Strategies for Avoiding the Headache of Preference Liability

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Although business bankruptcy filings have trended down in recent months, the lingering legacy of litigation prompted by the surge in filings at the outset of the U.S. financial crisis remains with us and continues to strike many general counsel with unexpected actions for recovery of payments made by the debtor in the run-up to a Chapter 11 case. This article focuses on new lessons emerging from key preferential transfer cases issued since 2008, and will include practice points to assist general counsel in helping their organizations, insofar as possible, to mitigate future preference liability through thoughtful application of ordinary course of business, contemporaneous exchange, and prepayment strategies.

In conjunction with the avoidance provisions of §550 of the Bankruptcy Code, §547 permits a trustee or debtor-in-possession to set aside and recover certain "preferential transfers" for the benefit of the estate. A preferential transfer is one that satisfies each of the following criteria: (i) prior to the bankruptcy filing, the debtor transferred an interest in property; (ii) the debtor transferred the interest to or for the benefit of a creditor; (iii) the debtor transferred the interest to pay or secure an obligation owed to the creditor prior to the transfer (an "antecedent debt"); (iv) the debtor was insolvent at the time of the transfer; (v) the transfer occurred within 90 days before the bankruptcy petition date (the "preference period") or, if the transfer was made to or for the benefit of an "insider" of the debtor, within the year prior to the petition date (the "insider preference period"); and (vi) the transfer permitted the creditor to receive more than it would have received upon the liquidation of the debtor under the code.

In granting a trustee (or a debtor-in-possession) broad powers to recover assets transferred to creditors within the preference period, §547 serves two basic policies: discouraging creditors (particularly those with greater influence over the debtor) from consuming available assets prior to bankruptcy, and promoting equal treatment among creditors.

From a creditor's perspective, a debtor's inability to pay going forward is bad enough; a debtor-in-possession or trustee seeking to claw back money already paid to the creditor is salt in the wound. Fortunately, §547 provides certain defenses for creditors in preference actions. With the guidance of conscientious counsel, a proactive creditor can take certain steps to better position itself to ultimately retain payments made during the preference period over a trustee's attempts to claw them back.

At the outset, it is important to remember that a creditor should never, for the sake of cultivating a future preference defense, avoid taking payment prior to bankruptcy on debts owed by troubled entities. In this context, as in all others, possession is nine-tenths of the law. Nevertheless, when the trustee or debtor makes a preference claim, several key defenses have given creditors strong lines of defense that have continued to evolve in recent years.

The most commonly asserted defense provides a safe harbor for payments made in the ordinary course of business. A trustee may not avoid an otherwise preferential transfer if it was made in payment of a debt incurred by the debtor in the ordinary course of business and if the transfer itself was made either (i) in the parties' ordinary course of business or financial affairs, or (ii) according to ordinary business terms.

As a practical matter, these provisions should lead in-house counsel to advise clients on the importance of regularity and consistency in establishing a "baseline of dealing." Creditors would be wise to demand upfront that payment will only be accepted in a particular manner, e.g., by check, and then hold the debtor to that standard over the course of dealing. Whenever possible — specifically for creditors who provide services rather than goods — invoices should be issued in a regular, consistent amount. Then, upon a debtor's descent into financial distress, a creditor must strive to maintain that baseline, at least with respect to those elements of the relationship that are under its control. Recent case law illustrates this model well.

For example, in Goldstein v. Starnet Capital Group LLC (In re Universal Marketing), 481 B.R. 318 (Bankr. E.D. Pa. 2012), the debtor made seven transfers of $25,000 each to a creditor over a nine-month period before filing for Chapter 7. The trustee sought to avoid and recover the final two transfers, totaling $50,000, which had occurred during the 90-day preference period preceding the bankruptcy petition. In response, the creditor asserted the ordinary-course-of-business defense.

