Preference Manual

The Credit Professional’s Preference Manual

The Credit Research Foundation

2 The Credit Professional’s Preference Manual

Scott Blakeley, Esq. Richard Ruszat, Esq. Blakeley & Blakeley LLP Wells Fargo Bank Tower 2030 Main Street, Suite 540 Irvine, CA 92614 Telephone: (949) 260-0612 Facsimile: (949) 260-0613 Los Angeles Office Home Savings Bank Tower 660 South Figueroa Street, Suite 1840 Los Angeles, CA 90017 Telephone: (213) 385-5815 Facsimile: (213) 385-5817 Website: www.bandblaw.com E-mail: [email protected] or [email protected] Copyright 2002 by the Credit Research Foundation. All rights in this publication are reserved. No part of this publication may be reproduced in any manner whatsoever without written permission. Printed in the United States of America Credit Research Foundation 8840 Columbia 100 Parkway Columbia, MD 21045 410-740-5499 www.crfonline.org

3 ABOUT THE FIRM

Blakeley & Blakeley LLP represents its creditor clients in the areas of creditor rights, commercial litigation and collection, credit documentation, e- commerce, bankruptcy and out-of-court-workouts. B&B’s collective experience and legal and practical understanding of vendors’ rights results in cost-effective representation and develops solutions to vendors’ problems. B&B’s attorneys have extensive experience working with vendors. Members of the firm routinely speak to national industry groups and trade associations concerning creditors’ rights and frequently publish articles in national and regional publications concerning creditors’ rights.

Scott Blakeley is a partner in the California law firm of Blakeley & Blakeley LLP, where he advises companies around the country regarding creditors’ rights, commercial law, e-commerce and bankruptcy law. He was selected as one of the 50 most influential people in commercial credit by Credit Today. He is contributing editor for NACM’s Credit Manual of Commercial Law, contributing editor for American Bankruptcy Institute’s Manual of Reclamation Laws , and author of A History of Bankruptcy Preference Law, published by ABI. Credit Research Foundation has published his manuals entitled The Credit Professional’s Guide to Bankruptcy, Serving On A Creditors’ Committee and Commencing An Involuntary Bankruptcy Petition. Scott has published dozens of articles and manuals in the area of creditors’ rights, commercial law, e-commerce and bankruptcy in such publications as Business Credit, Managing Credit, Receivables & Collections, Norton’s Bankruptcy Review and the Practicing Law Institute, and speaks frequently to credit industry groups regarding these topics throughout the country. He is a member on the board of editors for the California Bankruptcy Journal, and is co-chair of the sub-committee of unsecured creditors’ Committee of the ABI. Scott holds a B.S. from Pepperdine University, an M.B.A. from Loyola University and a law degree from Southwestern University. He served as law clerk to Bankruptcy Judge John J. Wilson.

Richard Ruszat graduated from the University of California at Irvine, Summa Cum Laude and Phi Beta Kappa honors. He continued his studies at the University of Minnesota Law School, Walter F. Mondale School of Law, where he earned his J.D., Cum Laude. While at the law school, Mr. Ruszat was a member of the school’s elite American Bar Association National Competition Team and the tournament champion of Maynard Pirsig Moot Court. Mr. Ruszat has published numerous articles and is a contributing author to a national treatise including, Manual of Credit and Commercial Laws , 93rd Ed., “CH 4: Transactional Guide to the Formation, Performance, and Enforcement of Contracts,” (Columbia: National Academy of Credit Management, 2002); “Escheatment: Reporting and Collecting Credit Balances, Business Credit, (forthcoming July 2002); “Force Majeure,” Business Credit, (May 2002); “Was Your Debtor’s Bankruptcy Planned? Preventing Discharge and Getting Paid on Your Unsecured Claim When the Debtor Least Expects It,” Trade Creditor Quarterly, Spring 2002; “Enforcing a Mechanics’ Lien for Materials Against a Non-Contracting Party: Participating Owners,” Trade Vendor Quarterly, Fall 4 2001; “Executory Privilege: Preference Payments and the Untouchables,” Trade Vendor Quarterly, Summer 2001; “The Unsecured Creditors’ Full Payment on Prepetition Claims Under the Perishable Agricultural Commodities Act: Has Spoiled Food Ever Tasted Better?”, Trade Vendor Quarterly, Winter 2001; “Are You a Critical Trade Vendor That Merits Immediate Payment On Your Pre-petition Claim? An Update on the Necessity Doctrine,” Trade Vendor Quarterly, all 2000.

5 Table of Contents

FOREWORD 3

I. INTRODUCTION 4

II. PURPOSE OF THE BANKRUPTCY PREFERENCE 4

III. WHY A BANKRUPTCY PREFERENCE: A HISTORY 5

English Bankruptcy Law: Creation Of The Preference 5

Development Of The Modern Preference: 5 American Bankruptcy Preference Law The Bankruptcy Reform Act of 1978 6

