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Bar News - May 9, 2003 How to Deal with a Trustee's Avoidance Powers in Bankruptcy By: Peter N. Tamposi A Preference Primer IF YOU ARE A business lawyer, it is only a matter of time before you get a call from a confounded credit manager or an outraged business owner who is the target of a preference action. Broadly speaking, a preference action is a lawsuit within a bankruptcy – essentially a collection action – to recover pre-bankruptcy payments or transfers by the debtor made within 90 days of a filing of a bankruptcy petition (or one year if payments are to be made to insiders). Authority for such a cause of action arises under §547 of the United States Bankruptcy Code (the "Bankruptcy Code") and is available to the trustee or debtor-in-possession. Section 547 is one of the most frequently litigated sections of the Bankruptcy Code. The purpose of this article is to assist the business litigator in understanding the basics of a preference action and to help in formulating a defense to such a claim. A second installment of this article will offer tips for business lawyers on avoiding preference pitfalls to the greatest extent possible. What is a Preference? A preference action is one of the so-called avoidance powers granted under the Bankruptcy Code to a trustee or debtor-in-possession. It is notable because it permits the trustee to upset a wide range of pre-bankruptcy settlements or transactions that were perfectly legitimate when they were made. These claims usually send clients through the roof because in many cases the judgment or settlement was obtained only after the expenditure of legal fees and dogged determination by the vendors, or in exchange for a significant compromise of a claim. Suddenly, for reasons that are difficult for most angry people to understand, your client is being asked to give back a hard-won judgment or settlement. Failure to pay the preference or reach a compromise will usually result in a lawsuit before a court that is unsympathetic to the inequities of such claims. Generally speaking, a preference is a transfer that favors one creditor over another. One of the main principles of the Bankruptcy Code is to maintain the equality of distribution to similarly situated creditors. A bankruptcy seeks to promote fair and equitable treatment among all creditors. Therefore, if a pre-bankruptcy transfer to a party will frustrate the distribution scheme, then it must be returned to the estate for the benefit of all creditors. Whether a transaction may be voided under §547 requires a two-step analysis. First, the trustee or debtor-in-possession must prove the existence of all of the elements of avoidable preference under §547(b). Second, if the trustee establishes a prima facie case for avoidance under §547(b), then the burden shifts to the creditor to go forward with any defenses or exceptions to preference liability under §547(c). The elements of a preference under §547(b) are: (1) a transfer; (2) of property of the debtor; (3) to or for the benefit of a creditor; (4) for or on account of an antecedent debt; (5) made while the debtor was insolvent; (6) made during the preference period of 90 days, or one year for insiders; (7) that enables creditor to receive more than it would have in a hypothetical Chapter 7 liquidation. Although the Bankruptcy Code’s preference provisions are intentionally broad, there are a number of statutory defenses to preference liability. These are designed to encourage creditors to continue doing business with and extending credit to financially troubled companies. These defenses, found at §547(c), include the following: (1) a contemporaneous exchange for new value; (2) an ordinary course of business transaction; (3) loans that enable the debtor to continue doing business; (4) subsequent advances for new values; (5) floating liens; (6) statutory liens; (7) domestic relations debt; and (8) small consumer transfers. In the majority of cases, the elements of preference are not difficult to meet, particularly where the transaction involves a simple trade credit transfer. If the transfer occurred within the 90-day period, there is a presumption of insolvency. This may be rebutted if the debtor’s assets exceed its liabilities based on their "fair valuation." This prong is frequently assumed away, but should not be overlooked. Frequently, the debtor’s own optimistic estimations in its schedules can be used as a source to rebut insolvency. If the transfer occurs within one year of filing and is to insiders of the debtor, there is no presumption of insolvency, and the target of the action should take a close look at the financial situation of the debtor at the time of the transfer. Defending Preference Actions In formulating a defense to a preference action, it is useful to know that most such claims are a single strand in a broad net cast by a trustee or, in many cases, by a delegate of the debtor, such as a creditors’ committee. That party is usually trying to bring as much money back into the estate for as little cost as