(Part one in a two-part series on avoidance litigation in bankruptcy cases)
While initial consumer and commercial bankruptcy filings have, in recent years, ebbed in the wake of the historic highs of the Great Recession, the tail of the bankruptcy boom continues to vex the business community from an unexpected source — avoidance litigation against the debtor’s service and product vendors. The Bankruptcy Code permits a trustee or debtor in possession to avoid and recover certain payments, known as preferences, made by the debtor to its creditors during the 90-day period preceding the filing of its bankruptcy petition. The legislative policy objectives of preference avoidance rest on a dubious proposition: that all creditors should share equally in the debtor’s financial failure and that those creditors who successfully pressured the debtor for payment immediately before the bankruptcy should not gain a greater share of the estate than creditors who did not prey on a distressed debtor.
However, there is a disconnect between Congressional intent and real-world practices. Rather than target the infrequent “aggressive” creditor who coerced payment from the debtor in the days leading to its bankruptcy, bankruptcy trustees will typically bring wholesale avoidance actions against all vendors who received payments during the preference period; thus forcing those creditors to incur the time and cost of defense. In larger cases, is not unusual for trustees to file dozens, if not hundreds, of adversary proceedings seeking the return of payments ranging from several thousand to millions of dollars. Preference avoidance is by far the most prevalent type of litigation in bankruptcy cases.
The receipt of a demand letter or the filing of an avoidance Complaint is typically met with confusion as to what is going on, followed by disbelief that the “system” could work in such a way to “add insult upon injury” to a trade vendor or business partner who dutifully supplied goods or services to a debtor during the final months before the bankruptcy filing. This is especially so where there was an unpaid balance due as of the petition date and the creditor will likely recover only pennies on the dollar on its claim, if anything at all. While the receipt of an avoidance Complaint is an unwelcome event for any creditor, there are strategies and techniques that can be employed in response that can often significantly lessen or even eliminate the liability alleged in the Complaint. This article will first discuss the statutory elements of a preference avoidance claim and then explore the effective defenses available to creditors.
I. The Trustee’s Burden to Demonstrate the Statutory Elements of a Preference.
Under § 547(b) of the Bankruptcy Code, a trustee may avoid a transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the commencement of the bankruptcy case; and (5) that enables such creditor to receive more than it would have if (a) the case were a liquidation case under chapter 7, (b) the transfer had not been made, and (c) the creditor received payment to the extent provided by the Bankruptcy Code.
First, there must be a transfer of the debtor’s interest in property.
A “transfer” is broadly defined in the Bankruptcy Code as the creation of a lien, the retention of title as a security interest, the foreclosure of a debtor’s equity of redemption and “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or an interest in property.” 11 U.S.C. § 101(54) What constitutes a transfer and, importantly, when it occurs, is a matter of federal law.
While “property” is not defined in the Bankruptcy Code, Courts construing the term and whether the debtor has an interest in it will look to, among other things, whether the property would have been part of the debtor’s bankruptcy estate — and presumably available for distribution to creditors — had the transfer not been made. For example, trust proceeds held by the debtor for the benefit of another are typically not considered to be property of the estate since the debtor lacks an equitable interest and efforts by trust beneficiaries to reclaim are not considered to be preferential. Conversely, payments from the debtor’s operating or checking account are considered to be transfers of the debtor’s interest in property and, unsurprisingly, are subject to avoidance.
The transfer must be to or for the benefit of the creditor.
A creditor is defined as someone who has a claim against the debtor that arose at the time of or before the petition is filed.
The transfer must be for or on account of an antecedent debt.
A debt is considered antecedent if it was incurred before the allegedly preferential transfer was made. Further, a debt is incurred at the time the debtor becomes legally obligated to pay.
The transfer must be made while the debtor is insolvent.
This element is typically easily satisfied by the trustee as there is a rebuttable presumption that the debtor was insolvent during the ninety-day period preceding the bankruptcy. A creditor who wants to contest this element bears the burden of proof in presenting evidence that the debtor was solvent at the eve of bankruptcy which is a daunting and costly proposition.
The trustee can only avoid transfers made during certain specified periods preceding the bankruptcy filing.
When the payment is made to a non-insider, the trustee may only avoid transfers made during the 90-day period preceding the bankruptcy. However, in instances where insiders of the debtor receive payment, the avoidance window is expanded from 90 days to one year. The term “insider” in the context of a corporation includes an officer, director or person in control of the debtor or a relative of such a person or a partnership in which the debtor is a general partner.
Finally, the trustee must demonstrate that the payment enabled the creditor to receive more than it would have in a chapter 7 liquidation.
This element is easily satisfied as the only time a payment would not provide a creditor with more than it would receive on a claim in a hypothetical chapter 7 liquidation had the payment not been made is if the liquidation of the debtor would result in a 100% distribution on such claim. This might occur when the underlying claim has a priority, placing it in the front of the line for payment, or the exceedingly rare instance where the assets of the estate are sufficient to pay general unsecured creditors in full.
