Settlement Pacts & Forbearance Within 90-Day Prepetition Period: New Value or No Value?

January 01, 2001

Currently, there is no definite answer as to whether or not settlement agreements based on the forbearance of a suit will be deemed as a new obligation or a “transfer for or on account of an antecedent debt.” The outcome may be different, depending on the jurisdiction of the dispute and the facts of each case. However, in order to buttress your client’s position, it is important to draft the agreement, whether forbearance or settlement, to provide for consideration, financial or otherwise, in addition to mere forbearance.

Consider this scenario:
Your vendor /supplier client has sent inventory to a retailer. The retailer is in default on its payment obligations under the contract for the sale of the inventory with the vendor/supplier. Currently, the vendor/supplier has no security interest in the inventory or any other assets of the retailer. The vendor/supplier is considering suing the retailer for breach of contract. The vendor/supplier is also considering forbearing suit and obtaining a security interest in the inventory. However, the vendor/supplier is worried that if the retailer files for bankruptcy within 90 days of this “transfer” then it will be looked on as a preference and will be avoidable.

Would forbearance of a lawsuit constitute “new value” so that the transfer is not preferential and, thus, unavoidable? Would payments from the debtor to the creditor under a settlement agreement, pursuant to litigation over an antecedent debt, be considered a “transfer for or on account of an antecedent debt owed by the debtor before such transfer was made?”

Defining ‘New Value’
Bankruptcy Code Section 547(c)(1) provides that “[t]he transferee may not avoid under this section a transfer…to the extent that such transfer was intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to

the debtor and in fact [was] a substantially contemporaneous exchange.”

The Code defines the term “new value” as “money or money’s worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee under any applicable law, including proceeds of such property, but does not include an obligation substituted for an existing obligation.”

Case Law Interpreting “New Value”
In In re Duffy, 3 B.R. 263 (Bankr. S.D.N.Y. 1980) the court held that forbearance of a lawsuit is not new value. The court provided that “an obligation substituted for an existing obligation is expressly excluded from the definition of ‘new value.’ ” Id. at 266.

In Duffy, the debtor was in default on payments for his leased vehicle. The creditor argued that it gave new value to the debtor when it accepted the late payment and forbore repossessing the leased vehicle so the debtor could keep the car for his use. The court found that this forbearance of repossessing the car did not enhance the value of the debtor’s estate and was of “no economic solace to the creditors of [the] estate.”

The court reasoned that the basic concept underlying bankruptcy legislation is the fundamental goal of equality of distribution. When a creditor gives new value in exchange for a debtor’s payment, this “has not depleted the debtor’s estate to the detriment of other creditors.”

Some believe that Duffy created a categorical rule that forbearance is not new value. However, this categorical rule has not been uniformly adopted. Many courts hold that mere forbearance of a lawsuit against a debtor is not “new value.” See id.; In re Pan Trading Co., 125 B.R. 869, 876-77 (Bankr. S.D.N.Y. 1991); Matter of Mid-Atlantic Fund, Inc., 60 B.R. 604, 609 (Bankr. S.D.N.Y. 1986). “To constitute new value, the actual value to the debtor of the forbearance in ‘money or money’s worth’ must be established by the defendant.” In re Buffalo Auto Glass, 187 B.R. 451, 454 (W.D.N.Y. 1995). “When a creditor threatens to exercise a legal remedy against a debtor, and in exchange for not so doing extracts a payment for antecedent debt, nothing of value has accrued to the debtor’s estate to compensate other creditors for the loss of that payment.” In re Maxwell Newspapers, Inc., 192 B.R. 633, 637 (Bankr. S.D.N.Y. 1996).

In In re Jet Florida System, Inc. the court listed examples of new value: the value of insurance coverage provided after the payment of delinquent premiums; the value of leased equipment when the lessor permitted the debtor-lessee to continue using the equipment to produce inventory after default in rental payments; and the value of the electricity supplied by the utility to the debtor after preferential payments. 841 F.2d 1082, 1084 (11th Cir. 1988) (citing In re Dick Henley, Inc., 45 B.R. 693, 699 (Bankr. M.D. La. 1985), In re Quality Plastics, 41 B.R. 241, 242 (Bankr. W.D. Mich. 1984), and In re Keydata Corp., 37 B.R. 324, 328-29 (Bankr. D. Mass. 1983)).

