By: David R. Hagen
Tens of thousands of preference demands seeking damages in the hundreds of millions of dollars were made in the Montgomery Ward and Kmart bankruptcy cases. Thousands more such demands are issued in bankruptcy cases across the United States every week. If you practice law it is inevitable that one has or will cross your desk shortly.
Preference laws compel creditors who received payments in the 90-day period before a bankruptcy filing to return those payments even though they were honestly earned and legally paid.
So the question arises: How can creditors avoid these demands, and how can their attorneys advise them to best do so? There are practical ways to avoid being the subject of a preference complaint, and to handle one if it arises.
To understand these strategies it is important to have a theoretical understanding of the preference laws themselves, and the statutorily available defenses to them. But if you’re looking for a practical checklist of strategies, they are contained at the end of this newsletter.
Preference Defined
The six elements of a preference are:
Defenses to Preference Claims
There are eight defenses to a preference action. The two primary defenses are the “Ordinary
Course of Business” defense and the “New Value” defense.
Section 547(c)(2) requires courts to undertake a factual investigation to determine whether a debt was incurred and payment was made (1) within the ordinary course of business of the debtor and the creditor, or (2) in accordance with ordinary business terms in the industry. This defense was considerably broadened in 2005, when Congress made these elements alternatives; prior to 2005 both the first and second elements in the preceding sentence had to be proved in order to establish the Ordinary Course defense.
“Within the Ordinary course of Business of the Debtor and Creditor”
In determining whether a payment was made “in the ordinary course,” courts have analyzed the method and timing of the payment, and the surrounding circumstances. In re Richardson 94 BR
56, 60 (Bankruptcy ED Pa 1988). If a debtor had always made payments by check, but made a payment in the 90-day pre-bankruptcy window by cashier’s check, the ordinary course of business exception would likely not apply. If in the past the debtor had always made payments approximately 40 days after the invoice date, but made a payment in the 90-day window pre-bankruptcy that was 80 days late, this too would not be ordinary course in the view of most courts. As a result the payment would have to be returned to the Bankruptcy Trustee. It is also worth noting that payments made as the result of threats of lawsuit by a creditor usually are determined to be outside the ordinary course of business as well.
“In Accordance With Ordinary Business Terms In The Industry”
In the alternative, a creditor can avoid having to return a payment made within 90 days of a bankruptcy proceeding by proving that the payments were made according to ordinary business terms prevailing in the industry. See 11 USC §547(c)(2)(C). There are several statistical research services that accumulate data regarding the timing of receivable payments by industry category. The Credit Research Foundation www.CRFOnline.org publishes a national trade receivables report. This data may help to settle a case, but ultimately if a case goes to trial there will be a need for a witness who is thoroughly familiar with the payment and billing practices in the industry to testify.
Some courts have held that payments made pursuant to a workout agreement may be made according to ordinary business terms prevailing in an industry – i.e., that the payment practices of financially distressed companies within the industry should be considered. In re Kaypro 218 F3d 1070,1073 (9th Cir 2000). This is because in some financially distressed industries debt negotiations are so frequent as to become “ordinary.” In this climate one can think of many industries that could fall into this category.
Section 547(c)(4) provides that the Trustee may not avoid a transfer “to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor.” 11 USC §S47(c)(4). New value here can be new product shipped or services supplied to the debtor after payment was made (but still within the 90 days pre-bankruptcy). The “new value” must be given after the allegedly preferential transfer was made. Creditors are generally entitled to a credit for the entire amount of the “new value” given.
For this reason, shipping product (or supplying services) within the 90-day preference period can reduce a creditor’s exposure to preference liability, particularly if there is a high mark-up on the creditor’s product/services.
Strategies to Reduce Exposure
Strategies to reduce exposure naturally follow from the defenses and elements outlined above. As suggested in the new value defense section, providing additional product and services – especially high-markup product – after payment is received (but before a bankruptcy is filed) can substantially reduce risk. While it is true that this requires potential additional losses, the retail value of the product shipped will likely count as the new value (not the cost of the product to the creditor itself).
Procuring payment from a third party (which is not having its own financial difficulty) is the safest way to avoid a possible preference lawsuit. The very first element of a preference is that the transfer has to be a transfer of “property of the debtor.” Property owned by a third party which does not file its own bankruptcy case cannot be a preference (unless of course a third party is secretly holding funds on behalf of the Debtor).
If your client is able to require a first position lien upon valuable assets of the debtor it will be in a very safe position with respect to a possible preference claim. The sixth element of a preference – that your client received a higher payment than it otherwise would have received – will be almost impossible to establish. This strategy could arise in other contexts as well. For example, in the construction industry your client could record a mechanic’s lien prior to receiving payment. If your client is suing on a business debt it can obtain an attachment lien prior to receiving payment as well. However, it is important to note that the recording of a mechanic’s lien and the creation of an attachment itself constitutes a transfer for preference purposes; so you may wish to let such liens “season” by waiting 90 days from the creation of such liens prior to enforcing payment.
A simpler strategy is to get paid in advance of shipping product or performing services, or concurrently with the delivery. The third element of a preference is that the transfer is on account of an antecedent (or preexisting) debt. If the payment is made in advance of shipping product or simultaneously therewith then this element cannot be established.
Courts have developed a defense known as the “earmarking” defense. Essentially, if a third- party lender loans funds to a debtor for the specific purpose of paying off your client, and that intention is designated in writing by the lender, your client is not treated as having received property of the debtor. This results in the payment not being a preference since the transfer is not considered to be a transfer of property of the debtor.
There is always some credit risk in selling product or providing services to a company that is experiencing financial distress. Good credit management practices (and a healthy desire to avoid a preference lawsuit) may lead to the decision to stop selling as soon as payments run late (unless payment is made on a COD basis for new product shipped). It is important to consider the importance of not putting undue pressure in the collection of receivables during this time. Simply put, if the ordinary course of business defense is to apply it is important to establish that the payment was made in the ordinary course of business; putting undue pressure can take the payment out of this exception.
Finally, since courts look at the practices of the entire industry, it is also important for your client to document what other workout agreements are occurring in the industry. Clipping articles from newspapers and saving this type of information can prove invaluable to your attorney in the future should a preference claim be filed.
Conclusion
Finally, and perhaps most importantly, we get many calls from counsel who suspect that their client may be filing bankruptcy but have just paid them on an invoice for services. They want to know if they should deposit the check. Our advice is always the same: TAKE THE MONEY! If you have some serious suspicion that it may be subject to a preference claim at some point, set it aside in a separate account. If the payment later is alleged to be a preference, you now know that you have some very substantial defenses and can negotiate it out with the Trustee at a later time. Most Trustees will send demand letters first with some settlement proposals. Look for defenses such as those outlined here and in the Bankruptcy Code, and negotiate with them.
Preference law was designed to create equality and fairness among creditors of a bankruptcy estate. Unfortunately, it almost always feels unfair when you receive a demand letter from a Trustee and are forced to return funds. Don’t just cough up the payment; review your defenses, and negotiate. Occasionally you can create a complete defense by providing the Trustee with a more complete set of facts regarding the payment and billing history.
If you have any questions, feel free to give either of us a call. We would be happy to spend some time with you answering questions from our professional friends.
