Defending Preference Actions – SECURITY INTERESTS IN INVENTORY OR RECEIVABLES

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

A Creditor holding a security interest in a bankruptcy debtor’s inventory or receivables may be able to avail itself to the defense provided for in Section 547(c)(5) of the Bankruptcy Code in order to defeat a bankruptcy trustee’s preference action. This section provides:

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

(5) that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent that the aggregate of all such transfers to the transferee caused a reduction, as of the date of the filing of the Petition, and to the prejudice of other creditors holding unsecured claims, of any amount by which the debt secured by such security interest exceeded the value of all security interest for such debt on the later of —

(A)

(i) with respect to a transfer to which subsection (b)(4)(A) of this section applies, 90 days before the date of the filing of the Petition; or

(ii) with respect to a transfer to which subsection (b)(4)(B) of this section applies, one year before the date of the filing of the Petition; or

(B) the date on which new value was first given under the Security Agreement creating such security interest.

This preference exception applies to creditors with a security interest in the debtor’s inventory or receivables that was perfected prior to the 90 day preference period. Assuming the creditor’s interest in the inventory and receivables does not improve within the 90 days before bankruptcy, the trustee will not be able to succeed in a preference case.

For most businesses inventory and receivables generally change on a regular basis. If a creditor is oversecured 90 days before the bankruptcy, then any increase or decrease in the value of the collateral makes no difference because there can be no preference as to an antecedent debt.

In contrast, if the value of the inventory and receivables of a debtor increase within the 90 days prior to bankruptcy, an undersecured creditor’s position grows, thereby creating an avoidable preference. This is particularly true if the creditor maintains an after acquired security interest in inventory or receivables, and the debtor then acquires additional inventory and receivables during the preference period without any corresponding advances of credit. The result is a preference because under Section 547(e)(3) of the Code, “a transfer is not made until the debtor has acquired rights in the property transferred.” See 11 U.S.C. Section 547(e)(3). A debtor therefore does not grant a security interest in after acquired inventory and receivables until it acquires rights in the collateral, which is always after the perfection date of the original security agreement. Thus, after acquired property during the preference period will be considered a transfer on the account of an antecedent debt and avoidable by the trustee, unless the creditor can successfully assert this defense or one of the other preference defenses under Section 547(c).

On the other hand, a secured creditor can receive a preference even if the value of the inventory and receivables is constant. In such instances, the debtor makes payments towards the debt resulting in an improvement of the creditor’s position, because the amount of the inventory and receivables to pay the debt has increased as a result of paying down the debt obligation.

Trustee preference actions against secured creditors who improve their position during the preference period are not nearly as common as preference actions against general unsecured creditors who receive a payment or transfer during the preference period. The reason for this may be that trustees do not take the time to analyze whether creditors holding security interests in a debtor’s inventory or receivables enhanced their security position just prior to bankruptcy.

When trustees do file such preference actions, the burden of proving a Section 547(c)(5) defense falls on the creditor. The defense requires the creditor to assess the value of the debtor’s inventory and receivables just prior to the preference period and at the time of the bankruptcy petition to determine if the creditor’s position improved. In making this determination, some courts have used a liquidation value, while others have used a going concern value. Proving the value of the secured creditor’s interest during these time periods can be as simple as reviewing the debtor’s financial records, or, if this fails, then it can be as involved as retaining an expert witness to offer an opinion. If the debtor’s inventory and receivables remained constant, then the creditor must show that the debt obligation did not decrease during the preference period.

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