Jonathan Azoff, Can One Size Fit All? an Analysis of the Interrelationship Between the "contemporaneous Exchange" Exception and 11 U.s.c. Sec. 547(e)(2)

• Jurisdiction: United States,Federal
• Publication year: 2011
• Citation: Vol. 26 No. 2

CAN ONE SIZE FIT ALL? AN ANALYSIS OF THE INTERRELATIONSHIP BETWEEN THE "CONTEMPORANEOUS EXCHANGE" EXCEPTION AND

11 U.S.C. Sec. 547(e)(2)

INTRODUCTION

On the eve of bankruptcy, insolvent debtors often transfer assets to their creditors.¹These preferential transfers frequently permit favored creditors to receive more than they would otherwise receive under the bankruptcy process.²

These transfers disadvantage the debtor's other creditors by diminishing the pool of assets available in the debtor's estate to pay off creditors during the bankruptcy process.³The Bankruptcy Code allows the trustee to avoid such preferential transfers.⁴

It is not beneficial, however, to mandate the setting aside of all transfers of assets made prior to bankruptcy.⁵Indeed, many of these pre-bankruptcy transactions are commercially responsible and, in the business setting, may be vital to the survival of companies.⁶If all pre-bankruptcy transfers were subject to preference avoidance, creditors would refuse to deal with any company in economic distress and bankruptcy would become inevitable.⁷As a result, the Bankruptcy Code provides for exceptions to preference avoidance. One of these exceptions-the "contemporaneous exchange" exception-was designed to protect transfers where both parties intend the transfer to be a simultaneous exchange for new value, despite the fact that a temporal gap may exist between the time of the exchange and the time when the transfer is legally consummated.⁸

Section 547(c)(1) of the Bankruptcy Code details this contemporaneous exchange exception to preference avoidance.⁹Section 547(c)(1) sets forth two core requirements: (1) both parties must intend for the transfer to be contemporaneous¹⁰and (2) the transfer must in fact be substantially contemporaneous.¹¹Ever since Congress codified this exception in the Bankruptcy Reform Act of 1978, confusion has surrounded its application.

In fact, application of the contemporaneous exchange exception, specifically to the transfer of non-purchase money security interests, has resulted in a split among the circuits.¹²The majority view, adopted by the Eighth, Ninth, and Eleventh Circuits, holds that the contemporaneous exchange exception is not limited by Sec. 547(e)(2).¹³Under this approach,

Sec. 547(e)(2) provides a 30-day window during which parties may perfect their security interests and treat the perfection as if it occurred at the time of the initial exchange.¹⁴The majority view does not apply Sec. 547(e)(2) to create an absolute deadline for when the perfection of a security interest can be deemed substantially contemporaneous under Sec. 547(c)(1). Rather, these circuit courts argue that Congress, in using the broad phrase "substantially contemporaneous," intended a flexible, case-by-case approach to the application of Sec. 547(c)(1), not to be limited by Sec. 547(e)(2).¹⁵

Conversely, the First and Sixth Circuits have held that just as courts have limited the application of the contemporaneous exchange exception with regards to the perfection of purchase money security interests,¹⁶courts should similarly limit the use of the contemporaneous exchange exception in the context of non-purchase money security interests.¹⁷The First and Sixth Circuits contend that Congress drafted Sec. 547(e)(2) to establish the specific window of time in which security interests could be perfected and still be deemed to have occurred at the time of transfer.¹⁸Under this minority view, permitting the contemporaneous exchange exception to protect transfers beyond this window would allow creditors "two bites at the apple."¹⁹

The opposing positions adopted by the circuit courts paint a black and white picture for applying the contemporaneous exchange exception, requiring the false choice between the clarity of a bright line rule and the flexibility of a case-by-case analysis. This Comment argues that the appropriate relationship between Sec. 547(c)(1) and 547(e)(2) lies between the two positions. Specifically, Sec. 547(c)(1) should be interpreted broadly, but only in terms of the types of transfers it can protect from avoidance. This breadth, however, does not prevent the use of other parts of the Code or commercially accepted practices to define the phrase "substantially contemporaneous." Section 547 (c)(1) does not prevent Sec. 547(e)(2) from defining "substantially contemporaneous" in the non-purchase money security interest context. Rather, integration of Sec. 547(e)(2) into Sec. 547(c)(1) reinforces Congress's intent to establish a mechanical and clear-cut approach for the perfection of security interests.