IV. WHAT MAKES A PREFERENCE 7

The Elements 7

1. Transfer Of Property Of The Debtor 7

2. Transfer On Account Of An Antecedent Debt 7

3. Insolvency & Presumption Of Insolvency 90-Days Prior To Filing 8

4. Counting the 90-Day Period 8

5 Earmarking As A Defense 8

6. One Year Reach Back For Insiders 9

7. Receiving More Than In A Chapter 7 Liquidation 9

V. VENDOR DEFENSES 10

Asserting All Of The Defenses 10

Contemporaneous Exchange Defense 10

Ordinary Course of Business Defense 11

1. The Subjective Inquiry: Payments Must Be In The Ordinary 11 Course of the Debtor and the Creditor.

2. The Objective Inquiry: 12 Payments Must be in the Ordinary Course Of Industry

3. Common Issues Concerning Ordinary Course 12

6 New Value Defense 13

Timing Is Everything With The New Value Defense 14

Ensuring A New Value Defense 14

Postpetition Advances Are Not Subsequent New Value 15

NEW VALUE ANALYSIS 15

Enabling Loan Exception 16

Statute Of Limitations Defense 16

1. Objection To Claim 16

Standing 16

1. When May Preference Actions Be Abandoned? 16

2. Selectively Pursuing Preference Actions? 16

VI. FILE PROOF OF CLAIM 17

VII. POSTPETITION AVOIDABLE TRANSFERS 17

VIII. ESSENTIAL VENDOR PROGRAM 17

IX. LITIGATING THE PREFERENCE ACTION 18

Cost-of-Defense Analysis 18

The Preference Complaint 18

1. The Vendor's Response 18

Trial 18

7 FOREWORD

Occasionally, a creditor will receive a demand on behalf of a bankruptcy estate (from either a trustee, debtor in possession, or their attorney, but generally the trustee) to refund to the bankruptcy estate payments the creditor received from its customer that is now in bankruptcy.

A layman's definition of a preference or preferential payment is any payment whether cash or property) made by the debtor to an unsecured creditor on a past due account within 90 days prior to the debtor filing bankruptcy in other than the ordinary cause of business.

The receipt of a preferential payment is not illegal. A debtor has a right to pay whichever creditor it may choose at whatever time it chooses. However, one of the primary objectives of the Bankruptcy code is to ensure that all creditors of a class are treated alike. One of the ways that the Bankruptcy Code accomplishes this objective is to give the bankruptcy trustee the power to recover from the creditor those payments that meet the statutory definition of a preference. If after the trustee's demand the creditor does not voluntarily return the payment(s), the trustee can file suit to obtain a judgment against the creditor for the amount of the alleged preferential payment(s).

This publication, A Credit Professional’s Preference Manual, is one in a series of monographs composed by the firm of Blakeley & Blakeley, LLP for the Credit Research Foundation. We are grateful for their contribution of time and importantly their expert knowledge on the subjects of bankruptcy, insolvency and creditor’s rights.

Reading and referencing this guide will provide you with the basics of understanding and working your way through the, too often, confusing and unsettling legal environment of working with your customers.

The purpose of the Preference Manual is to provide an overview of the bankruptcy preference laws, and is not to be a substitute for legal advise. The preference defenses may be subject to a particular court's view of the law.

Terry Callahan

Credit Research Foundation

8 I. INTRODUCTION

For the credit professional, the bankruptcy preference law is frustrating, and now more frequently faced. The flurry of bankruptcy filings has triggered a landslide of preference lawsuits being filed against vendors. The notion that a vendor with an active trade relationship whose customer files CH 11 and emerges from reorganization is immune from preference attack is no longer valid. Rather, the tendency of even a CH 11 debtor is to sue its vendors to recover the payments vendors receive during the preference period, perhaps prompted by bondholders or an undersecured lender. Given this new landscape of the preference action, the credit professional should understand what are the elements of a preference and the defenses the vendor may have.

The Bankruptcy Code vests the trustee (or debtor, creditors’ committee or liquidating trustee, for example) with powers to avoid payments and transfers prior to a bankruptcy filing. The power to avoid a preferential transfer is one of the trustee’s most powerful weapons. The Bankruptcy Code defines a preferential transfer broadly to include nearly every transfer by an insolvent debtor during the preference period.

II. PURPOSE OF THE BANKRUPTCY PREFERENCE

To Promote Equality Of Distribution, Discourage Dismembering The Debtor And Discourage Secret Liens

The purpose of the preference law is two-fold. First, creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain creditors by the requirement that any creditor that receives a greater payment than similarly situated creditors disgorge the preference so that like creditors receive an equal distribution of the debtor’s assets. Preference laws are the primary instruments in achieving equality of distribution. Associated with the tenet of equality of distribution is the bankruptcy policy of maximization of the bankruptcy estate. A larger distribution might be achieved through rehabilitation rather than liquidation. Preferential transfers result in diminishment of estate assets, thus frustrating decisions that would achieve maximization.

Not all transfers made within the preference period are avoidable. Congress has carved out exceptions or defenses to the trustee’s recovery powers, to protect transactions that replace value to the bankruptcy estate previously transferred.

To understand the rational supporting the preference, a history of the bankruptcy preference is considered.

9 III. WHY A BANKRUPTCY PREFERENCE: A HISTORY

The preference laws have evolved as an offshoot of fraudulent conveyance law, thus containing broad ethical pronouncements of sixteenth century English bankruptcy law and to standardize, technical rules of twentieth century American bankruptcy law. The focus of preference laws has shifted from the culpability of the debtor, to the culpability of creditors, to the present day standard of strict liability.

English Bankruptcy Law: Creation Of The Preference

Since 1570, English law has prohibited transfers by a debtor for the purpose of defrauding creditors. The penalty imposed for the crime was a forfeiture of the property transferred and imprisonment of the debtor. The emergence of preference law was closely tied to the law of fraud. Although the concept of pro rata distribution appeared in the first comprehensive bankruptcy statute, The Statute of 13 Elizabeth, the Statute was silent as to preferences. Early preference law developed through case authority.

Transfers on the eve of bankruptcy were void when creditors had not demanded payment or threatened to bring suit. Payments to creditors, on the eve of bankruptcy, who had threatened to collect their debts, were not considered preferential.

In 1746 Parliament created a bona fide creditor law, intending to protect innocent creditors from avoidance payments. Courts distinguished between good and bad transfers.

A bad transfer required the debtor to intend to benefit a creditor to the detriment of other creditors. The ethical inquiry under English preference law focused principally on the state of mind of the debtor, not on the actions of the creditor. Under this analysis the aggressive creditor was rewarded.

