Defending Preference Actions: Purchase Money Security Interest Transfers

Robert S. Bernstein, Esquire
Bernstein-Burkley, P.C.
Creditworthy News

The third statutory defense to a bankruptcy trustee’s preference action protects lenders who receive a purchase money security interest from a bankruptcy debtor. Section 547(c)(3) provides:

(c) The trustee may not avoid under this section a transfer —

(3) that creates a security interest in property acquired by the debtor–

(A) to the extent such security interest secures new value that was–

(i) given at or after the signing of a Security Agreement that contains a description of such property as collateral;

(ii) given by or on behalf of the secured party under such agreement;

(iii) given to enable the debtor to acquire such property; and

(iv) in fact used by the debtor to acquire such property. And

(B) that is perfected on or before 20 days after the debtor received possession of such property.

See 11 U.S.C. Section 547(c)(3).

All of the elements set forth in Section 547 (c)(3) must be met and proven by the lender in order for this defense to be successful. This Section is sometimes referred to as the “enabling loan” defense because it protects the transfer of a security interest to secure a loan that allows the debtor acquire collateral specifically covered under a security agreement. Because the transfer is not considered to have occurred until the debtor has rights in the collateral, the transfer is always on account of an antecedent debt. This Section protects such transfers.

For example, if a loan is made to the debtor to acquire certain equipment, and secured by way of a security agreement on the equipment, the security interest transfer is not considered preferential if perfected within thirty (30) days after the debtor receives possession of the equipment. Notably however, the loan must “in fact” be used to enable the debtor to purchase the equipment in which the security interest was granted. If not, then the transfer is a preference. The transfer would also be a preference if the secured party fails to perfect its interest within thirty (30) days after the debtor receives the equipment.

Problems can arise for the lender if the debtor places the loan monies in its general account and the monies are commingled with other funds. This creates a tracing problem and opens the lender up to the argument that the specific loan money was not used to purchase the equipment. Lenders can avoid this problem by making the loan check payable to the debtor and the vendor of the collateral.

Another problem for lenders is when they fail to perfect their interest within 30 days and thus assert Section 547(c)(3) in conjunction with the contemporaneous exchange defense. However, many of the Circuit Courts of Appeal have held that Section 547(c)(3) is the only protection for the purchase money security lender and that other defenses under Section 547 do not apply to such lenders.

Thus, a lender dealing with financially tenuous debtors should be careful to ensure its loan is used only for the collateral purchased by the debtor and that its security interest is perfected within 30 days of receipt of the collateral by the debtor. Failure to do this exposes the lender’s security interest to a trustee’s preference action.

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