This is the first post in our “Decoding the Code” Series.  The Series will cover various sections of the Bankruptcy Code in a clear and easy to understand manner.  Our first stop:  preferences.

Why do I care about preferences? 

Scenario 1:  Your company sells products and services to a large retail electronics chain.  You have been doing business with the electronics chain for years and they have been paying your invoices as they come due.  Recently, however, their payments have become sporadic and you are worried they have fallen on financial hard times.  You soon learn that they have filed for bankruptcy.  You know you have received payments from the now-bankrupt electronics chain within the last three months and you have heard something about preference claims but what does it all mean?

Scenario 2:  You are a claims trader interested in buying claims filed against bankrupt companies.  You know that some claims you are thinking about buying could be subject to preference litigation but are there ways to defend against it?

Let’s decode the basics:

What is a preference?

Section 547(b) of the Bankruptcy Code permits a debtor or trustee to recover “preferences.”  “Preferences” are payments made by a debtor to a creditor during the 90 days before the debtor files for bankruptcy.  These “preferential” payments allow the recipients to receive more than they would have received if the payment had not been made and the debtor’s assets were divided equally among all creditors.  According to the legislative history of Section 547, the purpose of Section 547(b) is two-fold:  (1) to promote the Bankruptcy Code’s policy of equal distribution among a debtor’s creditors, and (2) to discourage creditors from unfairly pursuing collection efforts against an insolvent debtor at the expense of other creditors.

What are the elements of a preference?

Section 547(b) of the Bankruptcy Code sets forth the elements of a preference:

• A transfer – defined very broadly to include monetary payments and non-monetary acts (e.g., the perfection of a security interest).
• Of an interest of the debtor in property – a transfer is preferential only if the property transferred belongs to the debtor.
• The transfer was made to or for the benefit of a creditor – for example, a creditor receives a check from the debtor for payment on an outstanding invoice, goods are returned by the debtor to the creditor, or an obligation of the creditor is reduced by the debtor.
• The transfer was made for or on account of an antecedent debt owed by the debtor before such transfer was made – a payment or transfer made on a pre-existing debt or obligation as opposed to a cash on delivery or cash in advance payment. As long as the transfer is made after the debt or obligation comes into existence, the transfer is deemed to be made “for or on account of an antecedent debt.”
• The transfer was made while the debtor was insolvent – Section 547(f) of the Bankruptcy Code specifically provides that for purposes of Section 547, the debtor is presumed to have been insolvent on and during the 90 days before the filing of a bankruptcy petition.
• The transfer was made 90 days before the date of the filing of the bankruptcy petition (extended to one year if the transfer was made to an insider).
• The transfer enables the creditor to receive more than it would have received if the case were a Chapter 7 liquidation – in other words, the creditor received a greater percentage of its claim as a result of receiving the allegedly preferential transfer than if the transfer had not been made and the defendant participated in the distribution of the estate’s asserts pursuant to a liquidation. Thus, this element requires a comparison between what the creditor actually received and what it would have received under a Chapter 7 liquidation.

What are some examples of preferential transfers?

• A payment made within the 90 days before the filing of a bankruptcy petition of an invoice that is substantially overdue.
• A payment made within the 90 days before the filing of a bankruptcy petition of all outstanding invoices owed in a lump sum payment when the debtor generally pays each invoice separately on a monthly basis.
• A payment made within the 90 days before the filing of a bankruptcy petition of a debt immediately upon incurring the debt when the debtor generally pays the debt within a period of time after receipt of the invoice.

How can a creditor defend against a preference action?

Section 547(c) of the Bankruptcy Code provides nine separate defenses that a creditor can assert to defeat a preference claim.  The most common defenses include:

• the subsequent new value defense;
• the ordinary course of business defense; and
• the contemporaneous exchange for new value defense.

What is the subsequent new value defense?

New value is defined in Section 547(a)(2) of the Bankruptcy Code as “money or money’s worth in goods, services or new credit . . . .”  Section 547(c)(4) of the Bankruptcy Code allows a creditor to offset against a preferential transfer if the creditor subsequently gives new value to the debtor after the alleged preferential transfer.  In other words, if a creditor supplies services or ships new goods on an unsecured basis after an alleged preferential transfer is made to the creditor, the value of those goods or services can be subtracted from the alleged preferential transfer on a dollar-for-dollar basis because the estate has been replenished by the new goods.

Courts have articulated the requirements for the new value defense as follows:

(1) a creditor must have received a transfer that is otherwise recoverable as a preference;

(2) after receiving the preferential transfer, the creditor must advance new value to the debtor on an unsecured basis; and

(3) the debtor must not have fully compensated the creditor for the new value as of the date that it filed its bankruptcy petition.

With respect to the third requirement, courts are divided on whether the new value has to remain unpaid.  However, the evolving standard is that new value credit will be given if (a) the new value remains unpaid or (b) the new value has been paid for by a payment which otherwise could be set aside as a preference.