The statute advanced a central theme in preference legislation: Preferential payments are contrasted with some sense of ordinary commercial practice. The goal of preference laws was to capture fraud and not unwind a transaction in the ordinary course. The focus of English bankruptcy law was not ensuring a mathematical pro rata distribution of assets, but rather, to prevent a debtor from creating his own form of distribution to creditors. In 1869 Parliament drafted a preference provision into its bankruptcy legislation. The preference law provided that any payment made within three months of bankruptcy, for the purpose of giving the creditor a preference, was void.

Development of The Modern Preference: American Bankruptcy Preference Law

Switching continents, a central consideration in American preference legislation is the review of changing relationships between the debtor and its creditors.

10 State regulation of preferential transfers began in the late eighteenth century. Under these laws, the debtor’s state of mind was essential in determining a preference. The first American Bankruptcy was the Bankruptcy Act of 1800. While fraudulent conveyances were included in the Act of 1800, preference actions were not.

The Bankruptcy Act of 1841 was the first to define and prohibit preferences. Any transfer by the debtor, within a two-month reach back period, was illegal if made for the purpose of benefiting a particular creditor. As a result of an illegal reference, the debtor would lose his discharge. The Act of 1841 did not consider state of mind as an element in finding an illegal preference.

The Act of 1867 made it easier to find a preference. In addition to extending the reach back period to four months, it changed the debtor’s contemplation of bankruptcy condition to the debtor’s insolvency or contemplation of insolvency.

The 1867 Act also added the state of mind condition requiring the creditor to have reasonable cause to believe the debtor was insolvent.

The 1898 Act reflects a shift in preference philosophy from the debtor’s moral duty to his creditors to the preferred creditor’s moral duty to fellow creditors. The focus was now on the state of mind of the creditor. A transfer was avoidable provided the preferred creditor had a reasonable basis to believe that the payment would cause a preference. The preference laws were intended to punish bad creditors, i.e. those that know of the debtor’s insolvency.

The Act of 1898 also addressed the secret lien, whereby a debtor who provides a creditor with a security interest well before the reach back period but who did not perfect the lien until the eve of filing, would fall within the reach back doctrine.

The Chandler Act of 1938 continues the trend to a more technical application of preference laws. The Chandler Act re-emphasizes that ratable distribution is the essence of bankruptcy laws and preference laws are the vehicles to achieve this. As with the Act of 1898, the focus of the legislation was avoidance of secret liens and last-minute liens, and its purpose was to prevent rewards to preferred reditors, insiders and creditors exerting economic pressure.

The Bankruptcy Reform Act of 1978

The Bankruptcy Reform Act fundamentally Changed American preference law. The drafters of the Bankruptcy Reform Act created a preference law, section 547 of the Bankruptcy Code, which is a precise, technical rule of definitions and numbered exceptions intended to avoid transfers that upset ratable distribution. Congress sought to simplify the preference laws and restrict court interpretation of these provisions through technical drafting and

11 on rule-oriented approach. The rule shifts the onus of preference litigation from debtor to creditor.

The Bankruptcy Reform Act made it easier to establish the existence of a preference by eliminating the requirement that the creditor have reasonable cause to believe that the debtor was insolvent (except for insider creditors). The state of mind element is eliminated, in part, out of concern that the innocent creditor exception conflicts with the policy of equality among creditors.

The reach back period is shortened from 120 days to 90 days. To aid the trustee in establishing a prima facie case of preference, the drafters added the provision that the debtor is presumed insolvent within 90 days prior to the bankruptcy filing. All forms of preference actions may be commenced in the bankruptcy court here, presumably, the action will proceed more swiftly. Aimed at the secret lien, the Bankruptcy Reform Act also requires creditors to timely perfect their security interests.

The elimination of the creditor’s state of mind element and the addition of the presumed insolvency of the debtor element broadens the scope of a preference. The drafters seek to limit the broadened scope with defined exceptions. We now discuss the modern bankruptcy preference and exceptions.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“2005 Act”) (Pub.L. 109-8, 119 Stat. 23, enacted 2005-04-20), providing for significant changes in Bankruptcy in the United States, was passed by the 109th United States Congress on April 14, and signed into law by President George W. Bush on April 20, 2005. Most provisions apply to cases commenced on or after October 17, 2005. Referred to colloquially as the "New Bankruptcy Law", the Act of Congress attempts to make it more difficult for consumers to erase debt by forcing more people to file under Chapter 13 rather than Chapter 7.

IV. WHAT MAKES A PREFERENCE

The Elements

A trustee may avoid a transfer by the debtor if such transfer is:

1. A transfer of property of the debtor;

2. A transfer on account of an antecedent debt;

3. Presumption of insolvency within 90 days of bankruptcy filing;

4. Within 90 days (one year if an insider) before the filing of bankruptcy; and, 12 5. A transfer that enables the creditor to receive more than it would have received in liquidation. The trustee, debtor or party assigned the avoidance actions, has the burden of proof to establish these elements.

Under existing law, in order to defend against a preference based on the fact that the alleged preferential payment was made in the ordinary course of business, the creditor had a two-prong test to meet in addition to proving the indebtedness was incurred in the ordinary course of business or financial affairs of the debtor and the creditor. The alleged preferential payment had to be a payment made in the ordinary course of business or financial affairs of the debtor and the creditor (the “subjective” test) and the payment had to be made according to ordinary business terms (the “objective” test). This created an extreme challenge to a trade creditor who had a limited history of transactions with the debtor. In particular, it was difficult for a creditor to prove “ordinary” if the preference payment was made as a result of a first transaction with a trade creditor. Further, a trade creditor was required to prove that the payment was ordinary in the industry as well as ordinary between the debtor and the creditor. Obtaining industry data, and sometimes an expert witness, to establish the ordinary course of business standard of a particular industry was burdensome and often expensive.