possible, and simply sues everyone who received money from the debtor within 90 days. Often these cases are brought without the trustee knowing the validity of the claims due to the incomplete records, or lack of help, from the debtor. It is the defendant’s counsel’s job, therefore, to quickly and thoroughly educate the trustee about the specific facts of any transfer, in hopes of reaching a quick and reasonable settlement. In doing so, one should keep in mind the natural tendency of all bankruptcy lawyers to want to horse-trade to reach a resolution, as well as the trustee’s reluctance to spend real money on litigation if the recovery is risky or if a settlement could be reached easily. To bolster your client’s position in this regard, you should immediately find out if your client has a claim against the debtor, such as for outstanding invoices, and file a proof of claim in the bankruptcy, if possible. If the estate has assets, your claim will give you some currency at settlement time. Before contacting the trustee, you should investigate which of the above defenses your client can use. The first defense to preference liability is the contemporaneous exchange of new value under §547(c)(1). A contemporaneous exchange is not a preference because of the prima facie element that the transfer be on account of an antecedent debt. Where there is a contemporaneous exchange, the debtor’s other creditors are not prejudiced unfairly by the transfer and there is no "race" to obtain the debtor’s assets. Two elements must be satisfied for the contemporaneous exchange exception: first, the debtor and the creditor must intend to make a contemporaneous exchange for new value; second, the transfer must in fact be a substantially contemporaneous exchange. If either the intent or the fact is lacking, the creditor will be unable to take advantage of this exception. Typical examples of this exception occur when the creditor sells something to the debtor for a roughly equivalent payment or when a debtor "transfers" security, such as a lien or mortgage, to a lender in exchange for a roughly equivalent loan. Perfection of the lien or mortgage must occur contemporaneously, however. Another less obvious example occurs when the creditor extends new credit to the debtor in exchange for the transfer. The classic exception to this exception is payment of old invoices for continued delivery of products. Such a transfer is not protected, even though the transfer occurs contemporaneously with the delivery, because the payment was on account of an antecedent debt. Generally, forbearance from the exercise of any rights a creditor may have does constitute "new value," which invokes this exemption. The most frequently used defense to preference liability is the ordinary course transfer. Not only is this exception the most significant, but it is also the most frequently litigated. The purpose of the contemporaneous exchange exception is to leave undisturbed the normal financial relations between parties. To have a transfer be deemed in the ordinary course, there are three requirements: (1) The debt paid must have been incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; (2) The payment must be made in the ordinary course of business or financial affairs; and (3) The payment must be made according to ordinary business terms. The first two prongs of this defense require a subjective in quiry into the ordinariness of the payment based on the parties’ history. This can be easily gleaned by simply analyzing the debtor’s payment history with the client over time, and comparing it with the transaction in question. The third prong calls for an objective inquiry into whether the payments were typical within the industry of the parties – i.e. do buyers of latex gloves, for instance, usually pay within 30, 60 or 90 days? The importance of this prong varies among jurisdictions, with some placing equal emphasis on the industry standard and the parties relationship, and with others looking more closely at the latter. Obviously, resolution of this element will require expert testimony. For all of these reasons, defending preference claims under an "ordinary course" defense is usually difficult and expensive, but frequently the only valid road to choose. The balance of the exceptions noted above are less frequently used, but no less effective than the contemporaneous exchange and ordinary course exception. The annotations to the U.S. Code or a secondary publication, such as Colliers, are good sources for fleshing out these defenses. A basic understanding of §547 of the Bankruptcy Code and cases interpreting that section is critical when advising clients who are the targets of such claims. Such an understanding, however, is also useful in advising a client whose customer or vendor is rapidly sliding into insolvency. In the second part of this article, I will discuss strategies for "preference- proofing" your clients in such situations as much as possible. Peter N. Tamposi is an attorney with Nixon Peabody LLP, Manchester.
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