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Replacement Checks, Preference Actions, and
the “New Value” Defense in Bankruptcy
The Ninth Circuit rules that an NSF check
may be immune to preference claims, but not
the cashier’s check that replaces it
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.
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