on the LC and received payment from SunTrust in the amount of $1.375 million.  Shortly thereafter, the bankruptcy court approved a section 363 sale of substantially all of the assets of ESA to Prospect Capital, including the assumption and assignment of many of the Hanover bonded contracts to an affiliate of Prospect.  This affiliate failed to complete the Hanover bonded contracts, and Hanover obtained an order from the bankruptcy court permitting it to exercise its rights as surety to complete the jobs.
ESA’s bankruptcy trustee subsequently filed an adversary proceeding to set aside the transfer of the LC funds to Hanover, claiming that Hanover was an indirect beneficiary of the transfer of the Prospect loan proceeds, and such transfer was avoidable as a preference under section 547 of the Bankruptcy Code.  (See previous blog posts here and here for a discussion of the elements of a preference action.)  Hanover moved for summary judgment on two grounds.  First, it asserted that it was protected under the “earmarking doctrine,” a case law exception to preferences under which Hanover argued that the Prospect loan proceeds never became property of the debtor or the bankruptcy estate (and, therefore, no transfer of an interest of the debtor in property occurred) because the proceeds were “earmarked” to cash collateralize the LC.  Second, Hanover argued that the transfer of the Prospect loan proceeds was a contemporaneous exchange for new value under section 547(c)(1) of the Bankruptcy Code.
Earmarking Doctrine
The “earmarking doctrine” is a judicially created defense to a preference action.  It creates the legal fiction that funds lent to a prepetition debtor that are “earmarked” to pay the claims of another creditor and are, in fact, used in that manner do not constitute property of the debtor.  Accordingly, when the loan proceeds are transferred from the new creditor to the existing creditor, no “transfer of an interest of the debtor in property” occurs within the meaning of section 547(b) of the Bankruptcy Code.  One of the principles underlying the earmarking doctrine is that it makes no sense to recover such a transfer if the transaction simply had the effect of replacing one creditor with another creditor having essentially the same rights as the existing creditor.  In other words, no diminution in the value of the debtor’s estate occurs in a proper earmarking transaction.
The bankruptcy court found that the indirect transfer of the Prospect loan proceeds for the benefit of Hanover (i.e., to cash collateralize the letter of credit issued to support ESA’s existing and future reimbursement obligations to Hanover) was protected from avoidance by the earmarking doctrine.  The Fourth Circuit, however, pointed out that it is not simply sufficient under the earmarking doctrine to show that the transaction had the effect of replacing one creditor with another creditor.
Although the Fourth Circuit acknowledged that it had recognized previously the earmarking doctrine where payments were made by a third party directly to an existing creditor, in that case it was clear that the loan was made for the specific purpose of paying a particular debt.  In ESA, though, Hanover did not present any evidence that the terms of the Prospect loan required ESA to use the loan proceeds solely to extinguish a specific debt.  Instead, ESA was permitted to (and did) use the proceeds to cash collateralize a letter of credit that supported both the repayment of existing obligations to Hanover and new obligations to Hanover.  Thus, ESA was not merely substituting one creditor for another, but owed a higher total debt than it did before the Prospect loan.  As a result, claims against the bankruptcy estate were increased (and the value of the estate diminished) as a result of the transaction.  Under this analysis, though, perhaps Hanover could have protected itself better if the loan had designated the specific use of proceeds and two separate transfers of the loan proceeds had been made — one to cash collateralize a letter of credit issued solely to support the existing reimbursement obligations and another to cash collateralize a separate letter of credit issued for the purpose of supporting ESA’s obligations to Hanover for new performance bonds.
New Value
The bankruptcy court also found that Hanover had a new value defense to the trustee’s preference action.  It held that the transfer of the Prospect Funds was a contemporaneous exchange for new value under section 547(c)(1) of the Bankruptcy Code because Hanover issued new performance bonds, enabling ESA to enter into new government contracts, the same day as the LC was provided.  Hanover proffered evidence that, in exchange for the $1.375 million LC, Hanover issued new performance bonds having a face amount of over $7 million, and ESA was able to enter into new government contracts to that would generate revenues in excess of $1.375 million.  (ESA’s former CEO estimated the revenues under the new contracts to exceed $3.9 million.)  The trustee did not contradict Hanover’s evidence or offer an alternative measure of value for the contracts.  The bankruptcy court also found it inequitable to require Hanover to return the LC funds, given that Hanover ultimately was required to complete ESA’s obligations on the bonded contracts.
