The insurance premium finance industry has been around for more than 50 years, and billions in premiums are financed each year. At its core, premium financing enables a business to prepay its insurance premiums in full at the inception of the coverage, without having to expend large amounts of cash immediately. In a typical premium finance transaction, the insured pays down 15 percent to 20 percent of the total premiums due. The remaining balance is then advanced by the premium finance company to the insurance carrier or agent. To secure repayment of the loan made by the insurance premium finance company, the insured assigns to the premium finance company all unearned and return premiums that are available upon reduction or cancellation of the financed policies. Although the premiums are prepaid at inception of the loan, the insurer typically earns its premiums on a pro rata basis, earning 1/365 of its premium for each day it extends coverage. Accordingly, at the time of loan inception, the entire amount of the prepaid premiums is unearned by the insurance company. The amount of return premium, however, decreases each day that the insurance coverage remains in place as the insurer gradually earns the premium. To the extent the coverage is canceled, the insurance company is required either by statute or contract to refund any unearned or return premium.
The insurance premium finance company is given certain protections from the borrower. Thus, the borrower grants a security interest in the unearned premiums to the insurance premium finance company. Also, the borrower provides the insurance premium finance company a power of attorney to cancel coverage in the event of default, after appropriate notice and an opportunity to cure has been afforded to the borrower. Further, the borrower assigns any unearned or return premiums directly to the premium finance company. The power of attorney to cancel coverage is perhaps one of the most important provisions in the premium finance agreement because this power ensures that the premium finance company does not become under-secured during the term of the loan by virtue of the fact that the collateral securing the loan declines each day as it becomes earned. By taking a security interest in the unearned premiums, obtaining the power of attorney to cancel coverage, and receiving an assignment of the right to the unearned premiums, insurance premium finance companies have an important remedy upon default. The premium finance company can cancel coverage and recover from the insurer the remainder of the loan balance through the receipt of the unearned premiums directly from the insurer.
Notwithstanding the fact that the insurance premium finance company is over-secured throughout the duration of the loan term and would otherwise be afforded the opportunity to cancel coverage upon a default, some courts, as discussed below, have adopted an approach in connection with preference lawsuits that might force the insurance premium finance company to return loan payments received in the 90-day period preceding the commencement of the debtor-borrower’s bankruptcy proceeding.
Section 547(b)(5) and the “Greater Amount Test”
Section 547(b) of the Bankruptcy Code sets forth five elements of a recoverable preferential payment, which elements the trustee must prove by a preponderance of the evidence as part of its prima facie case for recovery of pre-petition transfers as avoidable preferences. See 11 U.S.C. § 547(b),(g); In re Smith’s Home Furnishings, Inc., 265 F.3d 959, 963 (9th Cir. 2001); In re Robinson Bros. Drilling, Inc., 6 F.3d 701, 703 (10th Cir. 1993). A transfer is preferential only if it is (1) to a creditor, (2) on account of a preexisting debt, (3) made while the debtor is insolvent, (4) made on or within 90 days before the date of filing the bankruptcy petition, and (5) enables the creditor to receive more than it would have received if the estate was liquidated under Chapter 7. In connection with section 547(b)(5), a transfer is deemed preferential when a creditor enjoys a greater recovery on its claim than it would have if the transfer had not occurred and if recovery proceeded according to the order of distribution in a Chapter 7 case. Courts sometimes refer to this inquiry as the “greater amount test.” In re Powerine Oil Co., 59 F.3d 969, 972 (9th Cir. 1995).
Although section 547(b) instructs one to compare what a particular creditor received as a result of a transfer with what that creditor would have received on liquidation without that transfer, the Bankruptcy Code does not establish a point in time for determining when this hypothetical liquidation should occur. Those courts that believe the appropriate point in time is the petition date frequently cite the 1936 opinion of the United States Supreme Court in Palmer Clay Products Co. v. Brown, 297 U.S. 227 (1936), which construed the preference provision contained in the Bankruptcy Act of 1898.
In Palmer Clay, the debtor made a partial payment on account of an unsecured creditor’s claim during the preference period. The creditor argued that the date of “hypothetical liquidation” should be the date on which payment was made, and the payment should not be considered preferential “provided the debtor’s assets at the time of the payment would, if then liquidated and distributed, be sufficient to pay all the creditors of the same class an equal proportion of their claims.” Id. at 228. The Supreme Court rejected this argument. However, in light of the facts presented in Palmer Clay, the Supreme Court reached the correct result. Because the payments at issue in the casewere made on account of an unsecured claim, it makes logical sense that the payment enabled the creditor to receive more than it would have in a hypothetical liquidation. This is true no matter what date is used, the date of transfer or the petition date.
While the Palmer Clay opinion might appear to lend support to courts that use the petition date approach, the courts have taken varying approaches when dealing with the claims either partially secured or fully secured. Mazer v. Aetna Fin. Co. (In re Zuni), 6 B.R. 449 (Bankr. D.N.M. 1980) (because fair market value of collateral exceeded amount of debt after payment of alleged preferential transfers, payments not a preference); In re Smith’s Home Furnishings, Inc., 265 F.3d 959 (plaintiff must provide evidence that value of collateral was less than indebtedness at some point during the 90-day preference period). Notwithstanding the varying approaches taken by the courts, two approaches have arisen in the insurance premium finance context.
Paris Industries—The “Add Back” Approach
In re Paris Industries Corp., 130 B.R. 1 (Bankr. D. Me. 1991), was the first opinion to address the question of whether transfers made to an otherwise fully secured insurance premium finance company by a debtor within 90 days before the debtor’s bankruptcy case must be “added back” to the insurance premium finance company’s indebtedness as of the date of the filing of the bankruptcy case. Without undertaking an in-depth analysis of the preference statute and its potential impact on the insurance premium finance industry, the court in Paris Industries found that the payments made by the debtor during the pre-bankruptcy preference period should be added back to the insurance premium finance company’s outstanding debt at the time the bankruptcy case was commenced and then compared with the amount of collateral (i.e., unearned premiums) held by the insurance premium finance company. The court concluded that, to the extent the premium finance company’s collateral is valued at an amount less than the indebtedness, the difference represents the preference exposure of the insurance premium finance company. The Paris Industries court applied the “add back” method because it found that this method was followed by other courts when addressing the potential exposure of secured creditors. Id. at 3. To date, the Paris Industries decision has been followed by only one other court in the context of an insurance premium financing arrangement. See Falcon Creditor Trust v. First Ins. Funding (In re Falcon Prods. Inc.), 381 B.R. 543 (B.A.P. 8th Cir. 2008).
Schwinn’s Rejection of the “Add Back” Method
In re Schwinn Bicycle Co., 200 B.R. 980 (Bankr. N.D. Ill. 1996), the second case to consider the issue, rejected the “add back” method followed by Paris Industries. While acknowledging the general rule that collateral is usually valued for preference purposes as of the date of the commencement of the debtor’s bankruptcy case, the Schwinn court cautioned that case law was sparse on this issue and found support for the proposition that the analysis should differ depending on the nature of the collateral and whether the insurance premium finance company is secured or unsecured at any time during the pre-bankruptcy preference period. According to Schwinn, a court must begin its analysis by considering whether the insurance premium finance company was fully secured on the date of the debtor’s bankruptcy filing. In addition to examining the insurance premium finance company’s collateral position on the date of the bankruptcy filing, Schwinn holds that a court must also examine the insurance premium finance company’s collateral position immediately prior to each of the alleged preferential transfers. According to the Schwinn court, if the insurance premium finance company was fully secured at each of these times, it will have no preference exposure.
It is important to note that Schwinn does not impose any requirement that the insurance premium finance company “add back” any of the alleged preferential transfers to the amount of its indebtedness in order to determine potential preference exposure. In refusing to adopt the “add back” method, Schwinn concluded that measuring the insurance premium finance company’s collateral on the date of the bankruptcy filing (with no “add back requirement”) and immediately prior to the receipt of the alleged preferential transfer is proper because if the insurance premium finance company is found to be fully secured at these times, then it follows that a payment to the insurance premium finance company merely reduces the secured claim, contemporaneously releasing from the insurance premium finance company’s security interest the same amount of collateral.
In reaching a result that is consistent with the policies behind preference law, Schwinn also recognized the important role of the insurance premium finance industry. With respect to the policy of discouraging creditors from racing to the courthouse to dismember the debtor during the debtor’s slide into bankruptcy, the Schwinn court was not persuaded that this policy had any applicability to an insurance premium finance company’s receipt of a debtor’s payments.
With respect to the policy of facilitating “equality of distribution among creditors of the debtor,” the court reasoned that due to the debtor’s timely payments made to the insurance premium finance company during the preference period, the estate was benefited by its receipt of continued insurance coverage, which was essential to its business. If the debtor failed to make the alleged preferential payments, there was little doubt, according to the Schwinn court, that the insurance premium finance company would cancel coverage in an effort to avoid the possibility of ever becoming under-secured. Recognition of these real-world consequences was entirely appropriate because, in the Schwinn court’s view, neither the preference section of the Bankruptcy Code nor the Bankruptcy Code generally prohibits a court from considering what actually would have occurred had an alleged preferential transfer not been made.
The Schwinn court dismissed the suggestion that a depletion of the estate would ever arise from a debtor’s scheduled payment:
It is clear why, if a premium finance company is always secured it cannot be preferred in the 90 day period. At no time would unsecured creditors lose any value in their claims. The premium finance company is only receiving payment as the collateral is diminished. The diminishing of the collateral is allowed by the premium finance company because its indebtedness is also diminished through payments from the debtor, thereby maintaining its equity cushion. Where a debtor ceases to make payments to the premium finance company, the company has a costless remedy at its disposal, which is to cancel the policy and receive the rest of the debt it is owed by taking it out of unearned premiums. Debtor’s estate is in no way being depleted by payments made to a premium finance company which has a standard financing agreement in place.
Id. at 995.
The Schwinn court concluded its analysis with an examination of the two reasons why the status of a secured premium finance company might be distinguishable from that of a secured creditor holding, for example, a mortgage on real estate. The court acknowledged the possibility that payments to the mortgagee might well be preferential if the transfers were larger than the value by which the encumbered real estate suddenly diminished during the preference period. By comparison, the decline in value of the premium finance company’s collateral during the preference period is predictable, bargained for, and expected by both the debtor and the insurance premium finance company. Faced with the certainty that its collateral will decline in value, the insurance premium finance company can bargain for a payment stream that will ensure that the remaining debt will always be less than the value of its declining collateral.
The second fundamental difference between the two creditors, according to Schwinn, is that the insurance premium finance company’s borrower receives value for each day the insurance premium finance company’s collateral declines in value. Whether these distinctions are important remains to be seen. In any event, the reasoning of Schwinn has been followed by a number of courts. See, e.g., In re Rocor, 380 B.R. 567 (B.A.P. 10th Cir. 2007).
Paris Industries and Schwinn Revisited: In re Alabama Aircraft Industries Inc.
In connection with Forman v. IPFS Corp. of the South (In re Alabama Aircraft Indus. Inc.), 2013 WL 6332688 (Bankr. D. Del. Dec. 5, 2013), the United States Bankruptcy Court for the District of Delaware rejected the “add back” approach adopted by Paris Industries. Ruling on competing motions for summary judgment, the court determined that the $151,000 in payments made to the premium finance company were not recoverable by the trustee. As evidenced by the payment history in the case, at all times throughout the preference period and on the petition date (where there was no balance on the account), the premium finance company was over-secured.
With respect to the trustee’s argument that Palmer Clay mandates that the court determine the defendant’s secured status as of the petition date, the court rejected this approach, concluding that Palmer Clay is distinguishable because it addressed payment to an unsecured creditor. Rather, the court adopted the approaches set forth in Schwinn and In re Teligent, Inc., 337 B.R. 39 (Bankr. S.D.N.Y. 2005), stating that such approaches were the only “common sense” approaches that adequately accounted for the unique nature of a premium financing arrangement. In re Alabama Aircraft Indus., 2013 WL 6332688, at *3.
Since Schwinn, there have only been a handful of cases to consider the issue of whether or not the “add back” approach adopted by Paris Industries should be followed. See, e.g., In re Smith’s Home Furnishings, Inc., 265 F.3d 959 (9th Cir. 2001); In re Telesphere Commc’ns, Inc., 229 B.R. 173 (Bankr. N.D. Ill. 1999). With very little case law on the subject, the stakes are high for the insurance premium finance company defendant. If the reasoning of Paris Industries is widely adopted, it will almost always be the case that the premium finance company will face preference exposure. The importance of premium financing is self-evident. At the time of the Schwinn decision, the insurance premium finance industry was already a multibillion-dollar-a-year industry. While potential preference exposure may not dictate the practices of the insurance premium finance industry, the Paris Industries approach, if widely adopted, has the potential to disrupt the industry. Forcing an insurance premium finance company to accept larger down payments or to modify its loan criteria hurts not only the industry but also the many companies that rely on this method of financing to accommodate their cash flow needs. The decision of the Delaware Bankruptcy Court in Alabama Aircraft is an important one. With no opinions on this subject at the circuit level, the Schwinn/Alabama Aircraft Industries opinions appear to be the better-reasoned decision in this diverging body of law.
Keywords: bankruptcy and insolvency litigation, insurance premium finance, premium financing, preference, section 547(b), greater amount test, hypothetical liquidation, add back