The legislation has eliminated this subjective/objective test. Bankruptcy Code Section 547(c)(2) has been modified to permit the creditor to defeat a preference attack by proving that the alleged preferential payment was made in the ordinary course of business or financial affairs of the debtor and the creditor or according to ordinary business terms. This will enable creditors to choose the best defense available to them. A preference can now be defended based on past history of payments from the debtor without needing to ascertain what the industry standards are. Alternatively, in the case of a first transaction or only a few transactions, or where the subjective standard cannot be satisfied, the creditor can rely on the range of terms in the creditor’s industry. The legislation has also added a new defense to preference claims in business transactions where the aggregate amount of all property constituting or affected by the transfer is less than $5,000.

It is common for a trustee to commence an action (or at least threaten to commence an action) to recover a small preference with the anticipation that a creditor will make payment rather than spending the time and money to defend the preference action in a distant bankruptcy court. Section 1409(b) of title 28 of the United States Code, which provides the venue basis for preference actions, is modified to set monetary and jurisdictional limits for preference actions both in the commercial and consumer arena. With some limited exceptions, preference actions (or any action by a trustee to recover a money judgment) against a trade creditor of less than $10,000 can be commenced only in the district court for the district where that trade creditor is located.

13 The trustee has the burden to meet all five elements and failure to meet any one of them results in failure of complaint. The Bankruptcy Reform Act of 2005 provides that $ 500 is the minimum preference action that may be pursued.

This change protects the smaller vendors most prone to abusive litigation tactics, and the $5000 threshold amount does not undermine the policy supporting equality of treatment of like creditors.

1. Transfer Of Property Of The Debtor

Transfer is broadly defined under the Bankruptcy Code to include every direct or indirect, absolute or conditional, voluntary or involuntary, disposing of the debtor’s property.

Transfer does not include a set-off. The inquiry is whether the transfer diminished the bankruptcy estate.

2. Transfer On Account Of An Antecedent Debt

A transfer on account of an antecedent debt includes any debt or claim asserted against the debtor. A debt is “antecedent” if the debtor incurs it before making the alleged preferential transfer. A majority of courts conclude that an antecedent debt arises the date that the debt is incurred, and if the transfer occurs after such date, then the antecedent debt requirement is satisfied. However, the minority position is that an antecedent debt requires the debt to become past due, and therefore; a preference claim is negated if the transfer is made for payment on a current debt. A COD or CIA sale does not create an antecedent debt.

3. Insolvency And Presumption Of Insolvency 90-Days Prior To The Bankruptcy Filing

Generally, insolvency is a financial condition in which the sum of the entity’s debts is greater than the fair value of its property. A debtor is presumed insolvent 90-days before filing bankruptcy. If a vendor challenges the presumption, the burden is on the vendor to produce financial evidence to rebut the presumption of insolvency.

4. Counting the 90-Day Period

Generally, a transfer made on the date of the bankruptcy filing or within 90- days is deemed preferential. However, the courts are split on the computation of the 90-day period. Some courts count from the date of the bankruptcy filing backwards 90-days to determine the applicable preference period. Other courts count 90-days forward from the date of the transfer to determine whether a transfer may be a preference. Counting forward may provide the

14 trustee a period of time beyond that allotted by statute if the 90th day falls on a weekend or holiday.

Courts that apply counting backwards approach contend that a transfer can take place on any day of the week, including a weekend or holiday, and therefore does not require the bankruptcy court to be open for business for the purpose of determining a preference period.

Alternatively, courts that apply the counting forward approach contend that the preference period may be extended beyond the 90th day if the 90th day falls on a weekend or holiday. For example, if counting forward from the date of the transfer the 90th day falls on a Sunday, then the date of the transfer would be on the following Monday. This effectively expands the time period provided by section 547 by one day, or two-days if the 90th day falls on a Saturday, or threedays if the 90th day falls on a Saturday of a three-day weekend.

For purposes of the preference period, payment by check is considered to have been made when the debtor’s bank honors the check, not when the vendor receives it.

5. Earmarking As A Defense

The earmarking doctrine is invoked by the vendor as a preference defense if the payment was “earmarked” for the vendor by a non-debtor third party. The earmarking doctrine rationale is that a bankruptcy estate is not diminished by the payment as a non-debtor third party made payment to the debtor’s creditor. In essence, the third party steps into the shoes of the debtor’s existing creditor. The earmarking doctrine finds its genesis in circumstances where the non-debtor third party is personally obligated to pay the debtor’s creditor as a surety, successor or guarantor.

Under the majority test, in order for a payment to qualify as earmarking between a non-debtor third party and a debtor’s existing creditor, the following factors must be present: (1) an agreement between the non-debtor third party and the debtor that the new funds will be used to extinguish an existing antecedent debt; (2) the agreement must actually be performed; and (3) the transaction may not result in the a diminution of the estate.

The minority test requires satisfaction of the following factors: (1) the debtor’s lack of control over the disposition of non-debtor third party funds; and (2) the transfer does not diminish the estate’s funds.

Although certain defenses to preference actions are commonplace (e.g., ordinary course and new value), the earmarking defense is not specifically enumerated in the Bankruptcy Code. Instead, courts recognize the defense as one arising out of the trustee’s burden to prove that the estate is diminished by the transfer. However, unlike common defenses, which place the burden on the defendant, courts are split as to which party bears the burden when invoking the earmarking doctrine.

15 6. One Two Year Reach Back For Insiders

There is a onePursuant to the enactment of the 2005 Act the reach-back period has been extended to two-years reach-back period to avoid a transfer made to an insider. The definition of insider is comprehensive and includes:

 If the debtor is an individual, the insiders include relatives, general partners, partnerships in which the debtor is a general partner, and corporations in which the debtor is a director, officer or person in control.  If the debtor is a partnership, then insiders include general partners, relative of a general partner in, general partner of, or person in control of the debtor, partnership in which the debtor is a general partner, and persons in control of the debtor.

 If the debtor is a corporation, then insiders include directors, officers or persons in control of the corporation, general partners, and relatives of a general partner, director, officer, or person in control of the debtor.

