In re ESA Environmental Specialists, Inc., 2013 WL 765705 (4th Cir., Mar. 1, 2013)

CASE SNAPSHOT

As a condition to issuing a surety bond, the insurer required the insured to obtain a Letter of Credit in favor of the insurer. To obtain the LOC, the insured was required to purchase a certificate of deposit, which it funded with a loan from its primary lender. Following the issuance of the surety bond, the insured filed for bankruptcy, and the insurer liquidated the LOC. The trustee argued that the transfer to fund the LOC was an avoidable preference under section 547. The Fifth Circuit Court of Appeals overturned the lower court’s holding that the earmarking defense applied because the LOC was not made to satisfy an antecedent debt, but nevertheless affirmed summary judgment in favor of the insurer on the basis that the debtor received "new value" in exchange for the LOC funding because the surety bonds allowed the debtor to obtain government contracts worth more than the value of the LOC.

FACTUAL BACKGROUND

ESA Environmental performed construction projects under contracts with the federal government. Under federal law, as a condition precedent to the award of any such contract, ESA was required to obtain a surety bond. The Hanover Insurance Co. had, for a number of years, issued surety bonds on behalf of ESA. ESA asked Hanover to issue additional surety bonds in conjunction with seven new contracts ESA sought to obtain. Hanover was concerned about ESA’s financial condition, however, and refused to issue new bonds without additional security. ESA obtained an irrevocable Letter of Credit from SunTrust Bank, in the amount of $1.375 million, with Hanover as the beneficiary. The LOC collateralized the new bonds as well as all of Hanover’s existing guarantees and surety obligations on behalf of ESA. SunTrust required ESA to fund a certificate of deposit at SunTrust as security for the LOC, in the amount of $1.375 million. ESA turned to another lender, Prospect Capital, for these funds, which Prospect provided by amending the existing credit agreement it had with ESA. Prospect then transferred the funds to ESA, ESA transferred the funds to SunTrust, SunTrust issued the LOC, and Hanover issued the New Bonds, which ESA delivered to the government agencies.

ESA was awarded the contracts, but during the 90-day preference period, it filed for relief under chapter 11. Hanover then drew $1.375 million on the LOC, which caused SunTrust to liquidate the CD. Bound by the surety bonds to complete the project work, Hanover fulfilled those obligations and paid the subcontractors.

Following conversion to chapter 7 and an appointment of a trustee, the trustee filed an adversarial proceeding against Hanover, alleging that it was an indirect beneficiary of ESA’s transfer of the Prospect loan proceeds into the SunTrust CD, and that this transfer was an avoidable, preferential transfer under section 547. Hanover asserted two affirmative defenses – that the transfer was not a preference because the Prospect loan was earmarked specifically for payment to Hanover, and that ESA received new value in exchange for the Prospect loan proceeds.

The bankruptcy court granted summary judgment in favor of Hanover, holding that both of its asserted defenses applied. The trustee appealed.

COURT ANALYSIS

Section 547(b) provides that a trustee may avoid any transfer of an interest of the debtor in property (i) to or for the benefit of a creditor; (ii) for or on account of an antecedent debt owed by the debtor before such transfer was made; (iii) made while the debtor was insolvent; (iv) made on or within 90 days before the petition date; … (v) that enables such creditor to receive more than the creditor would receive if the transfer had not been made.

The court first addressed Hanover’s earmarking defense. Earmarking is a judicially created defense that applies when a third person makes a loan to a debtor specifically to enable the debtor to satisfy the claim of a designated creditor. The underlying rationale is that the earmarked loan never becomes part of the debtor’s assets, and therefore the transfer from the debtor to the designated creditor does not diminish the debtor’s estate. The court cited Fourth Circuit precedent recognizing the earmarking defense, noting that the test of a true earmarked transfer is not what the creditor receives but what the debtor’s estate has lost.

The court found that the bankruptcy court had erred in applying the earmarking defense here because the transfer lacked "a critical element of an earmarking defense: the funds at issue were not used to pay an antecedent debt." Because the loan proceeds were used to fund a new obligation, the LOC, there was "no debt by which one creditor is substituted for another. In the case at bar, a new debt was created where none previously existed."

The court then turned to the "new value" defense. Section 547(c)(1) provides that a trustee may not avoid a preferential transfer to the extent that the transfer was (i) intended by the debtor and the creditor to be a contemporaneous exchange for new value given to the debtor, and (ii) in fact a substantially contemporaneous exchange. When evaluating a new value defense, "the key question is whether the alleged preferential transfer diminished the debtor’s estate, i.e., whether the debtor in fact acquired a new asset that offset the loss in value to the estate when the debtor transferred existing assets to acquire the new asset at issue."

The trustee first argued that Hanover failed to carry its burden of proof to establish with specificity the exact measure of new value received by ESA, and that the bankruptcy court erred in finding that ESA had in fact received the new contracts.

As evidence of new value, Hanover offered an affidavit of the debtor’s former CEO that stated that the New Bonds enabled ESA to win contracts worth $3.9 million in revenues. Accordingly, Hanover asserted that the surety bonds provided ESA with the ability to earn more than the $1.375 million in loan proceeds required to obtain them. The trustee had no evidence contradicting this testimony, but rather argued that this was not precise enough for Hanover to carry its burden. The Court of Appeals held that there was no need for Hanover to prove with specificity any exact figure beyond the amount of the transfer.

As to the trustee’s second argument – that any new value ESA received was not contemporaneously exchanged for the $1.375 million transfer of funds because the new government contracts were not paid upon issuance of the bonds – the court found that "the trustee conflates two very different concepts, the value of the New Contracts, which have value in and of themselves, and the eventual revenues ESA would have received upon performance of the New Contracts." The court concluded that the trustee failed to recognize that the New Contracts had value in and of themselves in excess of $1.375 million, and so held that the bankruptcy court did not err in its conclusion.

The court affirmed the grant of summary judgment in favor of Hanover.

Dissenting Opinion –Chief Judge Traxler believed that Hanover was not entitled to summary judgment on the new value defense, agreeing with the trustee that Hanover failed to prove the extent of new value provided to ESA. Rather than receiving $1.375 million in new value, Judge Traxler concluded that ESA received only a conditional promise for payment at some indefinite future date, which "does not establish the legal conclusion ESA actually received at least $1.375 million in new value…. Hanover successfully obtained $1.375 million from the estate without replacing it with equal value." Judge Traxler rejected the notion that the New Contracts possessed independent value because the government, not ESA, was the bond beneficiary, and he also noted that if Hanover proved any new value, it was limited to the $74,000 premium that ESA paid for the bonds.

PRACTICAL CONSIDERATIONS

The opinion highlights the complicated nature of preference litigation. While demonstrating the limited circumstances upon which lenders and trade creditors may rely on the earmarking defense in preference actions, the opinion also provides support that expected value of some asset, in this case government contracts, may form the basis of a new value defense.