Replacement Checks and the Bankruptcy Preference:
Do You Keep The Money?
By Robert Norman
The good news is your customer replaced its NSF check to you. The
bad news is the customer filed bankruptcy within ninety days of issuing
the replacement check. Consequently, the trustee demands return of
the value of the replacement check as a preference. What are your
preference defenses when you have received a replacement check?
A replacement check intended to substitute a NSF check which is
initially transferred contemporaneously for new value may not be
protected from the trustee's avoidance powers. Bankruptcy courts
have interpreted 11 U.S.C. § 547(c)(1) to stand for the proposition
that a replacement check is not a contemporaneous transaction, and
generally is not tendered for new value, thus empowering the trustee
to avoid the transfer.
In In re JWJ Contracting Company, Inc., 287 B.R. 501 (9th
Cir. 2002), the court held that the substitution of a Cashier's Check
(i.e., replacement check) was not a contemporaneous exchange for
new value. The court found that the replacement check constituted
a credit transaction, not a cash transaction, thus the new value
exception would not protect a replacement check payment made to the
vendor within the preference period.
In JWJ, the debtor issued a check to the vendor in exchange
for an unconditional lien release that waived the vendor's right
to payment under a city bond. The debtor's bank returned the check
to the vendor unpaid for insufficient funds. Within two weeks the
debtor replaced the NSF check with a cashier's check. Although the
vendor asserted that they gave a contemporaneous exchange of new
value for the payment when they released their lien, the trustee
asserted that the later accepted " replacement check" cannot constitute
a contemporaneous exchange for new value.
In order to analyze why the replacement check did not qualify as
a contemporaneous exchange for new value, we must analyze the nature
of an 11 U.S.C. § 547(c) defense to a preferential transfer.
To illustrate, pursuant to § 547(c), the trustee may not avoid
a transfer made to a vendor, (1) to the extent that such transfer
was -- (A) 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 (B) in fact was a substantially
contemporaneous exchange. The contemporaneous exchange for new value
defense "is grounded in the principle that the transfer of new value
to the debtor will offset the payments, and the debtor's estate will
not be depleted to the detriment of other creditors." Lumbman
v. CA Guard Masonry Contractor, Inc. (In re Gem Constr. Corp.
of Virg.), 262 B.R. 638, 645 (Bankr.E.D.VA.2000). According to § 547(a)(2), "new
value" in the context of a contemporaneous exchange means "money
or money's worth in goods, services, new credit, or a release by
a transferee of property previously transferred to such transferee
in a transaction that is neither void norvoidable 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." The problem with a replacement check is that the debtor
is substituting it for an existing obligation; ordinarily no new
value is transferred to the debtor.
The parties' intent with respect to the transaction is a key factor
to consider when analyzing the effect of the replacement check. Note
that the party asserting a contemporaneous defense "has the burden
of proving that the parties intended the transfer to be a contemporaneous
exchange for new value, that the exchange was contemporaneous, and
that new value was given." Dye v. Rivera (In re Marino),
193 B.R. 907, 913 (9th Cir. BAP 1996).
As mentioned above, when analyzing the replacement check's effect
on a new value defense, one must determine whether the replacement
check (i.e. substituted check) was exchanged for new value. A review
of the legislative history of § 547(c) (1) reveals that the
payment of a debt by means of a check is equivalent to a cash payment
unless the check is dishonored. Customarily, when a vendor receives
a replacement check, the check satisfies a preexisting debt and therefore
is not a contemporaneous exchange for a new value. Congress also
expressed in the legislative history of § 547(c)(1) that a credit
transaction cannot be considered contemporaneous.
The court in JWJ reasoned that the dishonor of the check
changes the nature of the transaction from one intended for a contemporaneous
cash exchange to a credit transaction. Essentially, the court found
that the creditor "did not [intend to] give new value for the promise
to make the dishonored check good. Rather, the creditor intended
that the cashier's check would replace the dishonored check." In
re JWJ Contracting Company, Inc., 287 B.R. 501, 511 (9th Cir. 2002).
Therefore, a replacement check generally will not qualify as a contemporaneous
exchange for new value because it is a non-contemporaneous credit
transaction with no new value given to the debtor. Moreover, a replacement
check is typically issued with the intent to replace a previously
dishonored check, thus the bankruptcy court will generally allow
the trustee to avoid the transfer. Consequently, vendors must be
mindful of their preference defenses when accepting a replacement
check which substitutes a check drawn on insufficient funds.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley
LLP Summer 03