The court also listed examples of forbearance that did not constitute new value: no new value when the creditor forbears to repossess a leased car after the debtor defaults because this did not enhance the value of the debtor’s estate and forbearing to terminate a lease after the lessee defaulted was not new value because the lessor was only exercising a pre-existing right, not new value. See id. at 1084 (citing In re Duffy, supra and In re Lario, 36 B.R. 582 (Bankr. S.D. Ohio 1983)).

The court in Jet Florida System, Inc. then found that the creditor’s forbearance from terminating the lease was not new value. See id. The court reasoned that if the debtor had actually stayed and used the leased property it may have constituted new value, but the debtor did not. See id. Therefore, the lease was a financial drain on the estate. See id.

Where courts have found “new value,” the “new value” was more than merely forbearing litigation. See Lewis v. Diethorn, 893 F.2d 648 (3d. 1990); Nelson Co. v. AmQuip Corp., 128 B.R. 930, 935 n.13 (E.D. Pa. 1991) (providing that the debtor and creditor intended this exchange to be a “contemporaneous exchange for new value, which it was since the debtor “exchanged its right to contest the judgment for new value represented by the [creditors] reduction of the judgment amount”).

In Lewis a settlement agreement between the debtor and creditor was entered into prior to the debtor filing bankruptcy. The settlement agreement provided that the debtor would pay the creditor moneys owed for breaching their real estate contract and in exchange the creditors would drop their suit and lift the lis pendis on the property that the dispute was over. 893 F.2d at 648. The court held that this exchange fell within the statutory exception to the trustee’s avoidance power under section 547(c), since this was a “contemporaneous exchange for new value . . . ” and was in fact such an exchange. See id. at 650. The court stated that the new value was evidenced by the rise in the value of the property when the creditors lifted the lis pendens and also by the freedom from the risk of litigation. See id. at 649-50. Therefore, in certain circumstances where the debtor can establish that there was actually new value as a result of the forbearance of suit, the transfer will be unavoidable.

The underlying policies of these holdings under the Bankruptcy Code are to “encourage creditors to continue extending credit to financially troubled entities while discouraging a panic-stricken race to the court house” and “to promote equality of treatment among creditors.” In re Jet Florida Systems, Inc., 841 F.2d at 1083.

To promote these policies, forbearance of a claim or suit should only be new value when actual value can be established by the defendant. Therefore, the modification of an existing agreement may or may not constitute new value when forbearance of a lawsuit or claim is the sole consideration. See In re F & S Central, 53 B.R. 842 (E.D.N.Y. 1985) This question must be decided by the trier of fact. See In re F & S Central, 53 B.R. 842 (E.D.N.Y. 1985).

Section 547(b) of the Bankruptcy Code provides that “the trustee may avoid any transfer of an interest of the debtor in property – (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the date of the filing of the petition; … (5) that enables such creditor to receive more than such creditor would receive if – (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.”

Many creditors have argued that a transfer, pursuant to a settlement agreement, is not “for or on account of an antecedent debt,” but actually a new obligation. The argument is that what the debtor received was not the freedom from liability on an antecedent debt, but the freedom from the risk of litigation. The cash payment represents the debtor’s new obligation under the settlement agreement for getting this benefit. Therefore, the payment is not “for or on account of an antecedent debt.”

The Third Circuit in Lewis agreed with this analysis and held that the payments made to the creditor, pursuant to a settlement agreement where the creditor forbears their right to sue, was not “for or on account of an antecedent debt” and therefore was unavoidable. 893 F.2d at 649-50.

In Lewis, the court reasoned that what the debtor received was a rise in the value of his property when the lis pendens was lifted and freedom from the risk of litigation, not the freedom from liability of an antecedent debt. See id. at 650.

Similarly, in In re Anthony Sicari, the court held that there was no preference because the transfer was made prior to the 90-day period before the bankruptcy petition. See In re Anthony Sicari, 144 B.R. 656, 652 (Bankr. S.D.N.Y. 1992) (citing the Lewis case). However, the court further provided that even if it was a transfer, the release of funds was the result from settlement of litigation and served to extinguish the current obligation. See Id. Therefore, the payment was not on an antecedent debt. See Id. at 652; see also Nelson Co., 128 B.R. at 935 (providing that debtor’s agreement to forbear contesting the judgment in exchange for the creditor reducing the judgment was part of the negotiated settlement and an unavoidable transfer).