While in scenarios where the legislature has not provided guidance as to how to define "substantially contemporaneous" courts can apply a case-by- case approach under Sec. 547(c)(1), a bright line rule should be used for the perfection of non-purchase money security interests. This approach is consistent with not only the historical progression in American preference law towards greater certainty, but also Congress's intent to combat secret liens.

Any advantages gained from a flexible approach to the contemporaneous exchange exception are outweighed by the potential for increased litigation and resultant uncertainty associated with arguing the exception on a case-by-case basis.

Part I of this Comment will begin with a brief overview of the evolution of bankruptcy preference and preference exceptions, illustrating the historical movement away from subjectivity and towards bright line rules. Part II will explore the development of the contemporaneous exchange exception and the statutory codification of Sec. 547(c)(1). Part III will describe the current split in the circuit courts that has arisen in applying the contemporaneous exchange exception to the perfection of non-purchase money security interests. This Comment will argue in Part IV that Congress intended Sec. 547(c)(1) to be available in the context of non-purchase money security interests, and for

Sec. 547(e)(2) to be used in such contexts to define the phrase "substantially contemporaneous." This Comment will further argue that this interrelationship is supported by the relevant legislative history and is in line with both the historical development of preference law and broader bankruptcy policies.

I. HISTORICAL DEVELOPMENT OF PREFERENCE LAW: FROM SUBJECTIVITY TO

CERTAINTY

The concept of avoiding preferential transfers originally developed as a mechanism to combat fraudulent debtors, intent on hiding assets from their creditors.²⁰Today, courts use preference avoidance as a major tool to promote one of the core objectives of the bankruptcy process: equality of distribution among similarly situated creditors.²¹The evolution of the bankruptcy process's treatment of the inequities caused by preferential transfers is crucial to understanding the contemporaneous exchange exception. The evolution demonstrates a movement away from subjective rules in preference law and sheds light on how the contemporaneous exchange exception can best be applied to the perfection of non-purchase money security interests.

A. Origins of Preference Law

Modern American preference law traces its origins to English law,²²where preference avoidance law was inextricably tied to the law governing fraud.²³

Early English legislation allowed avoidance of preferential transfers, but only upon a showing of fraud.²⁴Eventually, over the course of more than 100 years,²⁵English common law regarding preference avoidance evolved into two distinct lines of cases: one line punishing debtors for dispensing their assets post-bankruptcy, the other punishing debtors for transferring their assets pre-bankruptcy.²⁶In determining whether a pre-bankruptcy transfer was voidable, English courts looked to the state of mind of the debtor and the actions of the creditor.²⁷English law only found a transfer voidable where the debtor acted without pressure from a creditor.²⁸When a transfer resulted from creditor pressure, the court found no preferential behavior.²⁹Lord Mansfield succinctly summarized the then general state of the law: "If the creditor demands it first, or sues the debtor or threatens him, without fraud, the preference is good. But where it is manifestly to defeat the law, it is bad."³⁰

B. American Preference Law

The first American bankruptcy legislation, the Bankruptcy Act of 1800, did not address preferential transfers.³¹It was not until the Bankruptcy Act of

1841 that preferences were first codified in the United States.³²Transfers to benefit a specific creditor made within two months of a debtor's declaration of bankruptcy were prohibited.³³To avoid such a transfer, the trustee was required to demonstrate both that the creditor was aware of the debtor's insolvency and that the debtor intended to favor the creditor over the debtor's other creditors.³⁴

In the years following the passage of the Bankruptcy Act of 1841, American courts de-emphasized the importance of the debtor's motive. They focused instead on the solvency of the debtor.³⁵This new emphasis on "the debtor's balance sheet rather than his motive" became the foundation of the "American approach."³⁶In Arnold v. Maynard, Justice Story rejected "the peculiar provisions of the bankrupt laws [sic] of England" and explained that whether the transfer was spontaneous or the result of a request from the creditor, "under our bankrupt act [sic] of 1841 . . . [it] does not make, and ought not to make, any difference as to the rights of the other creditors."³⁷

The Bankruptcy Act of 1841 was replaced by the Bankruptcy Act of 1867, which made it easier to establish the existence of preferences³⁸by lengthening the reach-back period. The United States Supreme Court, interpreting the Bankruptcy Act of 1867 in Toof v. Martin, moved closer to the concept of a presumption of insolvency, which Congress eventually codified in 1978. In

Toof, the Supreme Court held that a debtor who made a transfer knowing of his insolvency did so...