The U.S. Bankruptcy Court for the Eastern District of Pennsylvania first found that the debt arose in the ordinary course of the business: pursuant to an engagement letter, the debtor had agreed to pay the creditor $25,000 per month for financial advisory services. Nothing in the record suggested this was an unusual practice for the debtor, which operated a sophisticated distribution business and had substantial capital needs.

In assessing the transfers, the court compared the two payments made during the preference period with the five that preceded them, dubbing the latter the "baseline of dealing." In doing so, the court considered the length of the parties' relationship; whether the transfers were larger than usual; the manner of tender of the payments; any "unusual action" by either party to collect or pay on the debt; and whether the creditor did anything to gain an advantage, such as gain additional security, in light of the debtor's financial hardship. The court ultimately found that the transfers had been made in the ordinary course of business and allowed the creditor to retain them.

In Sparkman v. Martin Marietta Materials (In re Mainline Contracting), 2012 Bankr. LEXIS 4986 (Bankr. E.D.N.C. Oct. 23, 2012), the court addressed the issues of late payment and unusual collection activities. The Chapter 7 trustee sought to avoid and recover five transfers made during the preference period by the debtor, a general contractor, to one of its suppliers. The supplier asserted the ordinary-course defense. In response, the trustee argued that the timing of the transfers placed them outside the ordinary course of business, since none were made in compliance with its requirement for payment within 30 days of the invoice date. However, the court noted that late payments could still be considered "ordinary course" payments, if that was the standard course of dealing between the parties. Such was the case here: Even during the two-year "baseline" period, the debtor had still paid the supplier an average of 79 days after the date of the invoice, and never sooner than two months past the invoice date. In the year prior to the bankruptcy, the debtor never paid the invoices before 90 days past due, or until the supplier called to inquire about payment.

While late payments during the preference period may not necessarily defeat an ordinary-course-of-business defense, creditors must be aware that the "degree of lateness" cannot deviate too much between the preference period and the baseline period.

The trustee in Sparkman also argued that the supplier's "unusual collection activity," including phone calls and emails seeking payment on the past-due invoices, took the transfers outside the ordinary course of business. However, the court found that such phone calls and emails were not unique to the preference period.

Finally, the trustee argued that the circumstances under which the transfers were made — particularly the supplier's threats to place the debtor on cash-on-delivery (COD) terms, requiring prepayment for materials — were not part of the ordinary course of the parties' business relationship. However, the court found that even this collection strategy was still within the parties' ordinary course of business. The court ultimately held that the transfers made during the preference period had been within the ordinary course of the parties' business and denied the trustee's attempt to avoid and recover them.

Creditors should also be advised that certain communications with a debtor could constitute "unusual" collection activities, taking a transfer out of the ordinary course of business, if there is no precedent for such conduct during the parties' baseline period. If a creditor undertakes such conduct for the first time during the preference period, a trustee could persuasively argue that those transfers were not made in the ordinary course of business and potentially claw them back.

With this in mind, creditors should strive early in their relationships to establish open lines of communication with debtors regarding payment of invoices, extending firm and regular demands when payment is not timely. Likewise, creditors should not be timid about discussing COD terms as a realistic option in the event of nonpayment, and, if necessary, placing a debtor on COD terms until accounts are brought current. Taking these steps early in a relationship will establish them as part of the parties' regular course of dealing.

Finally, in a similar vein, the prudent creditor will be prepared to switch troubled customers to a cash-in-advance regime as the ultimate protection against mounting preference exposure. By doing so, the creditor will not be receiving payment "on account of an antecedent debt," and thus there will never be preference in this scenario because one of the six elements fails at the outset.

Regular discussion of these basic strategies with credit and collection staff, and periodic review of compliance, should do much to reduce an organization's exposure to preference liability. As with many other best practices in the cross between the legal and business realm, knowing a customer and filtering customer conduct through the lens of established legal standards will give a business effective tools to reduce, if not eliminate, preference exposure.