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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

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