New value involving the provision of services is deemed given on the date the services are rendered.  A challenging question is presented when a creditor ships goods to a debtor before receiving the preferential transfer at issue but the goods are not received by the debtor until after the preferential transfer is made.  Some courts have held that in such circumstances, a creditor extends new value at the time the goods are shipped.

What is the ordinary course of business defense?

Pursuant to Section 547(c)(2) of the Bankruptcy Code, a creditor may also attempt to defend against a preference claim on the basis that the payments it received from the debtor were made in the ordinary course of business.  For example, payments made within invoice terms are generally not preferential, unless the terms changed close to the 90 day preference period due to creditor pressure or special treatment of a favored vendor by the debtor.

To prove an ordinary course of business defense, a creditor must show that:

(1) the underlying debt on which payment was made was “incurred by the debtor in the ordinary course of business or financial affairs” of both parties;

AND, that the transfer was either:

(2a) “made in the ordinary course of business or financial affairs” of both parties (i.e., the transfer is one normally incurred between the parties);

OR

(2b) “made according to ordinary business terms” (i.e., the transfer is standard to the industry).

Let’s break that down.

(1)  Debt Incurred in the Ordinary Course of Business:  The underlying debt on which the payment was made must have been incurred by the debtor in the ordinary course of business or financial affairs of both parties.  Most courts assume this requirement is met by inferring from the evidence that there was nothing “unusual” about the transactions underlying the preferential payment.  Courts generally are interested in whether the debt was incurred in a typical, arms-length commercial transaction that occurred in the marketplace or, on the other hand, whether it was incurred, for example, as an insider arrangement with a closely held entity.  If the debt were incurred in the routine operations of the debtor and the creditor, then it can be said to have been incurred in the ordinary course of each party’s business.  As long as these criteria are met, either long-term debt or first-time debt can be debt incurred in the ordinary course of business.

(2a)  Transfer Made in the Ordinary Course of the Parties’ Respective Businesses or Financial Affairs:  Determining whether payments by a debtor during the 90 day preference period were made in the ordinary course of business or financial affairs of both parties is a subjective test.  The controlling factor is whether the transactions between the debtor and the creditor both before and during the 90 day period were consistent.  Even if the allegedly preferential payments were irregular, they may be considered “ordinary” for purposes of the ordinary course of business defense if they were consistent with the course of dealing between the parties.

Courts generally consider the following factors to determine whether a transaction was ordinary:

• the prior course of dealing between the parties;
• the amount of the payments;
• the timing of the payments; and
• the circumstances surrounding the payments.

In some instances, there may be no prior course of dealing between the parties before the preference period.  Most courts have held that a first-time transaction is eligible for protection from avoidance.  Generally, the courts look to the terms of the parties’ agreement to determine the ordinary course of dealing between the parties.  If payment was in accordance with the terms of the agreement, then courts will generally find that the ordinary course of business defense is established.

In order to prove that payments were ordinary between the debtor and creditor, a creditor should prepare a payment history (one to three years before the preference period) that compares the days outstanding prior to the preference period to the days outstanding during the preference period and shows that the average days to payment prior to the preference period was consistent with the days to payment during the preference period.  Reduced terms during the preference period, change in mode of payment (regular check changed to wire), change in mode of delivery of payment (regular mail changed to overnight courier), collection action (threats to cut off shipments, decision to enforce credit limit) or an increased number of invoices paid during or shortly before the commencement of the preference period might result in the inability to prove the payment was ordinary between the parties.

(2b)  Transfer Made According to Ordinary Business Terms:  Courts have held that “ordinary business terms” implies an objective standard based on the relevant industry.  Thus, even if the allegedly preferential payments were irregular, they may be considered “ordinary” if they were consistent with the patterns within a relevant industry.  In order to prove this requirement, a creditor should present evidence demonstrating that the payments sought to be recovered were made in a timeframe which is consistent with the industry standard.  This frequently requires the use of experts and industry source materials.

To prove that payments were made according to ordinary business terms, a creditor should look to industry data for the creditor’s and debtor’s industries that shows the preference payment terms were consistent with the range of terms in the industry.

What is the “contemporaneous exchange” for new value defense?

This is the corollary to the requirement that an allegedly preferential transfer must have been made on account of an antecedent debt (i.e., a pre-existing debt).  If the transfer was made as a contemporaneous exchange for new value, then by definition, it could not have been made on account of an antecedent debt.  The most typical example of a contemporaneous exchange is a cash-on-delivery exchange of money for goods or services.

Under this defense, Section 547(c)(1) of the Bankruptcy Code states that a transfer is not preferential if:

• the creditor extended new value to the debtor;
• both the creditor and the debtor intended the new value and the reciprocal transfer by the debtor to be contemporaneous (this is a fact-intensive analysis); and
• the exchange was in fact contemporaneous or substantially contemporaneous (exchanges of two to three weeks have been found by some courts to be contemporaneous).

Like the subsequent new value defense described above, the contemporaneous exchange defense protects transfers only to the extent of the new value given (i.e., on a dollar-for-dollar basis of the new value given by the creditor).

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Stay tuned for our next installment of “Decoding the Code.”