Download Preference Actions?

FREQUENTLY ASKED QUESTIONS REGARDING BANKRUPTCY PREFERENCES
What is a preference?
Section 547(b) of the Bankruptcy Code permits the debtor-in-possession or a trustee to
recapture payments made by the debtor prior to its bankruptcy filing. Although it is not always
achieved in practice, the asserted policy goal underlying the preference statute is to further
the goal of equality of treatment of creditors of the debtor. Accordingly, the Bankruptcy Code
authorizes the recapture of payments to certain creditors for the benefit of those creditors
whose debts remain unpaid by the debtor.
What are the elements of a
preference?
The elements of a preference set forth in Section 547(b) of the Bankruptcy Code are the
following:
•
The transfer was made to or for the benefit of a creditor (i.e., creditor receives a check
from the debtor, goods are returned by the debtor to the creditor or an obligation of the
creditor is reduced by the debtor);
•
The transfer was made for or on account of an antecedent debt owed by the debtor before
the transfer was made (this is merely a payment or transfer made on an old debt, i.e., not
a cash on delivery or cash in advance payment);
•
The transfer was made while the debtor was insolvent;
•
The transfer was made 90 days before the date of the filing of the bankruptcy petition
(extended to one year if the transfer was made to an insider); and
•
The transfer enables the creditor to receive more than it would have received if the case
were a Chapter 7 liquidation. A payment received within 90 days of the bankruptcy filing
almost always enables a creditor to receive more than it would have received in a Chapter
7 case. Indeed, the only time this would not be true would be in the unusual case where
creditors were receiving 100% on their claims pursuant to a plan of liquidation.
It is neither wrong of the debtor to make a preferential payment nor wrong of the creditor to
accept it. Creditors are almost always better off attempting to get payment of their clams from
debtors and dealing with any efforts to recover the money when, and if, such attempts are
made in bankruptcy.
What are the major
affirmative defenses to a
preference action?
What is the new value
defense?
There are several affirmative defenses to a preference action. Three of the major affirmative
defenses which can be asserted by the creditor/defendant are:
1.
the new value defense;
2.
the ordinary course of business defense; and
3.
the contemporaneous exchange defense.
New value is defined under Section 547(a)(2) of the Bankruptcy Code as “goods, services or
new credit…” In connection therewith, Section 547(c)(4) of the Bankruptcy Code provides an
offset against a preferential transfer if a creditor subsequently gives new value to the debtor
after the allegedly preferential transfer. Accordingly, if a creditor supplies services or ships
new goods on an unsecured basis after that transfer, the value of those goods or services
would ordinarily be subtracted from the original preference because the estate has been
replenished. This is known as the “subsequent advance rule” and often provides the best
defense to a preference because dollar-for-dollar credit is provided when it is applicable.
Unfortunately, that also means the creditor has a claim against the debtor for unpaid invoices.
Further, Section 547(c)(4)(B) provides that the trustee may not avoid an alleged preference to
the extent that after such payment, the creditor gave new value “on account of which new
value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such
creditor.”
What does the confusing
language of Section
547(c)(4)(B) mean – does
new value have to remain
unpaid?
Courts have divided on this issue, but the evolving standard is that new value credit will be
given if (1) the new value remains unpaid or (2) the new value has been paid for by a
payment which otherwise could be set aside as a preference. On the other hand, if the
debtor’s subsequent payments cannot be set aside as a preference because the prima facie
elements of Section 547(b) are not satisfied or because the creditor has another affirmative
defense under Section 547(c), the new value which gave rise to those payments will not
qualify for new value credit. This avoids double credit being given to defendants for new
value relating to a payment which is already insulated from preferential recovery. See, In re
Pillowtex Corp., 416 B.R. 123 (Bankr.D.Del. 2009).
How does the subsequent
advance rule apply to
specific situations?
There are any number of scenarios, but below is an example.
The creditor receives $10,000 from the debtor on December 1st and an additional $5,000 on
December 5th on account of services rendered. The creditor then provides $18,000 in
additional services on December 12th and subsequently receives $7,000 on December 18th on
account of prior services previously rendered in November. The debtor files for bankruptcy on
December 31st.
In that instance, the creditor would be entitled to $15,000 in new value credit advanced on
December 12th which remained unpaid to offset the two payments totaling $15,000 made on
December 1st and December 5th, but would not be able to offset the final $7,000 payment
received on December 18th because there were no subsequent advances after that payment.
Accordingly, under this scenario there is a possible preference of $7,000 subject to other
defenses.
Can there ever be an
exception to the new value
defense when the creditor
has not been paid for its
goods or services before
the bankruptcy filing?
