Potential Situations in Which the Surety May Receive a Direct Preference
By In prior Surety Today the Blog posts we have addressed the concept of preferences in bankruptcy. In this post we will look at some of the potential transfers that a surety may receive from its principal within 90 days of the principal’s subsequent filing of bankruptcy (the preference period) that may constitute a direct preference. I use the word “may” because as we discussed in a prior blog post there are a number of well-recognized defenses to preference actions that could come in to play to repel a preference claim, it just depends on the facts of each situation.
A. The surety receives payment of the bond premium.
Yes, the surety may receive a preferential transfer when the principal pays the bond premium, unless one of the defenses to a preference is available. The bond premium may be paid at any number of times: (a) some sureties require the premium to be paid prior to or contemporaneously with the execution and delivery of the bond; (b) some sureties require payment within a specified period of time, such as 45 days after the execution and delivery of the bond; (c) some sureties are willing to wait until after the obligee pays the principal the bond premium in the principal’s first payment application; and (d) some sureties may allow even greater flexibility for bond premium payments. The two most obvious preference defenses in this situation are:
- A contemporaneous exchange for new value – the value is the surety’s execution of the bond in return for the payment of the premium. But, as discussed in our previous post, a “contemporaneous exchange” means “contemporaneous,” and most of the payment options listed above, other than the first one, are not necessarily “contemporaneous.”
- A payment in the ordinary course of business. However, the “flexibility” of some sureties for when the premium payment is made, and whether the payment meets the “ordinary course of business” or “ordinary business terms” standards, may make this defense difficult for a surety to maintain or prove. This defense may be available for more of the payment options listed if they are truly “ordinary” payments.
In summary, a surety’s execution and delivery of a bond prior to receiving a payment for the bond premium may result in a claim for a preferential transfer. We have faced this situation before so we know that it can occur.
B. The surety may receive a voluntary transfer of the principal’s real and/or personal property.
A surety may receive collateral at the inception of the surety’s bond program for the Debtor, and prior to or contemporaneously with the bonds being executed – and the contemporaneous exchange for new value defense will be effective for this transfer of collateral. This situation would not result in a preferential transfer. A surety may have executed some prior bonds, but then may require and receive collateral before the surety’s execution and provision of new and additional bonds. Then, within 90 days of the surety’s receipt of the collateral, the Debtor files its bankruptcy case. Whether or not there were actual claims against the prior bonds, those prior bonds are an “antecedent debt” of the Debtor under the definitions of “debt” and “claim” in the Bankruptcy Code. To the extent that the surety wishes to use the collateral to reimburse itself for losses on the bonds executed prior to its receipt of the collateral, the surety may have received a voidable preference. However, to the extent that the surety may have losses on the new bonds issued in reliance upon the receipt of the collateral, the surety should not have a preferential transfer because of the new value provided to the Debtor with the issuance of the new and additional bonds.
A surety may make a demand for collateral or demand to be placed in funds due to actual or anticipated claims and/or losses on bonds executed prior to the Debtor’s filing of its bankruptcy case. To the extent that the surety receives the transfer of the collateral within 90 days of the filing of the Debtor’s bankruptcy case, there likely would be a preferential transfer. Question: Are the surety’s pre-petition financing agreement rights against the principal, including the receipt of collateral, an avoidable preferential transfer if the principal files for bankruptcy within ninety days of the financing agreement’s execution and implementation? Some performance bonds may provide the surety with the option to finance its principal as the surety’s performance under the performance bond, or the surety may decide to finance its principal anyway as a business decision to mitigate potential loss. Most indemnity agreements provide that the surety may finance the principal, with any funding becoming a loss for which the surety is entitled to be reimbursed. And, under most financing agreements, the surety obtains whatever collateral the principal may have to secure the surety for those potential losses as well as trust fund rights to the bonded contract funds.
Notwithstanding the surety’s financial assistance, the principal may file a bankruptcy case less than 90 days after the execution of the financing agreement and the surety has perfected its liens on the collateral. The question is whether the surety’s financing provides “new value” to the principal, now the Debtor, and provides a defense to the surety’s receipt of the collateral and any other rights. See Chad Schexnayder and J. Blake Wilcox, Ch. 14, Bankruptcy, in The Law of Performance Bonds, 864-871 (Lawrence R. Moelmann, Matthew M. Horowitz & Kevin L. Lybeck eds., Am. Bar Ass’n, 2d ed. 2009). Unfortunately, under the definition of “new value” in Section 547(a)(2) of the Bankruptcy Code, the “new value” definition “does not include an obligation substituted for an existing obligation.” Therefore, there may be a conflict between the surety’s position and the trustee’s position.
