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The Floating Lien on Inventory and Accounts and the Improvement in Position Test How Safe Is the 547(c)(5) Safe Harbor

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The attachment of a commercial lender's floating lien on inventory and receivables is a "transfer" subject to the preference rules of §547(b). For purposes of §547, the "transfer" is made when the debtor has acquired rights in the inventory or receivables. (§547(e)(3).)

The attachment of a commercial lender's floating lien on inventory and receivables is a "transfer" subject to the preference rules of §547(b). For purposes of §547, the "transfer" is made when the debtor has acquired rights in the inventory or receivables. (§547(e)(3).)

Thus the general rule, which secured lenders find hard to fathom, is that receivables created during the preference period and inventory coming into the debtor's possession during the preference period give rise to potential avoidable preference claims, regardless of when the lender filed its financing statement.

Section 547(c) contains the exceptions to the preference rules, and §547(c)(5) contains the exception that provides a safe harbor for the lender secured by inventory and receivables. That subsection provides that the trustee or debtor-in-possession may not avoid as a preference any transfer:

that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent that the aggregate of all such transfers to the transferee caused a reduction, as of the date of the filing of the petition and to the prejudice of other creditors holding unsecured claims, of any amount by which the debt secured by such security interest exceeded the value of all security interests for such debt on the [date of the commencement of the preference period; i.e., 90 days or one year before the filing date].

This exception to the preference rule is commonly known as the "improvement in position" test. The preference is limited to the amount by which the floating lien creditor has reduced its unsecured position.

The floating lien creditor is therefore at risk to the extent its secured position has improved during the preference period. That improvement is determined by measuring the extent of the creditor's debt in excess of the value of creditor's collateral at the beginning and end of the preference period. A creditor whose debt is fully secured throughout the preference period is not at risk, as no inventory or receivable created during the preference period could have caused (in the words of §547(c)(5)) a "reduction" in the amount by which the creditor was undersecured.

Thus, the first inquiry is whether the creditor was undersecured at the beginning of the preference period, and the second inquiry is whether the creditor was less undersecured at the time of the bankruptcy filing. A valuation of the collateral becomes the crucial issue.

"Value" is determined on a case-by-case basis. See In re Ebbler Furniture & Appliances Inc., 804 F.2d 87, at 91 (7th Cir. 1986), which stated: "We follow the Fifth Circuit's lead and hold that under §547(c)(5) value should be defined on a case-by-case basis, with the factual determinations of the bankruptcy court controlling."1 In re Ebbler upheld the bankruptcy court's application of the cost of inventory as its value. Other courts have adopted different valuation standards.2 This, of course, leaves the secured creditor subject to considerable uncertainty, as significant dollar differences (and preference risk) can hinge on the testimony of experts and the standard of valuation adopted by a court. The uncertainty of valuation of the inventory and/or accounts can leave the creditor perilously close to (or over) the edge of preference liability.

A reduction in the creditor's undersecured position is not sufficient for a preference to exist. Section 547(c)(5) also requires that the reduction in the secured creditor's undersecured position be "...to the prejudice of other creditors holding unsecured claims..." Courts have had difficulty applying this requirement; that which constitutes "prejudice" is not well defined.

The "prejudice to other creditors" standard has been defined by one court to require a showing that "[G]enerally, there must be some diminution in the estate that is available for distribution to unsecured creditors." In re Castletons Inc., 154 B.R. 574, 579 (D. Utah 1992); aff'd 990 F.2d 551 (10th Cir. 1993). If the debtor's assets that are used to purchase or create inventory or receivables are already subject to the secured creditor's lien, the cases have held there is no "prejudice" to unsecured creditors.

In Castletons the debtor was a clothing retailer that started liquidating outside of chapter 11 and completed the liquidation in chapter 11. The lower court found that the pre-petition debtor was selling inventory and turning receivables into cash, then using the cash to buy inventory and pay its expenses. The fact that the bank may have improved its position was found to be irrelevant, because unsecured creditors had no superior claim to those assets; therefore the estate was not diminished to their detriment. The district court affirmed, relying on the conclusion that increases in the value of the collateral based on profits or financing by a secured creditor do not give rise to "prejudice" to unsecured creditors. Castletons, 154 B.R. at 579-580.