Possibly. Section 503(b)(9) of the Bankruptcy Code accords administrative priority status to
claims for goods received by the debtor in the ordinary course of its business within 20 days
of its bankruptcy filing (“20-day claims”). Accordingly, several bankruptcy courts have held
that it would be unfair to the bankruptcy estate by allowing a creditor to receive both (1)
payment on its 20-day claim for goods sold and (2) new value credit in defending against a
preference action at the same time. In re Circuit City Stores, Inc., 2010 WL 4956022 (Bankr.
E.D. Va. 2010); In re TI Acquisition LLC, 429 B.R. 377, 385 (Bankr. N.D. Ga. 2010).
However, the law in this area is unsettled as at least one court has rejected that carve-out as
unfairly depriving trade creditors of the priority accorded payment of 20-day claims under the
Bankruptcy Code. In re Commissary Operations, Inc., 421 B.R. 873 (Bankr. M.D. Tenn.
2010). Further, a Delaware bankruptcy court has held that post-petition payment of a claim
for pre-petition wages by virtue of the equitable doctrine of necessity allowing payment for a
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critical vendor did not eliminate the new value defense based upon providing those services.
In re Friedman’s Inc., 2011 WL 5975283 (Bankr. D.Del. November 30, 2011). While this case
did not involve a 20-day claim, the key issue for the Court was that payment was made after
the bankruptcy filing, thus satisfying the Third Circuit’s holding in In re New York City Shoes,
880 F.2d 679, 690 (3rd Cir. 1989) which, inter alia, required that the debtor must not have fully
compensated the debtor for the “new value” as of the date it filed its bankruptcy petition. If
that reasoning were to be followed in subsequent Delaware cases, new value supplied on
account of 20-day claims would count as a valid defense because it was not paid for prior to
the debtor’s bankruptcy filing.
What is the ordinary
course of business
defense?
A second major affirmative defense to an alleged preference is provided for in Section
547(c)(2) of the Bankruptcy Code, which protects transfers made in the “ordinary course of
business”. The purpose of the ordinary course of business exception is to “leave undisturbed
normal financial relations, because it does not detract from the general policy of the
preference section to discourage unusual action by either the debtor or his creditors during
the debtor’s slide into bankruptcy”. House Report 95-595, 95th Cong., 1st Sess. 373.
Accordingly, payments within invoice terms are generally not preferential, unless the terms
have changed close to the 90-day preference period due to creditor pressure or special
treatment of a favored vendor by the debtor.
How did the law relative to
the ordinary course of
business defense change
under the 2005
amendments to the
Bankruptcy Code?
Previously, defendants had to prove that alleged preferences (1) were consistent with the
parties’ prior course of dealing (the “Subjective Test”) and were also (2) consistent with
common industry practice (the “Objective Test”). However, under the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005 Section 547(c)(2) of the Bankruptcy Code
was changed to provide that for bankruptcy cases filed as of October 17, 2007, defendants
only need to prove either the Subjective Test or the Objective Test. In some instances, this
will make the defense of a preference action easier for the defendant.
What are the factors
considered by courts in
determining whether the
Subjective Test has been
satisfied?
What are the key issues in
analyzing the parties’ prior
course of dealing?
The following factors are usually considered to determine whether a transaction was ordinary:
1.
the prior course of dealing between the parties;
2.
the amount of the payments;
3.
the timing of the payments; and
4.
the circumstances surrounding the payments.
In reviewing the parties’ prior course of dealing, a key issue would be the creditor’s ability to
demonstrate that the allegedly preferential payments were made in a time frame which is
reasonably close to the average number of days late during the period preceding the 90-day
preference period, with the greatest emphasis placed upon the payment history closest in
time to the alleged preference. Some courts have gone as far as to take a weighted average
of payments for a period of months before the preference period or to look at five and ten day
“buckets” of payments. However, creditors should be aware that the standard employed in
analyzing the ordinary course defenses varies around the country and each case will be
decided on its particular facts.
Some courts will also look at the range of payments prior to the preference period as the
basis of comparison rather than a statistical average, either independently or together with an
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average. Regardless of whether an average or a range is utilized, the payments in question
must not have been made in response to additional or different requirements imposed by the
creditor during the preferential period. For example, a payment made timely can be deemed
preferential because of unusual collection practices, i.e., the creditor received a certified
check from the debtor whereas it previously was always paid by regular check.
What if the parties have no
prior history?
In some cases, there will be no history between the parties prior to the preference period.
Most courts have held that a first-time transaction is not per se ineligible for protection from
avoidance. Generally, the courts look to the terms of the parties’ agreement in order to
determine the ordinary course of business between the parties. If payment was in
accordance with the terms of the agreement, then the defense is established. See, e.g.,
Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003).
