Preferential Transfer Avoidance Actions
A fundamental goal of bankruptcy law is to marshal the assets of a debtor for fair distribution to as many creditors as possible. In furtherance of this goal a Litigation Trustee in Bankruptcy or a Creditors Committee (collectively, Trustee) is empowered to sue creditors for the return of payments by a debtor within 90 days of the Petition Date.2 These lawsuits are commonly known as “preferential transfer avoidance actions” or “preference actions.” Unfortunately, preference actions are usually unanticipated by a creditor and can impose a severe financial strain on the company.
A preferential transfer is defined as a payment: (1) to or for the benefit of the creditor, (2) for or on account for an antecedent debt owed by the customer before the payment was made, (3) made while the customer was insolvent, (4) made on or within 90 days before the date of the Bankruptcy Petition, and (5) that such payment enabled the creditor to receive more than it would receive if there was a liquidation of the debtor's bankruptcy estate under Chapter 7 of Bankruptcy Code.3
It is up to the creditor to prove that a challenged payment is not a preferential transfer, or that an exception to the trustee’s avoidance power applies. Although there are other potentially available defenses, this article focuses on the three most common ones, the Substantially Contemporaneous Exchange Defense, the Ordinary Course of Business Defense and the Subsequent New Value Defense. Fortunately, these three defenses often significantly reduce, or entirely eliminate, a Trustee’s preferential transfer avoidance power.
CONTEMPORANEOUS EXCHANGE FOR NEW VALUE DEFENSE
The Contemporaneous Exchange for New Value Defense4 often applies to payments that are cash on delivery, cash in advance or cash with order. There are four requirements for establishing a contemporaneous exchange for new value defense. First, the value given to the creditor (the challenged payment) equals the value the debtor received. Second, the debtor and creditor both intended the transfer to be contemporaneous. Third, the exchange was, in fact, contemporaneous. Fourth, a specific measure of "new value" was provided to the debtor that enhanced the worth of the debtor's estate. Contemporaneous new value exchanges are not preferential in that they encourage creditors to deal with troubled debtors and because other creditors are not adversely affected when the debtor's estate receives new value.
ORDINARY COURSE OF BUSINESS DEFENSE
The rationale for the Ordinary Course of Business (OCB) Defense is that a creditor should not be compelled to return money paid by a debtor within 90 days of the Petition Date when such payments were consistent with the debtor/creditors’ historical business relations. There are three elements to the Ordinary Course of Business (OCB) Defense.5 First, in all cases, the creditor must prove that a challenged payment was made in the ordinary course of each party's respective business.
Second, the creditor must prove that the challenged payment was ordinary as between the debtor and the creditor specifically. This "subjective test," often requires that the course of dealings between the creditor and debtor be thoroughly examined during the preference period and, if possible, for at least a year to two years prior to the preference period (the historical period).
Typically, this element of the ordinary course defense is established by creating a statistical baseline (average, median, mode, etc.) of the number of days between invoicing and payment for historical period transfers. Then each alleged preferential transfer is compared against the historical baseline. On the one hand, preference period payments that are consistent with the historical baseline will most likely fall within the OCB exception to the trustee’s preferential transfer avoidance power. On the other hand, preference period payments that significantly deviate from the historical baseline will be less likely to qualify for the OCB exception under the subjective test. Depending on the facts of the case, there are other means of establishing an OCB defense based on the subjective analysis of the parties’ historical dealings which may be used in lieu of, or as a supplement to, the statistical data, (e.g., the parties’ typical compliance/non-compliance with the terms of their contract).
Third, in the alternative to the subjective test, a creditor can establish an OCB defense by showing that a challenged transfer conforms to payment norms in the creditor’s industry. This "objective test" requires the creditor to provide evidence of the ordinary business terms in its own industry. The phrase "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. Only dealings so idiosyncratic as to fall outside that broad range fail to meet the objective test.
To pass the objective test in most cases, the creditor will present an expert witness with the requisite industry knowledge to identify common payment terns within the creditor’s industry. The expert must testify that the specific payment terms between the parties are included in the range of common industry payment terms. The industry standard is most often established, not only by evidence of the practices of a debtor and its own creditors, but also evidence of those practices in which firms generally similar to a debtor and a defendant/creditor commonly engage.
Regardless of which means of proof is used, the ordinary course of business exception to the trustee’s preferential transfer avoidance power is intended to induce creditors to continue dealing with a distressed debtor so as to enhance its chances of survival The prohibition against preferential transfers in the Bankruptcy Code is designed not to disturb normal debtor-creditor relationships, but to derail unusual ones which threaten to heighten the likelihood of a debtor filing for bankruptcy at all.
SUBSEQUENT NEW VALUE DEFENSE
The Subsequent New Value (SNV) Defense6 is another exception to the Trustee’s preferential transfer avoidance power. As with the OCB defense, the intent behind the SNV defense is to encourage the extension of credit to financially troubled companies.
Essentially, the SNV defense affords a creditor a dollar-for-dollar set off from preferential transfer liability for the value of any goods or services provided to the debtor after the creditor’s receipt of a preferential transfer, but before the petition date. There are three requirements for establishing an SNV defense. First, the creditor must have received a transfer that is otherwise voidable as a preference under §547(b). Second, after receiving the preferential transfer, the preferred creditor must advance "new value" to the debtor on an unsecured basis. Third, the debtor must not have fully compensated the creditor for the "new value" as of the date that it filed its bankruptcy petition. If the three elements of the SNV defense are proven, a creditor can reduce its preferential transfer liability in an amount equivalent to the subsequent new value extended to the debtor.
By limiting the risk of loss incurred by suppliers who continue ordinary credit arrangements with troubled companies, the SNV exception encourages transactions that may allow the debtor to stave off bankruptcy. Furthermore, the protection provided by the SNV exception does not materially harm other creditors. The requirement that an advance be followed by an extension of new value insures that any injury to the estate is followed by a subsequent addition to the estate.
In many cases, a preferential transfer avoidance action can pose a serious threat to the economic well being of a creditor. Initially, most people find it hard to believe that a creditor can be compelled to return payments even though it honored all contractual obligations to a debtor. Nevertheless, the Bankruptcy Code affords a Trustee the power to do so under certain circumstances. Consequently, a preference action should not be ignored, nor should settlement negotiations with a Trustee’s counsel be initiated before all supportable defense theories are articulated. In most cases, once the available defense options are explored, a preferential transfer avoidance action may not turn out to be as financially devastating as the creditor initially thought.
1 Due to space limitations all case law citations are omitted.
2 If the creditor is an “insider” of debtor (e.g., partner, affiliated company, shareholder, etc., ) the reach back period extends to one year prior to the date the bankruptcy petition was filed.
3 11 U.S.C. § 547(b).
4 11 U.S.C. § 547(c)(1)
5 11 U.S.C. § 547(c)(2)
611 U.S.C. § 547(c)(4)