Be careful when taking regular checks for lien release or cash transactions: a commentary on the JWJ Contracting Co. case.(Column)

In the February 2005 edition of Business Credit, Robert Schwartz, in his article titled "Unconditional or Conditional Lien Releases: Choose Carefully Or Lose Your Lien Rights: A Case Analysis", discussed the recent Ninth Circuit Court of Appeals decision in the JWJ Contracting Co. case. The decision raises risks that should concern every credit professional, even beyond those folks holding mechanics' lien claims or bonds that were the subject of the article.

Say you have a valid perfected security interest, mechanics' lien, performance bond, trust fund protection, or other special protection to secure payment of your claim, or you switched terms to cash terms (i.e., cash in advance ("CIA") or cash on delivery ("COD")). Your customer tenders full payment of your claim by delivering a regular check in exchange for goods, or a general release of your lien, bond or other rights. You accept the check and deliver the goods, or an unconditional lien/bond release, to your customer. Unbeknownst to you, the check was drawn against insufficient funds and bounces. Now, really irate, you demand immediate payment from your customer, or else--and your customer capitulates by delivering a replacement certified or bank check, or wires the funds. You are now paid in full. Do you rest easy? Not on your life!

In Endo Steel Inc. v. Janas (In re JWJ Contracting Co.), a creditor, Endo Steel, released its claim on a bond provided by the debtor, JWJ Contracting Co. ("JWJ") in exchange for a regular check in the amount of $194,286.71 that bounced (the "NSF Check"). Then, 19 days later, JWJ replaced the NSF check with a cashier's check in the same amount. But that was not the end of the story for Endo Steel. JWJ filed bankruptcy within two months of the delivery of the replacement check, which set up a confrontation between Endo Steel and JWJ's bankruptcy trustee on whether the replacement check was an avoidable and recoverable preference. Endo Steel invoked the Section 547(c)(1) contemporaneous exchange for new value defense to the trustee's preference claim, by arguing that the release of its claim against the bond was made in exchange for the replacement cashier's check.

The Ninth Circuit upheld the trustee's preference claim and rejected Endo Steer's Section 547 (c)(1) contemporaneous exchange preference defense. The court found no contemporaneous exchange for new value because Endo Steel had unconditionally released its claim on the bond in exchange for a bounced check. The dishonor of the NSF check, followed shortly after by JWJ's delivery of the replacement cashier's check, changed the nature of the transaction from what was originally intended to be a contemporaneous cash exchange for new value (the NSF Check tendered in exchange for Endo Steel's unconditional release of the bond), to a credit transaction (the NSF check paid by the replacement cashier's check). By the time JWJ delivered its replacement cashier's check, Endo Steel had no claim against the bond to release and, therefore, gave no new value ...