Most credit managers recognize that Section 547 of the Bankruptcy Code provides that, in part, transfers made to or for the benefit of a creditor within 90 days of the filing of a bankruptcy petition are subject to “recapture” by a bankruptcy trustee. This is, in essence, a preferential transfer (“preference payment”). As explained in Part I, transfers which were made within the “ordinary course of business” are not subject to the Section 547 Preference Recapture Action.

This article focuses on the next most commonly utilized basis to avoid a preference action–the contemporaneous exchange for new value exception (“contemporaneous exchange exception”). The contemporaneous exchange exception is found at Section 547(C)(1)(a)(b). Specifically, the statute exempts transfers which are made by a debtor to the creditor within 90 days of the filing of a bankruptcy petition where the benefit was made as a “contemporaneous exchange” for “new value” given to the debtor and, in fact, a “substantially contemporaneous exchange” took place.

This may seem like a mouthful; however, the rule is fairly simplistic in its application. Consider the following:

Tinker Inc. is in financial peril and is past due on payments. The purchasing agent for Tinker calls creditor and agrees to purchase additional product on a COD basis. Here there is a contemporaneous exchange for new value and the COD transfer will not be subject to recapture by a bankruptcy trustee if a petition is filed within a 90 day period.

Clearly, the COD sale is the most common form of a contemporaneous exchange. In such cases, however, it is only “fair” to exempt such transfer because (presumably) the bankrupt estate was not “depleted” by the transfer. This is commonly referred to as the “no net loss” analysis (i.e., the incoming new value offset, or took the place of the outgoing transfer).

This is a very simplistic example. Most troublesome and difficult issues arise when the transfer is not a COD transaction but where the exchange was fairly quick (i.e., payment within 48 hours, or by the way of international funds “cable” which can take upwards of 8 to 10 days). In such cases, there may not be an absolute contemporaneous exchange, but it can be asserted that the exchange was “substantially contemporaneous” and, therefore, exempt from recapture. This issue requires a case-by-case factual analysis and there are no clear cut rules that can be relied upon.

There are many variations of the COD sale. Consider the following hypothetical situation:

Tinker Inc. is in financial trouble. It is past due on payments to ABC. ABC creditor agrees to allow it to continue to purchase the product in 3/4 quantities for the same payment as would be on a full shipment.

Here the contemporaneous exchange rule would apply; however, in reality, the creditor is trying to disguise a COD sale with the “COD plus” program. Clearly, the “plus” portion relates back to the past due balance and will not be exempt. Again, an analysis of the “no net gain or loss” to the bankrupt estate will indicate whether the exception will be allowed. In this example, the estate has been depleted to the extent of the transfer on the 1/4 shipment value and, therefore, this amount will be subject to recapture.

Other common issues arise when the value is simply manufactured (“phantom” value). These cases attempt to invoke the exception without providing the transferee with any tangible value. A good example follows:

ABC creditor grants a five-month forbearance period to Tinker in return for immediate transfer of $25,000 (25% of Tinker’s balance). Tinker files a bankruptcy petition within 90 days of the transfer.

Here ABC will argue that the five-month forbearance period was “value” in exchange for the “substantially contemporaneous” transfer of $25,000. For the most part, the courts have been uniform in holding that this will not be recognized as value and the transfer will be recapturable by the trustee (provided that no other legal basis exists for avoidance).

In summary, the contemporaneous exchange exception primarily protects a creditor on a COD sale (or a very quick turnaround payment) to the troubled debtor. It is under these conditions that many struggling businesses survive and continue to obtain inventory. So long as NSF checks (certified fund transfers are most reliable) are not an issue, the COD seller (or someone arranging for very quick turnaround on payment) can be confident that such transfers will not be recaptured by a bankruptcy trustee. However, a creditor should always consider the tangible value and the relative contemporanity of the exchange. Careful attention to these factors will avoid potentially contested factual questions and provide for a smooth application of the exception.

For complicated transactions with troubled companies which contemplate further ongoing sales, it is best to consult professional advice prior to engaging in extensive transfers.