How does a defendant
satisfy the Objective Test?
The defendant should present evidence demonstrating that the payments sought to be
recovered were made in a time frame which is consistent with the industry standard. This
frequently requires the use of experts and industry source materials.
Accordingly, defendants who are sued frequently for preference should now give greater
consideration to the industry standard which is often ignored in the earlier stages of
negotiations with plaintiff’s counsel. Those creditors should obtain access to recent industry
studies or surveys which provide a range or average of the time to pay in their industry. If
creditors have that information readily available, they will be able to present it at the beginning
of the negotiation if it is advantageous. This could potentially result in a better settlement for
the defendant.
The industry standard varies somewhat among the various circuits, but many have fairly
lenient standards. This arises out of the influential case of Matter of Tolona Pizza Products
Corp., 3 F.3d 1029, 1033 (7th Cir. 1993), in which the Seventh Circuit held that “ordinary
business terms refers to the range of terms that encompasses the practices in which firms
similar in some general way to the creditor in question engage, and that only dealings so
idiosyncratic as to fall outside that broad range should be deemed extraordinary and
therefore outside the scope” of the industry standard defense (emphasis supplied by the
Court).
What is the
“contemporaneous
exchange” defense?
It is another affirmative defense to an alleged preference. Under Section 547(c)(1) of the
Bankruptcy Code, a transfer is not preferential if the parties (1) intended a contemporaneous
exchange and (2) the payment was in fact substantially contemporaneous. Accordingly,
cash-on-delivery transactions will generally qualify for this defense. Payments made in
advance are also not recoverable as preferences, because they do not satisfy the
requirement under Section 547(b)(2) of the Bankruptcy Code that the payment be on account
of an antecedent debt owed by the debtor before the transfer was made.
In considering the contemporaneous exchange defense, the focus is on the first test which
relates to the parties’ intent. See In re Hechinger Inv. Co. of Del., Inc., 489 F.3d 568, 574 (3rd
Cir. 2007) (holding that a credit relationship does not preclude, as a matter of law, a finding of
contemporaneous exchange for new value and that the determination of whether the parties
intended a contemporaneous exchange is a question of fact to be decided by the fact finder).
While the case law varies, courts have generally allowed defendants to employ the defense if
they have been paid within 2 to 3 weeks and the intent to create a contemporaneous
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exchange has been established.
What is the date of a
preferential transfer – is it
the date that the debtor’s
check is delivered to the
creditor or the date that
the check was honored by
the debtor’s bank?
This distinction is critical because it could determine whether or not the transfer falls within the
90-day preference period under Section 547(b)(4). The issue was decided by the United
States Supreme Court in the case of Barnhill v. Johnson, 125 S.Ct. 1386 (1992). There, the
Court determined that for the purposes of a preference action brought pursuant to Section
547(b) of the Bankruptcy Code, a transfer made by check is deemed to occur on the date the
check is honored by the payor’s bank, rather than the date of the payee’s receipt of the check.
However, the Supreme Court refused to address the issue of when a transfer is made for the
purpose of analyzing both the new value and ordinary course of business defenses under
Section 547(c). Nevertheless, it should be noted that most courts which have subsequently
considered the issue have concluded that a date of delivery rule should apply to check
payments for purposes of defenses to preference actions. These courts have recognized that
as a matter of policy, it is critical for vendors to agree to ship goods or supply services to
purchasers upon receipt of a check because those vendors do not have the capability to
determine whether the payor’s bank will honor that obligation.
Are payments under an
agreed-upon payment
schedule preferential?
If a debtor does not pay in accordance with terms and later enters into a stipulation with a
creditor to make payment over time in accordance with the terms of a payment stipulation, the
payments may still be preferential. It is well established that unusual collection activity during
the preference period supports a finding that payments made during that period are outside
the ordinary course of business. The courts are divided, however, on whether payments
made pursuant to a settlement or restructuring agreement prohibit use of ordinary course
defense.
For example, the Third Circuit disfavors payment plans, which it stated in In re Molded
Acoustical Products, Inc., 18 F.3d 217, 228 (3rd Cir. 1997) is “an act which does not suggest
business as usual within the industry but, quite to the contrary, resembles a calculated
response to a deteriorating creditor–debtor relationship. In contrast, the Second Circuit held
in In re Roblin Industries, Inc., 78 F.3d 30, 42 (2nd Cir. 1996) that a creditor that agrees to
restructure a debt by instituting a repayment plan “in a manner consistent with industry
practice in those circumstances does not lose the benefit of the exception”. However, even in
circuits where payments made pursuant to payment plans may not be preferential, the burden
is on the creditor to demonstrate that the restructuring of the debt is consistent with prior
dealings of the parties or the customary practice in the relevant industry.