While the trustee bears the burden of proof on all of these elements, absent unusual circumstances, they are typically easily satisfied and the landscape of the litigation shifts to the defendant to establish its defenses.
II. Now that the Trustee has Established the Elements of a Preference, Just What is a Preference Defendant to do?
The vast majority of preference avoidance actions are settled without any judicial intervention. This is because most avoidance actions seek the recovery of less than $50,000.00, where it is simply not cost-effective to engage in full-blown litigation leading to trial. More importantly, though, under ideal circumstances counsel for the trustee and the defendant are both well versed in the substantive law of preference avoidance and can cut through the chatter to the merits of available defenses leading to an appropriate and cost-effective resolution of the claim. The skill, experience and persuasive abilities of defense counsel can produce dramatic reductions of liability. The following discusses the most commonly-invoked affirmative defenses to a preference avoidance claim.
Contemporaneous exchange for new value.
A trustee may not avoid an otherwise preferential transfer to the extent that the debtor and the creditor intended a contemporaneous exchange for new value given to the debtor and was in fact a substantially contemporaneous exchange. Avoidance is excepted because in such an exchange, the transfer to the creditor does not ultimately diminish the debtor’s estate. The Bankruptcy Code does not define what time period constitutes a “substantially contemporaneous” exchange. Attempting to fill the void, courts have ruled that payments made a few days to as long as two weeks after the delivery of the goods or services may nevertheless satisfy the contemporaneous exchange exception.
Ordinary course of business.
The effectiveness of this defense rests, in large part, on the abilities of defense counsel to analyze the transaction history between the debtor and creditor and present the information in a compelling manner. The trustee may not avoid a transfer to the extent that it was made in payment of a debt incurred in the ordinary course of business and made in the ordinary course of business or made accordingly to ordinary business terms. This deceptively simple sounding defense, due to is subjective nature, has spawned countless judicial opinions which provide opportunity for enterprising defense counsel to craft a forceful defense tailored to the specific facts of the case.
The ordinary course of business defense is intended to protect normal recurring business payments that just happened to have been made during the avoidance period. The time, amount and manner of a payment are considered in determining whether the transfer is ordinary between the debtor and creditor. A comparison of account receivable aging is made between the pre-preference and the preference periods, often with analysis of average or weighted average payables aging and the range of payments. An ordinary course of business defense can be sustained when the payments made during the preference period are shown to be consistent with past established practice.
Alternatively, an ordinary course of business defense may rest on a showing that the payment was made according to objective business standards. However, due to the cost of expert testimony usually required by courts to prove industry standards, this defense is usually seen in only larger cases.
Subsequent new value.
A payment made during the preference period is not subject to avoidance to the extent that the creditor provides additional goods or services after the transfer and before the filing of the bankruptcy. The basis for this exception is that the estate is “replenished” by these new goods and services. There is significant disparity among courts in the application of this defense. Some require the new value to remain unpaid to be available as a defense, while others recognize the defense regardless of whether the additional goods and services are paid. Other courts limit the offset of new value to only the immediately preceding transfer while other courts permit the new value to offset all preferential transfers.
Small dollar amount and venue considerations.
The Bankruptcy Code provides creditors with a safe harbor where the aggregate value of the challenged transfers is less than $5,850.00 for non-consumer debts.
Bankruptcy courts have nationwide jurisdiction and service of process over adversary defendants. This means that a California company that did business with a Texas company that was incorporated in and filed for bankruptcy in Delaware will have to appear in Delaware to defend a preference action. Bankruptcy courts have a broad grant of venue and litigation arising under, arising in or related to a bankruptcy case may be filed in the district where the bankruptcy case is pending. However, there exists a “small dollar” venue exception requiring suits arising in or related to the bankruptcy case seeking to recover amounts less than $11,725.00 to be brought only in the district court where the defendant resides or conducts business. However, due to the wording of the statute, it is unclear whether Congress intended this protection to apply to preference actions which “arise under” title 11. Some courts protect small-claim preference defendants who reside in outside districts from the expense and tactical disadvantage of defending an adversary proceeding in the debtor’s “home court.” Others, applying a rigid plain-meaning approach to the statute, have concluded that the omission of the term “arising under” in the language of the statute was intentional and that, as a result, the small-dollar venue exception does not apply to preference actions.
While new bankruptcy filings may be in decline with the improving economy, avoidance litigation — which often is not initiated until two years after the commencement of the case — continues at a torrid pace, often catching unwary creditors by surprise. The elements of a preference are typically easily established by the trustee and it is incumbent upon the creditor defendant to advance defenses to minimize liability. Successful outcomes are often the result of knowledgeable counsel who has the ability to analyze the business relationship with the debtor and present defenses in a creative and compelling manner.