 If the debtor is a municipality, elected official of the debtor or relative of an elected official of the debtor.

• All affiliates or insiders of affiliates as if such affiliates were the debtor.

7. Receiving More Than In A Chapter 7 Liquidation

Whether the transfer is preferential also requires an analysis of whether the vendor subject to the preference received more than it would have in a hypothetical Chapter 7 liquidation. Courts employ a two-tiered analysis. Under the first tier, the court determines the amount each creditor would have received if the estate was liquidated as provided under Chapter 7 on the date the bankruptcy petition was filed. This is labeled the “hypothetical Chapter 7 liquidation.”

With the second-tier, the court determines whether the vendor, subject to the preference, received a greater percentage payment on its prepetition claim than similarly situated creditors. If the vendor received a greater percentage, then the trustee satisfies this element.

A. Letter Of Credit

If the vendor has backed up the credit sale with a letter of credit (“L/C”) and the vendor draws down on the L/C during the 90 days prior to the bankruptcy, is this a preference? The general rule is the vendor’s draw down on the L/C is not a preference. The rationale is that the vendor with an L/C backing up the credit sale is like a secured creditor. As the vendor is entitled to full payment, it does not receive a greater percentage under a Chapter 7 liquidation.

16 B. Burden Of Proof

The trustee has the burden to establish the elements of a preference. The trustee’s burden is a preponderance of the evidence.

C. Confirming the Trustee’s Numbers: Are Their Records Correct?

The trustee alleges the vendor received, say $500,000, within the 90 days prior to the bankruptcy. Is the figure correct? The vendor must confirm the payments and dates the check cleared. Usually, preference actions are pursued by a bankruptcy trustee who may receive incomplete information from the debtor. The trustee’s lack of documents may be important as the vendor builds its preference defenses.

Means test for Chapter 7

The 2005 Act makes it considerably more difficult for individuals to file for bankruptcy under Chapter 7, under which most of their debts are forgiven (or discharged), as opposed to Chapter 13, under which no debts are forgiven. The 2005 Act substitutes a means test to determine whether filers have enough income to pay some portion of their debts, and thus file under Chapter 13. The means test applies to filers whose gross income (based on the six month period prior to filing), is above the median income in their state (ranging from $72,451 in Massachusetts to $42,290 in West Virginia, as of 2005). Individuals whose incomes are below the median automatically qualify for Chapter 7. Filers whose incomes are above the median must then calculate their Disposable Monthly Income (DMI) to determine whether they are able to make payments on their debts sufficient to qualify them for Chapter 13. The DMI is determined by subtracting priority debt payments, secured debt payments, Internal Revenue Service determined expense allowances, taxes and certain other expenses from a filer’s monthly income. If the DMI is less than $100 per month, they are permitted to file under Chapter 7. If the DMI is above $100, they must file under Chapter 13.

This formula effectively rewards filers with assets that are heavily mortgaged and debtors with larger amounts of unsecured debt. Since alimony and child support payments are "priority debts" it also has the effect of making it easier for people who owe back domestic support obligations (such as "deadbeat dads") to file under Chapter 7 than other debtors (but the child support is not dischargable).

A trade creditor no longer has to fear a preference action because that creditor is holding the personal guaranty of such insider. The debtor may then make a payment to that trade creditor to prevent that creditor from pursuing its rights against the insider of the debtor. Section 547 of the Bankruptcy Code is modified to include an additional point which states:

17 If the trustee avoids under subsection (b) a transfer made between 90 days and one year before the date of the commencement of the bankruptcy case, by the debtor to an entity that is not an insider for the benefit of a creditor who is an insider, such transfer shall be considered to be avoided under this section only, with respect to the creditor that is an insider.

The modifications made by this section will enable a trustee or debtor to commence a preference action against a trade creditor in order to reach the insider. However, any recovery or avoidance of a transfer shall only be valid against a creditor who is the insider of the debtor.

V. VENDOR DEFENSES

Asserting All Of The Defenses

The most commonly asserted preference defenses asserted by vendors are the contemporaneous exchange defense, the ordinary course of business defense and the new value defense. If the vendor sells on a secured basis, such as with a purchase money security interest, the vendor may have an enabling loan defense. In addition, vendors may have procedural defenses, including the statute of limitations defense, standing defense and demand for jury trial. Be mindful that the trustee generally has no duty to investigate and consider a vendor’s preference defenses, as it is the vendor’s burden to establish the defenses. Thus, the vendor must analyze the documents to build its preference defenses.

Contemporaneous Exchange Defense

A transfer may not be avoided where such transfer (1) was intended by the debtor and creditor to be a contemporaneous exchange for new value, and (2) was in fact a substantially contemporaneous exchange.

It is generally required that the transfer to the creditor to have occurred within days or at most (depending on the intent of the parties and the facts of each case) weeks of the transfer of the new value by the creditor to the debtor. Trade creditors dealing with a debtor during the 90 day preceding bankruptcy often fail to qualify for this exception because payments received from the debtor are applied to invoices that have aged significantly before the transfer. Payment by check will usually qualify as a contemporaneous exchange. However, a dishonored check will not.

One method a vendor may consider to reduce the preference risk when it is perceived that the debtor is financially unstable is to create a new account ledger for the debtor and apply payments received to this account contemporaneously with any shipment being made to the debtor. This may qualify these transactions as a contemporaneous exchange defense.

Ordinary Course of Business Defense

18 Pursuant to section 547(c)(2), a transfer may not be avoided if the transfer was in payment of a debt incurred in the ordinary course of business. The ordinary course of business defense adheres to bankruptcy’s general policy to discourage unusual collection practices during the debtor’s financial demise.