On of the prima facie
elements of a preference
claim is that the transfer
must be made when the
debtor is insolvent. Is
there a presumption of
insolvency?
Yes. Pursuant to §547(f) of the Bankruptcy Code, the debtor is presumed to have been
What is the legal standard
in determining
insolvency?
Section 101(32)(A) of the Bankruptcy Code defines “insolvent” as a “ . . . financial condition
insolvent during the 90 days immediately preceding the bankruptcy filing. However, while the
presumption requires the creditor being sued for preference to come forward with some
evidence to rebut the presumption, the burden of proof remains upon the debtor-inpossession or the trustee bringing the preference action.
such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair
valuation . . . .” Many courts have defined “fair valuation” as the reasonable estimate of what
could be realized from the assets by converting them into or reducing them to cash under
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carefully guarded, if not ideal, conditions. However, this raises the question of whether a
going concern or liquidation standard should be used, or a combination thereof. Once again,
the resolution of this issue will depend on the particular facts of a case.
Litigation of this issue therefore often involves the retention of accountants or other financial
consultants as experts to analyze the debtor’s financial condition 90 days before it filed for
bankruptcy. Accordingly, when confronted with a preference action, a creditor can often delay
the action or improve its position in settlement negotiations by asserting the insolvency
defense and by seeking discovery on this issue, particularly if the debtor’s schedules or SEC
filings (if any) show a positive net worth.
What is the statute of
limitations for a preference
action?
Under Section 546(a) of the Bankruptcy Code, a preference action may not be commenced
after the earlier of:
i.
the later of (a) 2 years after the entry of the order for relief or (b) 1 year after the
appointment or election of the first trustee (if any); or
ii.
the time the case is closed or dismissed.
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COOLEY LLP’S BANKRUPTCY PREFERENCE ACTIONS PRACTICE
Overview
One of the most challenging obstacles for creditors to navigate in bankruptcy law is
preference actions. Under the Bankruptcy Code, bankruptcy trustees and debtors are able to
pursue these types of cases against creditors that received payment for goods or services
within 90 days of a debtor filing for bankruptcy. Accordingly, creditors that received
payments during that time period before the bankruptcy are frequently sued for recovery of
preferences by the trustee, who also may allege fraudulent conveyance claims. Bankruptcy
preference actions are a somewhat unique type of litigation which involve a distinctive
statistical analysis of the parties’ account history and the industry standard for payment
combined with traditional litigation.
Cooley’s Bankruptcy & Restructuring group has extensive experience in defending hundreds
of preference actions involving our creditor clients from all types of industries, including retail,
financial services, travel, electronics, and technology, among many others. We carefully
evaluate the claims being brought by a bankruptcy trustee, as well as the payment history
between the creditor and debtor, and decide on the appropriate affirmative defenses to
assert, including the “new value” defense, the “ordinary course of business” defenses, or the
“contemporaneous exchange” defense. Our deep understanding of the line of attack likely to
be employed by a trustee and the defensive strategies that will limit our client’s exposure
enables us to handle these types of cases in the most cost-effective and efficient manner
possible.
Key Differentiator
We have a track record of successfully implementing aggressive defensive tactics by
applying our broad knowledge of the issues and nuances of preference law to obtain
favorable results for our clients. Further, a distinct advantage Cooley has over its competitors
in preference defense work is that one of our senior bankruptcy & restructuring attorneys is
an active mediator of preference actions and serves on the panel of mediators in several
bankruptcy courts. By being able to leverage this experience, which includes acting as
mediator in over 100 preference actions, our lawyers have an in-depth understanding of the
strategies that are most effective for minimizing a creditor’s liability to the bankruptcy estate.
Representative Matters
•
Defense of preference actions brought by the Circuit City bankruptcy trustee seeking
recovery of $30M, $11M and $2.5M
•
Defense of a $2M preference action brought by Lehman Brothers
•
Defense of preference actions brought by the Linens N Things bankruptcy trustee seeking
recovery of $1.5M, $1.3M and $500K
•
Defense of a $7M preference action brought by the Merry-Go-Round Stores trustee
•
Defense of a $1.7M demand by the Eos Airlines trustee
•
Defense of 56 separate preference actions brought against our client by County Seat
Stores trustee
•
Defense of $700K preference action brought by Meadowcraft, Inc.
•
Defense of $630K preference action brought by Ames Department Stores
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Key Contacts
•
Jay Indyke, Bankruptcy & Restructuring Practice Chair
(212) 479-6080
[email protected]
www.cooley.com/jindyke
•
Eric Haber, Special Counsel
(212) 479-6144
[email protected]
www.cooley.com/ehaber
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