The surety’s position is that it has the right, but not the obligation to finance the principal under the existing indemnity agreement or under the existing bonds, and that the surety’s financing has provided new value and a benefit to the principal, including access to and use of the bonded contract funds as trust funds for the principal’s performance of the work and payment of its subcontractors and suppliers. The surety may also argue that the effect of its financing will reduce the surety’s eventual unsecured claim to the benefit of other unsecured creditors. The trustee’s position is that the performance and payment bonds are “existing obligations” for the surety, and that the surety’s financing of the principal through the financing agreement is substituting one method for the performance of the surety’s obligations under the bonds (the financing agreement) for the surety’s already existing obligations for the performance of the work under the performance bond and the payment of the principal’s subcontractors and suppliers under the payment bond.
The surety wants to preserve its trust fund control over the collection and use of the bonded contract funds and the collateral it obtained to secure the risk of financing the principal. Whether a particular bankruptcy court will allow this to happen is, unfortunately, an open question based on a case by case assessment of the facts.
C. The surety may receive an involuntary transfer of the principal’s real and/or personal property.
- Real property
Some indemnity agreements authorize the surety to file a mortgage or deed of trust on the principal’s property in the event of a default or as collateral security. Using the attorney-in-fact provision of the Indemnity Agreement a surety can even file the mortgage or deed of trust without the participation of the principal involuntarily. If the surety issues bonds and then at a later time decides to file a mortgage or deed of trust to secure itself, maybe because the principal’s finances are not looking to good or because the surety has received payment bond claims or unfavorable status reports from obligees, and the principal files for bankruptcy within 90 days of the recording of the mortgage or deed of trust, the prepetition establishment of a lien on the now Debtor’s property would constitute a preference and could be avoided if all the other elements of a preference are met.
Section 101 of the Bankruptcy Code defines a “transfer” as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property….” Id. § 101(54). Sections 547(e)(2)(A) and (B) of the Bankruptcy Code further provide that a transfer is made 1) at the time the transfer takes effect between the parties if the transfer is perfected at or within ten days after such time; and 2) if perfection does not occur within ten days, then at the time of perfection. Id. § 547(e)(2). In re Alexander, 219 B.R. 255, 258 (Bankr. D. Minn. 1998). Since the right to record a mortgage was granted when the Indemnity Agreement was executed, it is the subsequent recording of the mortgage that is a potential preferential transfer.
- Personal property
Most Indemnity Agreements provide that the agreement constitutes a security agreement under the UCC and when the Indemnity Agreement is filed with a UCC-1 financing statement a perfected security interest under Article 9 of the UCC is created in the designated personal property of the principal. In some instances, a surety will automatically file the UCC-1 and obtain a security interest as a matter of course when the Indemnity Agreement is executed. In that case, if the bonds are issued contemporaneously there would not be a preferential transfer. If however, the surety waits to file is UCC financing statement until later, when claims start rolling in and a bankruptcy is filed within 90 days thereafter, a preference may exist. Under the Bankruptcy Code the granting of a security interest is a transfer within the definition of section 547. Vogel v. Russell Transfer, Inc., 852 F.2d 797 (4th Cir. 1988). Similarly, the perfection of a security interest is also a “transfer of property” under the Code. In re Phillips, 24 B.R. 712 (Bkrtcy. E.D.Cal. 1982).
- Judgment liens
In some cases, the surety incurs losses and is then able to obtain a judgment against the principal and the principal then files bankruptcy. The Bankruptcy Code definition of transfer is broad enough to include any judicial proceeding that fixes a lien upon property of the Debtor. In re Burnham, 12 B.R. 286 (Bkrtcy. N.D.Ga. 1981). Moreover, executions or garnishments on judgments, fall within the definition of a “transfer” under the Code. In re Rocky Mountain Ethanol Systems, Inc., 21 B.R. 707 (Bkrtcy. D.N.M. 1981); In re Conner, 733 F.2d 1560 (11th Cir. 1984).
D. The surety may receive a letter of credit from a bank for an “antecedent debt,” which letter of credit is secured by the principal’s collateral.
As we have discussed in a prior Surety Today blog post, a letter of credit and the proceeds of a letter of credit are not property of the Debtor’s bankruptcy estate. Therefore, generally speaking, the letter of credit itself and the proceeds from a letter a credit may not be the subject of a preference action because property of the Debtor are not involved. But, as we have also noted before, and will address again briefly next month, some courts have deemed a letter of credit an “indirect preference” to the surety. An indirect preference can be found where the Debtor’s property, whether it is cash or other collateral, is pledged as collateral to the bank in exchange for the bank agreeing to issue a letter of credit to the surety. The collateral provided to the bank by the principal would constitute property of the estate. Some courts have found that in such a factual situation where the letter of credit and the principal’s collateral supporting it was provided to secure an antecedent debt, and which meets the other criteria of being a preference, is essentially an indirect transfer of the principal’s collateral to the surety through the bank. The courts have merely collapsed the three transactions into one transaction and ignore the independence principal.
Conclusion
Preference actions allow a trustee or debtor in possession to go back in time and void transfers of the Debtor’s property. Every surety must be familiar with the preference exposure and potential defenses even before a bankruptcy is filed.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.