The 10th Circuit affirmed the Castletons district court decision, stating:

Thus, it is irrelevant whether [the bank] improved its position so long as unsecured creditors did not have a claim to [the bank's] collateral. The purpose of §547(c)(5) is "to protect the secured creditor against preference actions resulting from mere market fluctuations in the value of debtor's accounts or inventory during the relevant 90-day period. 4 Collier ¶547.13, at 547-62. At the same time, however, a creditor may not improve its position at the expense of other creditors. Id. Thus, "if the secured creditor improves its position by acquiring a lien on additional after-acquired inventory or receivables during the 90-day period...preceding bankruptcy and makes no new advance to match its improved position, then there is a preference...
Id. at 547-60 to 547-61.Castletons, 990 F.2d at 556. The Castletons Court of Appeals decision defines the "prejudice" requirement in terms of whether the secured lender financed the new receivables or inventory, either by the use of proceeds of old collateral or by the advance of new funds. That court also stated that, as long as the reduction in the secured lender's unsecured position did not diminish the assets otherwise available to unsecured creditors, there is no "prejudice."3 See, also, In re Carper, 63 B.R. 582, 585 (Bankr. W.D. Va. 1986).

Castletons is the furthest a court has gone to attempt to define the "prejudice" standard of Code §547(c)(5). Other courts have struggled with it, to the point that the secured creditor's obligation to meet its burden of proving the §547(c)(5) exception (see §547(g)) becomes the critical evidentiary standard. Thus in In re Universal Foundry Company, 163 B.R. 528, 533-534 (E.D. Wis. 1993) the court reached a conclusion that there was prejudice to unsecured creditors after rejecting the secured creditor's argument that a build-up of inventory and receivables was not prejudicial to unsecured creditors as it could only have benefitted a junior secured creditor. In an unpublished ruling, the Seventh Circuit Court of Appeals upheld the district court decision based on the secured creditor's failure to prove that the build-up in inventory and receivables arose solely out of assets already encumbered by the creditor's security interest. See 1994 U.S. App. Lexis 20634.

The burden of proving lack of "prejudice" to unsecured creditors and the extent to which a court requires a creditor to carry that burden leave much to the discretion of the bankruptcy judge. These cases offer little guidance; there are relatively few cases. One suspects that the uncertainty of the law leads to settlement opportunities.

Other questions arise. One may ask, for example, how much "prejudice" must be shown. If some of the inventory build-up during the preference period was paid for out of collected receivables, and some of the inventory was provided by unpaid suppliers, is it only the value of that unpaid inventory that should be included in the preference calculation, as an unsecured creditor was only prejudiced to that extent? Or is some prejudice to one unsecured creditor sufficient to make all of the improvement in position preferential?4 The above cases do not answer these questions, or those left by the Castletons decision. The courts must resolve these issues before secured lenders will be able to effectively measure their floating lien preference risk.


Footnotes

1The Ebbler court also noted Collier's suggestion that a liquidation standard of valuation would apply in a chapter 7 case and a going concern standard of valuation should be used, subject to exceptions, in chapter 9, 11 or 13 cases. See Ebbler footnote 2.[Return to Text]

2See, e.g., In re Lackow Bros. Inc., 752 F.2d 1529 (11th Cir. 1985) and In re Universal Foundry Co., 163 B.R. 528 (E.D. Wis. 1993), which applied a going concern standard of valuation; and see In re Clark Pipe & Supply Co., 893 F.2d 693 (5th Cir. 1990) and In re Joe Flynn Rare Coins Inc., 81 B.R. 1009 (Bankr. D. Kansas 1988), which applied a liquidation standard of valuation. Many courts also make reference to õ506(a) and its direction that "such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property..."[Return to Text]

3One may ask if Castletons establishes one or two standards: (a) there is no prejudice if there are no assets for unsecured creditors; and (b) there is no prejudice if the improvement in position arose from additional secured creditor financing or the proceeds of existing collateral.[Return to Text]

4Courts other than the Universal Foundry Company court also have struggled with the burden of proof issues. See In re Missionary Baptist Foundation, 796 F.2d 752 (5th Cir. 1986). [Return to Text]

Journal Date: 
Monday, December 1, 1997

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