Three elements make up the ordinary course of business defense. First, the debt must be incurred in the ordinary course of business or financial affairs of the debtor and vendor. The dispute as to the application of the ordinary course of business usually concerns whether the transfer at issue satisfied the second and third statutory requirements. Second, the transfer must have been made in the ordinary course of the business or financial affairs of the debtor and vendor. This element is often referenced as the “subjective” test to the ordinary course of business defense. Third, the transfer must have been made according to ordinary business terms within the respective industry. This element is often referenced as the “objective” test of the ordinary course of business defense. The 2005 Act as per the provisions of section 409 amends the ordinary course of business exception and makes it easier for the vendor to prove up the ordinary course of business defense by allowing the vendor to establish either that the payment was ordinary between the debtor and the vendor, or that the payment was ordinary in comparison to the terms in the industry. The vendor is no longer required to prove both elements.

This provision strengthens the ordinary course of business defense. Provided the debt is incurred in the ordinary course of business, the vendor should prevail assuming that either the payment was in the ordinary course of business between the vendor and the debtor, or that the payment was made according to ordinary business terms.

Thus the 2005 Act has eliminated the subjective/objective test. Bankruptcy Code Section 547(c)(2) has been modified to permit the creditor to defeat a preference attack by proving that the alleged preferential payment was made in the ordinary course of business or financial affairs of the debtor and the creditor or according to ordinary business terms. This will enable creditors to choose the best defense available to them. A preference can now be defended based on past history of payments from the debtor without needing to ascertain what the industry standards are. Alternatively, in the case of a first transaction or only a few transactions, or where the subjective standard cannot be satisfied, the creditor can rely on the range of terms in the creditor’s industry. The legislation has also added a new defense to preference claims in business transactions where the aggregate amount of all property constituting or affected by the transfer is less than $5,000.

1. The Subjective Inquiry: Payments Must Be In The Ordinary Course

Of The Debtor And The Creditor

19 Courts often employ a “baseline of dealings” test to determine whether the transfer was made in the ordinary course of the business or financial affairs of the debtor and creditor. The baseline of dealings compares two time periods to determine the course of dealings between the debtor and creditor. The first time period is the course of dealings beyond the 90-day preference period (“preinsolvency period”). The second time period is the preference period, which includes the date of the bankruptcy filing through the 90th day after the date of the bankruptcy petition. If the course of dealings between the two periods is consistent, then the payments satisfy the subjective prong of the defense. However, if the course of dealing between the two periods is not consistent, then the payment is not made in the ordinary course of business and may be recovered as a preference.

In addition to the baseline of dealings test, courts review the “ordinariness” of the transfer between the debtor and creditor in relation to past practices. Issues that are considered include: (1) the length of time that the parties were engaged in the transaction at issue; (2) whether the amount or form of the payment differed from past practices; (3) whether the debtor or creditor engaged in any unusual collection or payment activity; and (4) whether the creditor took advantage of the debtor’s deteriorating financial condition. If any of these factors are present, then a court may find that the transfer does not qualify for an ordinary course of business defense.

2. The Objective Inquiry: Payments Must Be In The Ordinary Course Of Industry

The third element requires the vendor to show by a preponderance of evidence that the transaction occurred according to “ordinary business terms” for the industry. This is often referred to as the objective test and is the majority approach in evaluating the ordinary course of business defense. The seminal case defines ordinary business terms for the industry as the range of terms that encompass the practices in which businesses similar in some way to the creditor in question engage, and that only dealings so unusual as to fall outside that range should be considered extraordinary and outside the scope of the industry. In addition, other courts have adopted the majority approach with some minor variations, such as accounting for the length of the parties’ relationship and evaluating the once financially healthy debtor.

Although the industry standard does not require a creditor to establish the existence of a uniform set of business terms, it does require evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems. To establish the industry standard, the creditor must usually rely on evidence that is external to the debtor and creditor. Generally, reliance on the testimony of the vendor attesting to the industry standard may be ineffective as it blurs the distinction between the objective and subject elements to the ordinary course of business exception.

3. Common Issues Concerning Ordinary Course

• Late Payments Not Per Se Outside The Ordinary Course 20 A late payment is considered “ordinary” if the baseline of dealings between the parties demonstrated by a preponderance of the evidence that the creditor accepted late payments from debtor. As discussed above, a range is determined for both the pre-insolvency period and the preference period. The acceptable range of a late payment is determined upon the circumstances of each case.

• First Time Transactions Not Per Se Outside The Ordinary Course

If the alleged preferential transfer is a “first-time” transaction, then the ordinary course of business exception may apply. Although it is beneficial in determining whether the ordinary course of business exception applies, a course of dealings between the debtor and creditor is not an absolute prerequisite. Instead, an ordinary course of business defense may be established by the terms of the parties’ agreement and adherence to those terms.

• Restructuring Agreements Not Per Se Outside The Ordinary Course

Restructuring agreements may qualify to assert an ordinary course defense. In determining whether restructuring agreements are ordinary, courts apply the subjective and objective test. If restructuring agreements were common between the debtor and creditor, then the subjective inquiry may be satisfied. The objective test requires the court to review those terms employed by similarly situated debtors and creditors facing similar problems. If the terms are ordinary for industry participants under financial distress, then that may be ordinary for the industry.

New Value Defense

A transfer may not be captured to the extent that, after such transfer, such creditor gives new value to or for the benefit of the debtor.

Timing is key for the vendor to have a new value defense. For example, on January 1 the debtor gives a vendor a check for $10,000 for goods furnished. On January 5, the vendor provides the debtor an additional $10,000 in goods on open account (no purchase money security interest is taken in the goods). On February 1, the debtor files bankruptcy. The January 1 payment, made within 90 days before bankruptcy, may be recaptured as a preference assuming that the criteria for the preference are met. However, because the subsequent advance of goods by the vendor replenished the bankruptcy estate, the subsequent advance rule permits the vendor to set off its January 5 advance against the preference, and does not have to disgorge the payment. The vendor is left with an unsecured claim for $10,000.