By a 2-1 majority, the Fourth Circuit agreed with the bankruptcy court that Hanover had a complete new value defense.  Noting that a payment may support a new value defense even if the debtor receives it from a party other than the creditor, the majority framed the key question as whether, on account of the alleged preferential transfer, the loss in value to the estate from the transfer of existing assets was offset by the acquisition of a new asset.
The trustee did not dispute that the government contracts ESA had obtained on account of the new bonds had value, and, instead, argued that Hanover had not proved with specificity the amount of new value ESA received.  The Fourth Circuit majority found that Hanover only had to show that the new government contracts ESA obtained had a value at least as great as the amount of the alleged preferential transfer to demonstrate the value of ESA’s bankruptcy estate had not diminished as a result of the transfer.  Thus, the bankruptcy court’s conclusion that Hanover proved with specificity the new value given to the debtor was not clearly erroneous where the trustee failed to introduce evidence to contradict the affidavit of ESA’s former CEO that the revenues under the new ESA government contracts would exceed $3.9 million.
On appeal, the trustee also argued that any new value was not exchanged contemporaneously with the transfer of the Prospect loan proceeds.  The majority, however, found that the trustee was conflating the value of the new government contracts, in and of themselves, with the eventual revenues that ESA would receive upon performance of the contracts.  Although ESA did not receive the actual revenues under the contracts at the time the Prospect loan was made, the evidence showed that the new contracts had a value in and of themselves in excess of $1.375 million.  Thus, it was not erroneous for the bankruptcy court to find the flow of the Prospect loan proceeds occurred substantially contemporaneously with the posting of the new performance bonds and award of the new contracts.
The Dissent
The dissent did not agree that Hanover should prevail on its new value defense because it disagreed with the majority’s reasoning that the new government contracts made possible by Hanover’s new performance bonds had a “new value” of at least $1.375 million.  Instead, it characterized ESA’s contract rights as a conditional promise to pay ESA money at some indefinite future time and noted that the ESA CEO’s affidavit only supported the premise that ESA expected to make a profit of more than $1.375 million by performing the work under the new contracts.  Section 547(a)(1) of the Bankruptcy Code specifically defines “new value” as “money or money’s worth in goods, services, or new credit,” and the dissent reasoned that a promise of future payment for future services is not “money or money’s worth,” even if ESA’s unrealized expectation of future profit may have had “value” in traditional business/commercial parlance.  It believed that Hanover had reduced the size of ESA’s estate because Hanover did not replenish the estate with value equal to the $1.375 million it received.  Instead, it concluded that Hanover jumped ahead of ESA’s other creditors to receive far more as a result of the LC draw than if the transaction had not occurred, and Hanover had been forced to recover payment on its existing bonds in the bankruptcy estate.
The Take Away
The majority observed in a footnote that the bankruptcy court’s findings that Hanover had established both an earmarking defense and a new value defense were legally inconsistent determinations.  To invoke the earmarking doctrine, a defendant must prove that the alleged preferential transfer was used to pay an antecedent debt.  In contrast, under the new value defense, the alleged preferential transfer must have been used to support a new transaction.  It would seem that, in most circumstances, the defenses are mutually exclusive, although a defendant could plead both in the alternative.
Of note is the dispute between the majority and dissent regarding Hanover’s burden in proving that the new contracts provided “new value” of at least $1.375 million.  While the majority adopted an expansive definition of “new value” that looked to the value of the new government contracts as a “commercially fungible asset,” the dissent argued for the adoption of a stricter reading of “money or moneys’ worth” under section 547.  The debate between the majority and dissent serves as a word of caution for defendants in preference actions seeking to assert a new value defense to consider carefully the evidence proffered in support of new value, particularly where the commercial value of the assets is tied to future profits.