However, other courts have held that a settlement agreement where the debtor pays the creditor to forbear litigation of an antecedent debt is “for or on account of the antecedent debt.” In Bioplasty Inc. v. First Trust Nat. Assoc., 155 B.R. 495, 499 (D. Minn. 1993), the defendants argued that the transfer was made to eliminate the costs and risks associated with litigation, relying on Lewis. The court rejected the Lewis holding providing that “[t]he opinion contains no analysis whatsoever, and simply makes the conclusory statement that the payments were made for one reason rather than another.”

The court further stated that even if they did agree with the Lewis holding it would be distinguishable from this case because here the settlement agreement was made due to the debtors concern over the possible liability in the class action suit, as evidenced by the debtor’s statements in paragraph V of the settlement agreement. Therefore, the settlement agreement was made “on account of the antecedent debt.”

In Lease-A-Fleet, Inc. v. Wolk, 151 B.R. 341, 351-52 (Bankr. E.D. Pa. 1993). the court held that the debtor was a secured creditor and thus not an avoidable preference because the Debtor could not prove that the creditor received more than they would have if a Chapter 7 liquidation had been filed. The court then went on to comment on the argument that the payment was not made “for or on account of an antecedent debt.” See id. The court disagreed with the holding in Lewis and provided that “merely because a payment is made by a debtor in settlement of litigation, a payment on an antecedent debt is [not] necessarily transformed into a contemporaneous exchange.” Id. at 352.

The court further provided that it was “nonsensical” to argue that “merely because the parties settled litigation, and this settlement resulted in payments to the creditor, the settlement creates a new obligation for which the payment may be deemed outside of the scope of section 547(b)(2).” Id. at 352.

About the Author
Ted A. Berkowitz is a partner at Farrell Fritz, concentrating in Bankruptcy and Creditors’ Rights. He represents secured and unsecured creditors, landlords, purchasers of assets and other parties in interest in bankruptcy court proceedings. He defends preference and fraudulent conveyance actions as well as claims arising out of failed business transactions. Mr. Berkowitz also counsels clients in out-of-court workouts and debt restructurings. An often-published author on bankruptcy and secured lending topics, Mr. Berkowitz served as editor of the Bankruptcy Strategist, a publication of the New York Law Journal, and is currently a member of its board as well as a frequent contributor.

Creditors’ Rights Department
Our bankruptcy and workout group is a microcosm of Farrell Fritz’s overall practice, drawing from all areas of the firm’s expertise. The group is made up of a core of attorneys who spend their time solely on bankruptcy and workout matters. However, the group frequently draws upon lawyers from litigation, corporate, environmental, labor and tax to assist it with the multitude of issues that frequently arise in troubled financially distressed situations.

The Creditors’ Rights and Bankruptcy Practice Group represents primarily creditors, both secured and unsecured, although the firm has represented borrowers in limited strategic engagements. The group represents official committees, trustees, examiners and officers and directors in Chapter 11 cases. The group also represents parties acquiring assets through bankruptcy as well as parties being sued by debtors or trustees to recover preferences or fraudulent conveyances, or parties seeking reclamation of goods sold. With respect to institutional lenders, the Creditors’ Rights and Bankruptcy Practice Group: Reviews loan documents and lender’s collateral coverage for existing and potential defects and enforcement problems

Advises the client regarding available alternatives

Works with the client to avoid lender liability exposure

Evaluates the borrower’s proposals against the backdrop of potential litigation strategies

Documents pre-bankruptcy resolutions with an eye toward possible future bankruptcies.

In addition, the group’s attorneys frequently assist their colleagues in the Corporate and Real Estate Departments in analyzing bankruptcy issues that arise in loan originations including, for example, preferential payments, credit enhancement issues, fraudulent conveyances, alter ego, substantive consolidation and intercreditor issues. Our clients may have an ongoing relationship with a debtor in bankruptcy, as a landlord, a service provider or other.. We assist these clients in continuing to do business with the debtor while assuring prompt payment for products or services provided post-petition.

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