The subsequent advance rule has its most frequent application where a vendor provides goods or services on open account and the debtor pays the vendor at various points during the preference period. Congress intended to protect the open account vendor with the new value rule. Under this analysis, 21 a single transfer during the preference period is not analyzed in isolation from the overall course of business between the vendor and debtor, as the basis for maintaining the open account is the debtor's entire financial picture and not the debtor's most recent payment.

The objectives of the new value rule are: (1) to encourage vendors to continue to extend credit to financially troubled debtors, possibly helping the debtor avoid bankruptcy; (2) to promote equality among vendors; and (3) to reward vendors who actually enhance the estate during the preference period. Without the exception, a vendor who continues to extend credit to the debtor would merely be increasing its bankruptcy loss and in effect be punished for continuing to work with the debtor.

1. Timing Is Everything With The New Value Defense

When The Vendor Ships The Goods Versus When The Debtor Receives The Goods The following highlights the importance of timing to qualify for the new value defense. Say the vendor ships goods on credit to the debtor on December 20 and December 27. On January 3 the debtor delivers a check for payment of the invoices on the two shipments. The debtor receives the shipments from the vendor on January 6. The debtor files bankruptcy within 90 days of making payment, and the vendor is sued for a preference. The vendor contends that it has an absolute defense to the preference under the new value.

A bankruptcy court facing these facts found otherwise:

“ The purpose of section 547(c)(4) is to encourage creditors to deal with troubled businesses. . . If that is the purpose, the Court believes that the relevant date to determine when the new value is given is the date of the shipment of the goods. In this case, [the vendor] extended credit and shipped the goods before the preference occurred. New value cannot be given as an aforethought. Further, use of the delivery date would treat creditors arbitrarily based on the method of shipment used or distance the product must travel.” i

The court observed that services are relinquished at the time when rendered, unlike with a vendor’s shipment of goods where there is delay from shipment to the debtor’s receipt.

• When The Check Is Received By The Vendor Versus When The Check Clears

When should the new value defense be measured with payment by check, from the date that the vendor receives the check or when the check clears the vendor’s bank? A bankruptcy court considering this issue observed that the purpose of the new value defense was to encourage vendors to continue to 22 sell to a financially troubled debtor. If a vendor was required to wait until the debtor’s check cleared before the new value defense applied, a vendor would delay shipment hastening a debtor’s slide into bankruptcy. The court ruled that the new value defense applied when the vendor received the debtor’s check as opposed to when the check cleared the vendor’s bank.

2. Ensuring A New Value Defense

A credit professional must be mindful of timing of shipments when continuing to sell to a financially troubled account. For a new value defense to apply to a preference lawsuit, the vendor must ship goods after it receives payment, not prior to payment. If the debtor pays for the new shipment by check, the vendor need not wait until the check clears for the new value defense to apply. A credit professional that recognizes that timing is everything for the new value defense to apply, may find a solid defense if the debtor they continue to sell files bankruptcy and they are sued for a preference.

3. Postpetition Advances Are Not Subsequent New Value

Does a vendor’s postpetition credit sale qualify as a new value defense for a preference? The general rule is that it does not. One court reasoned:

Postpetition advances of new value may not be applied to offset preferential transfers. Bergquist v. Anderson-Greenwood Aviation Corp. (In re Bellanca Aircraft Corp.), 850 F.2d 1275, 1284 (8th Cir. 1988). First, section 547(c) (4) specifically requires that the advances be made “to or for the benefit of the debtor,” and any postpetition Transfers would not be for the debtor, but for the bankruptcy estate. Id. Second, the purpose of the subsequent new value exception – to encourage creditors to deal with troubled businesses --- is better served by other Bankruptcy Code provisions, such as sections 364 or 503(b)(1) once a petition has been filed. Id.ii

The following table highlights the operation of the new value defense.

New Value Analysis

CHECK DATE CHECK AMOUNT GOODS PREFERNCE SHIPPED 10,000.00 0.00 1/01/03 10,000.00 10,000.00 10,000.00 0.00 1/30/03 20,000.00 20,000.00 20,000.00 0.00 2/15/03 30,000.00 30,000.00 30,000.00 0.00 2/28/03 10,000.00 10,000.00 10,000.00 0.00 3/15/03 20,000.00 20,000.00 23 20,000.00 0.00 3/25/03 Bankruptcy Filed TOTAL $90,000.00 $100,000.00 $0.00

Enabling Loan Exception

If the vendor sells secured, such as with a purchase money security interest or inventory or accounts receivable lien, the transaction should be immune from a preference attack. Provided the vendor gave new value, the debtor signed a security agreement and the vendor perfected the security agreement within 20 days of the debtor’s possession, the transaction should be immune from a preference challenge.

Statute Of Limitations Defense

The trustee has two years from the date of the bankruptcy petition to file a preference action. If the trustee fails to file the preference action within two years, the trustee is generally barred from pursuing the preference. When you are served with the preference complaint, check the date of the bankruptcy filing and the date of the preference action was filed.

1. Objection To Claim

Even if the statute of limitations to commence a preference action expires, a trustee may use the preference laws defensively by objecting to a vendor’s claim. With this strategy, a trustee objects to the vendor’s proof of claim contending the vendor received a preference. Until the vendor pays the preference, the trustee argues, the vendor is not entitled to be paid on its claim.

Standing

The Bankruptcy Code gives the preference powers to the bankruptcy trustee or debtor, if a trustee has not been appointed. The debtor may assign these powers to the creditors’ committee or a trust.

1. When May Preference Actions Be Abandoned?

Should the creditors’ committee be assigned the preference powers, may the committee elect not to pursue preferences? What if the committee is comprised of a majority of vendors who received payments during the preference period. May the committee elect not to pursue the preference actions? These issues touch on a committee member’s fiduciary duty. The general rule is that a committee member has a duty to maximize payment to general unsecured creditors. The argument in support of abandoning the preference actions is that the cost to pursue the claims offsets the recovery of any preferences.

