On March 1, 2013, the US Court of Appeals for the Fourth Circuit in Campbell v. Hanover Insurance Co. (In re ESA Environmental Specialists, Inc.) affirmed the decision of the US Bankruptcy Court for the Western District of North Carolina which held that the new value defense applied to protect a debtor's use of loan proceeds to cash collateralize a letter of credit within 90 days of bankruptcy from a preference attack under section 547(b) of the Bankruptcy Code. In upholding this decision, the Fourth Circuit clarified that the new value defense requires a showing that the alleged preference did not diminish the debtor's estate.

ESA Environmental Specialists, Inc. (ESA) is an environmental and industrial engineering firm that entered into contracts with the federal government to perform services. ESA was required to obtain and present two types of surety bonds as a prerequisite to being awarded any contracts. To obtain seven additional government contracts, ESA asked The Hanover Insurance Company (Hanover), one of its existing surety bond companies, to issue additional surety bonds. Hanover insisted on a $1.375 million irrevocable letter of credit as collateral to address its concerns about ESA's financial stability. ESA complied by borrowing money from Prospect Capital (Prospect), using those funds to purchase a certificate of deposit (CD) from SunTrust Bank (SunTrust). It then pledged the CD to SunTrust in return for a letter of credit issued by SunTrust to Hanover.

Soon after, ESA filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. Hanover then drew on the letter of credit, receiving the $1.375 million face amount from SunTrust, which in turn liquidated the CD. During the bankruptcy proceedings, most of ESA's assets were sold to Prospect, including ESA's government contracts. However, Prospect failed to complete these contracts. Eventually, the Bankruptcy Court entered an order allowing Hanover to take responsibility for their completion, as it remained bound by the surety bonds.

ESA's bankruptcy trustee filed an adversary proceeding to set aside the transfer of the letter of credit funds to Hanover, alleging that Hanover was an indirect beneficiary of ESA's transfer of the Prospect loan proceeds into the CD, and that this transfer was an avoidable preference under section 547 of the Bankruptcy Code.

Hanover argued against avoidance, asserting the following two defenses:

The Bankruptcy Court granted summary judgment in favor of Hanover and held that both defenses applied to prevent the funds from being an avoidable preferential transfer. The US District Court for the Western District of North Carolina affirmed the Bankruptcy Court's decision.

The trustee appealed the District Court's ruling to the Fourth Circuit. It argued that the Bankruptcy Court improperly applied both:

The Fourth Circuit held that the Bankruptcy Court clearly erred in applying the earmarking defense because ESA did not use the Prospect loan proceeds just to pay an existing debt. Instead, ESA used the Prospect loan proceeds to collateralize both existing obligations to Hanover and the additional surety bonds issued by Hanover. In doing so, ESA did not merely substitute one creditor for another, but actually increased its total debt, and as a result diminished the value of the estate available for repayment of ESA's existing creditors. Therefore, the earmarking defense did not apply because the indirect transfer of the Prospect loan proceeds for the benefit of Hanover were not used to pay an antecedent debt, which is a critical element of the earmarking defense.

However, the Fourth Circuit upheld the holding of the Bankruptcy Court regarding the new value defense. It agreed that Hanover met its burden of proving with specificity the new value because Hanover only had to show that the new government contracts had "a value at least as great as the amount of the alleged preferential transfer in order to demonstrate that ESA's bankruptcy estate had not diminished as a result of the transfer." The uncontradicted evidence on record demonstrated that the new contracts would generate revenues in excess of $1.375 million, the amount of the alleged preference. The Fourth Circuit rejected the trustee's argument that Hanover was required to demonstrate the exact amount of new value beyond that amount.

The Fourth Circuit also found that the Bankruptcy Court did not clearly err in holding that the award of the new government contracts occurred substantially contemporaneously with the transfer of the Prospect loan proceeds. While the Fourth Circuit agreed that ESA did not receive the actual revenues under the contracts at the time Prospect made the loan, it explained that the trustee was conflating the value of these contracts which, based on the record, had a value in excess of $1.375 million in and of themselves, with the eventual revenues that ESA would receive after the contracts were performed.

Although the majority adopted an expansive definition of "new value," the dissent argued that the term should be interpreted strictly, so that the expectation of future profit cannot constitute new value. Therefore, defendants in preference actions asserting the new value defense should take note that courts may reject evidence of new value that is dependent on future profits.

The Fourth Circuit also noted that the earmarking defense and the new value defense are legally inconsistent. While the former requires that the alleged preferential transfer was used to pay an antecedent debt, the latter requires that it was made to support a new transaction. Therefore, in most cases they are mutually exclusive, but a defendant could assert both in the alternative.

For more information on preferences, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors.