Legal Definitions - subsequent-advance rule

The subsequent-advance rule is a principle in U.S. bankruptcy law that provides an exception to a bankruptcy trustee's power to reclaim certain payments made by a debtor before filing for bankruptcy.

When a company or individual files for bankruptcy, a court-appointed trustee reviews past transactions. The trustee can often "avoid" or "claw back" payments made to creditors shortly before bankruptcy if those payments gave one creditor an unfair advantage over others. These are called "preferential transfers."

However, the subsequent-advance rule states that a bankruptcy trustee cannot reclaim such a preferential payment if all of the following conditions are met:

• The creditor, after receiving the preferential payment, then provided new value (like goods, services, or new credit) to the debtor.
• This new value was unsecured, meaning the creditor did not receive any collateral or guarantee for it.
• The debtor never paid back this new value to the creditor.

The purpose of this rule is to encourage creditors to continue doing business with financially struggling companies, even after receiving a payment, by protecting those creditors from having their initial payment clawed back if they extend further, unpaid credit.

Examples:

• Scenario: Manufacturing Supplier

  A small electronics manufacturer, "Tech Innovations Inc.," owes its primary circuit board supplier, "Components Co.," $50,000 for past deliveries. Tech Innovations is struggling financially but manages to pay Components Co. the full $50,000. A week later, Components Co., seeing the payment and wanting to maintain the business relationship, ships a new, urgent order of specialized chips worth $30,000 to Tech Innovations on 30-day credit, without requiring any upfront payment or collateral. Tech Innovations files for bankruptcy two weeks later, before paying for the new chip shipment.

  How it illustrates the rule: The $50,000 payment to Components Co. could be considered a preferential transfer. However, because Components Co. subsequently provided $30,000 worth of new, unsecured chips (new value) that Tech Innovations never paid for, the bankruptcy trustee cannot reclaim the initial $50,000 payment from Components Co. The rule protects Components Co. because they continued to support Tech Innovations by extending new credit.

• Scenario: Marketing Consultant

  A struggling startup, "Bright Ideas LLC," pays its marketing consultant, "Creative Campaigns," $10,000 for services rendered over the past two months. A few days after receiving this payment, Creative Campaigns agrees to develop an urgent, new social media strategy for Bright Ideas, valued at $7,000, on the understanding that they will be paid upon completion. Bright Ideas files for bankruptcy before the new strategy is fully implemented or paid for.

  How it illustrates the rule: The $10,000 payment to Creative Campaigns might be a preferential transfer. However, Creative Campaigns then provided $7,000 worth of new, unsecured marketing services (new value) that Bright Ideas did not pay for. Therefore, the bankruptcy trustee cannot force Creative Campaigns to return the initial $10,000 payment. The rule acknowledges that Creative Campaigns continued to provide services to Bright Ideas even when the startup was in financial distress.

• Scenario: Retail Store and Wholesaler

  A small clothing boutique, "Fashion Forward," owes its main apparel wholesaler, "Style Distributors," $15,000 for inventory delivered three months ago. Fashion Forward makes a payment of $15,000 to Style Distributors. The following week, Style Distributors, wanting to help Fashion Forward prepare for an upcoming holiday season, ships a new consignment of popular winter coats worth $10,000 on credit, without any security interest. Fashion Forward sells some of the coats but files for bankruptcy before paying Style Distributors for the new shipment.

  How it illustrates the rule: The $15,000 payment from Fashion Forward to Style Distributors could be deemed a preferential transfer. However, Style Distributors subsequently provided $10,000 worth of new, unsecured inventory (new value) that Fashion Forward never paid for. Consequently, the bankruptcy trustee is prevented from reclaiming the initial $15,000 payment from Style Distributors, as the wholesaler extended new credit to the struggling boutique.