Replacement Checks, Preference and the “New Value” Defense in Bankruptcy

In the early 1990s, Endo Steel subcontracted with JWJ Contracting to supply and install rebar on a runway project at Sky Harbor. In the middle of the project, JWJ gave Endo a bad check in exchange for an unconditional lien release. By accepting the check and simultaneously executing the unconditional release, Endo unwittingly gave up important rights in JWJ’s later bankruptcy. Acceptance of the bad check was the first step in a long and painful lesson to which all subcontractors should pay close attention.

When JWJ fell behind on its payments to subcontractors, the subcontractors threatened to demand payment from Continental Insurance, which had issued a payment bond to JWJ. In response to Endo’s demand, on April 14, 1994, JWJ paid Endo $194,000. In exchange, Endo immediately executed an unconditional lien waiver, giving up its rights to payment from Continental Insurance. JWJ’s check to Endo bounced. Endo stopped work and told JWJ that it would not resume work until it received certified funds. On May 2, JWJ replaced the bad check it had given to Endo with a cashier’s check. Endo resumed its work on the project.

On July 1, 1994, JWJ entered bankruptcy under Chapter 11 and continued to operate for two more months before closing its doors. The Chapter 11 was converted to a Chapter 7, and a Trustee was appointed. Nearly three years later, in February 1997, the Trustee filed a preference action against Endo because Endo had received its payment from JWJ during the 90-day period preceding JWJ’s bankruptcy filing. Endo sought dismissal of the preference claim, arguing that, when it executed the unconditional lien waiver in exchange for JWJ’s payment and waived its rights to make claims against Continental Insurance, new value was created for JWJ. (One of the defenses to a preference claim is that, in exchange for its payment to a creditor, the debtor received “new value,” and the estate was not diminished by the payment to the creditor.) The Bankruptcy Court agreed and dismissed the Trustee’s preference claims against Endo. The Trustee appealed to the U.S. Bankruptcy Appellate Panel (BAP) for the Ninth Circuit.

REVERSAL

In 2002, the BAP reversed the Bankruptcy Court’s decision in favor of Endo and remanded the Trustee’s action for a new hearing. The BAP reversal was based on its reasoning that Endo waived its lien rights, including the right to pursue payment from Continental Insurance at the time it received the bad check. Thus, when Endo received the replacement check, it no longer had any lien rights to release. Therefore, JWJ did not receive any new value in exchange for the cashier’s check.

Endo appealed, without success, to the U.S. Ninth Circuit Court of Appeals. In its 2005 ruling, the Ninth Circuit upheld the BAP’s finding that the unconditional lien waiver that Endo executed in exchange for JWJ’s NSF check did not provide a valid “contemporaneous ‘new value’” defense for the cashier’s check that Endo received a few days later. Joining other circuits that have ruled in comparable cases, the Court went on to conclude that the debtor’s issuance of a bad check “transforms what would have been a contemporaneous exchange … into a credit transaction .” (Emphasis added.)

In other words, if JWJ’s first check to Endo had cleared the bank, Endo could have successfully defended against the preference action based on the “new value” it gave to JWJ in the form of its lien release. In effect, the cashier’s check that Endo received from JWJ was not a payment to Endo in exchange for its delivery of goods and services. According to the BAP and the Ninth Circuit, the cashier’s check satisfied a new obligation to Endo that JWJ created when its first check bounced. Since JWJ received no new value in exchange for its cashier’s check (as it had when Endo waived its right to pursue payment from Continental Insurance), that replacement payment became vulnerable to the Trustee’s preference claim.

Subcontractors should protect themselves from Endo’s fate by requiring the owner or general contractor to make payment in certified funds when unconditional lien releases are used, and by always using conditional releases when the owner or general contractor is paying with anything but certified funds.