24 2. Selectively Pursuing Preference Actions?

May a debtor, or other party assigned the preference powers, selectively pursue preference actions? While the Bankruptcy Code does not impose on the preference plaintiff to undertake an analysis of preference defenses prior to suing on a preference, it may be that the preference plaintiff may analyze the defenses of vendors. Based on the preference defense analysis that may show substantial defenses, the preference plaintiff may elect not to pursue the preference claims.

VI. FILE PROOF OF CLAIM

If you have to pay on the preference claim, file a proof of claim for the amount paid within 30 days.

VII. POSTPETITION AVOIDABLE TRANSFERS

The Bankruptcy Code creates incentives to encourage trade creditors to provide postpetition credit. For instance, it provides that credit incurred post- bankruptcy is entitled to administrative priority (i.e., payment before prepetition unsecured claims). It allows a Chapter 11 debtor to continue to purchase goods and services on credit in the ordinary course of business without seeking court intervention and further provides that creditors holding administrative claims are entitled to cash payment in full on the effective date of a confirmed Chapter 11 plan. However, if payment is made by a debtor with postpetition assets for goods or services purchased prepetition, such payment may be deemed a postpetition preference and recaptured.

VIII. ESSENTIAL CRITICAL VENDOR PROGRAM

A twist to the preference laws is the trend of bankruptcy courts in some jurisdictions to authorize a debtor to pay certain vendors post-bankruptcy on account of their pre-bankruptcy delinquent accounts, the so-called essential vendor or critical vendor. In other words, if the vendor received payment prior to the bankruptcy on account of a delinquent account the vendor may be subject to a preference challenge for the payment. However, if the vendor is selected as an essential vendor by the debtor and the bankruptcy court authorizes the postbankruptcy payment on the pre-bankruptcy delinquent account, there is no preference.

Under the essential vendor doctrine, a vendor may find that the product or service it provides a Chapter 11 debtor is essential to continued operations. The uniqueness of the product or service may give the vendor leverage in negotiating post-bankruptcy sales. One court noted the rationale supporting the necessity doctrine:

“Payment of the prepetition claims of these vendors as set out in

25 the Debtor’s motion is necessary to realize the possibility of a successful reorganization. . . the Court may authorize the payment of prepetition claims when such payments are necessary to the continued operations of the Debtor.”

In re Wehrenberg, 260 B.R. 468 (Bankr. Mo 2001)

Unlike the vendor that receives payment on a delinquent account prior to the bankruptcy filing (which may be challenged as a preference), the vendor that is designated an essential vendor and is paid postpetition with bankruptcy court approval on a prepetition delinquent account, is immune from a preference challenge.

IX. LITIGATING THE PREFERENCE ACTION

Cost-of-Defense Analysis

When served with a preference complaint, a first step is analyzing the cost to defend the preference suit. What are the defenses available to defeat or reduce the preference action? A bankruptcy trustee often offers a standard discount to settle the preference action prior to the vendor responding to the preference complaint, for example 20%. Should the vendor have no other defenses to reduce the preference risk, this may be the benchmark in determining the cost of defense. The vendor usually must employ counsel to represent the vendor in defending the action. The general rule is that the vendor bears the cost to defend the action. The vendor should also investigate the funds the trustee has to litigate the preference action. This may be gleaned from the plan of reorganization, if one is filed, or through discussions with the trustee. If the trustee has limited funds, the trustee may be more inclined to settle a preference action if there is the risk the attorneys, trustee and accountant may not be paid.

The Preference Complaint

The Bankruptcy Code provides that the filing of a preference action requires that the action be prosecuted as an adversary proceeding. An adversary proceeding is commenced by a complaint and summons. The proper location to file the preference complaint is the district in the United States in which the debtor’s bankruptcy case is pending. The trustee has 120 days from filing the preference complaint to serve the vendor with the preference complaint. The 2005 Act requires that a preference action seeking less than $10,000 must be brought in the bankruptcy court where the vendor has its principal place of business.

This change protects vendors from a trustee taking advantage that it will cost the vendor more to litigate the preference given the inconvenient forum. This change of forcing the trustee to litigate in the vendor=s home court for amounts between $5,000 to $10,000, should require the trustee to carefully 26 consider a vendor's defenses, such as the new value and ordinary course of business before filing suit in a foreign court.

1. The Vendor's Response

The vendor must file a responsive pleading within 20 days after service of the summons and complaint. If no responsive pleading is timely filed, the trustee may move the bankruptcy court for a default judgment against the vendor.

In contesting the preference complaint, the vendor often raises the following defenses: (1) contemporaneous exchange defense; (2) the new value or subsequent advance defense; (3) the ordinary course of business defense; and (4) solvency. These defenses are not exhaustive. Depending on the merits of the defenses and aggressiveness of the vendor, motions may be filed by the vendor to dispose of the preference complaint before it goes to trial. The vendor, or the debtor, may contend that the law requires the court to dismiss the petition based on the undisputed facts. Alternatively, the vendor may contest the preference complaint by filing an answer, preferring to wait until trial to establish its defenses.

To prevail at the time of trial, the trustee must first establish the prima facie elements of a preference. If done, the burden shifts to the vendor to establish one or more of the defenses to reduce or eliminate the preference. The vendor must prove the section 547(c) defenses by a preponderance of the evidence.

Many preference trials may be resolved between a half-day to a full day. Depending on the jurisdiction, a bankruptcy court may allow declarations or affidavits of witness, with their taking the stand only on cross-examination.

After trial, the court will enter judgment in favor of the trustee or vendor. If judgment is for the trustee, the court may allow prejudgment interest from the time the preference demand was made. The legal expenses incurred by the trustee and the vendor are borne by each party.