Preferential Transfers

Notwithstanding the debtor's satisfying the preference elements, a defendant in a preference action may assert individually or in tandem eight exceptions enumerated in section 547 (c) of the Bankruptcy Code. Specifically, a transfer which satisfies the elements of section 547(b) may be avoided if 1) there was a substantially contemporaneous exchange for new value; 2) the transfer represented a payment in the ordinary course of business; 3) the transfer was a purchase money security interest; 4) the creditor gave new value after the transfer; 5) the transfer resulted from a security interest in inventory or receivables, thereby creating a floating lien, and there was no “improvement in position” of the creditor during the preference period; 6) the transfer involved the fixing of a statutory lien not avoidable under section 545; 7) the transfer was a payment for alimony, maintenance or support; or 8) the transfer was consumer related and was less than $600.

Of the eight exceptions of 547(c), two of the most commonly asserted defenses are the ordinary course of business and the subsequent new value defenses. These two defenses, which are mutually exclusive, essentially forward the same objectives underlying the purpose of a preference transfer to the extent that these defenses help alleviate a debtors downward slide into bankruptcy by encouraging creditors to continue short-term credit dealings with the financially troubled debtor.

Section 547 (c)(2) of the Bankruptcy Code outlines the payment in the ordinary course of business defense to an otherwise avoidable preferential transfer. In order to be protected by this exception, a creditor/transferee must show that: 1) the transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and creditor; 2) the transfer was made in the ordinary course of business between the debtor and creditor; and 3) the transfer was made in accordance with ordinary business terms. The purpose of this exception it to protect recurring customary credit transactions which occur during the ordinary course of business between the debtor and the creditor/transferee. It should be noted that the 1984 amendment to the Code, which eliminated the 45-day rule requiring payment within 45 days after the debt was incurred, affords creditors greater protection since payments on long-term debts may now qualify under this exception.

Common Defenses

In order to be successful under the ordinary course of business defense, defendants typically bifurcate the analysis by addressing the ordinary course of dealing between the parties and the industry norm. First, the record must reflect that there was nothing “unusual” about the subject transactions underlying the preferential payment in relation to prior course of dealing between the parties. In other words, an important factor will be the extent that the transaction between the debtor and creditor, both before and during the preferential period, were consistent. In making this determination, courts will examine the duration that the parties were engaged in the transaction in issue, whether the amount or form of payment differed from past practices, the customary collection and payment practice between parties, and the circumstances under which the subject payment was made.

Second, a defendant must show that the subject payment was ordinary in relation to the industry of the debtor and creditor. To that end, courts often afford a defendant-creditor some latitude and flexibility in defining what the relevant industry is, in light of the inherent difficulty in precisely and objectively identifying an industry and its ordinary practice. Moreover, the degree of compliance with industry standards that a court will require often depends on the duration and nature of the relationship between the parties. In particular, the Third Circuit noted that “when the parties have had an enduring, steady relationship, one whose terms have not significantly changed during the pre-petition insolvency period, the creditor will be able to depart substantially from the range of terms established under the objective industry standard.” Fiber Lite Corp. v. Molded Acoustical Prods., Inc., 18 F. 3d 217, 226 (3d Cir. 1994).

The other commonly asserted defense, the subsequent new value defense, protects the creditor that made further extensions of credit in reliance on past payments. This defense is grounded in the principle that the transfer of new value to a debtor will offset payments, and therefore debtor's estate will not be depleted to the detriment of other creditors. In order to satisfy the subsequent new value defense, a defendant-creditor must show: 1) receipt of a preference payment by the creditor (ie, preferential transfer); 2) after receiving the preference payment, the creditor advances additional unsecured credit to the debtor; and 3) the additional unsecured credit is unpaid in whole or in part on the petition date.

Significantly, the new value defense protects transfers only up to the value of the contemporaneously exchanged new value. Moreover, for the purpose of this exception the specific valuation is determined as of the date of the alleged preferential transfer, which generally occurs at the time payment is received by the creditor.

Importantly, “contemporaneous” as referenced in the new value exception of the Code is not textually defined. To that end, a creditor may successfully assert the new value exception even where a creditor receives a preferential payment after it forwards new value. For example, in In re Coco, the court held that a Chapter 7 debtor tenant's rent payments, which were as much as 7 days late, were substantially contemporaneous exchanges for new value, and therefore a trustee could not avoid such payments as preferences. 67 B.R. 365 (Bankr. S.D.N.Y. 1986). In fact, certain courts have held that a 7-day delay is presumptively contemporaneous. In re Mason, 189 B.R. 932 (Bankr. N.D.Iowa 1995).

Accepting Setoffs

In addition, a creditor may avoid a preferential transfer under the new value exception by accepting setoffs. In particular, setoffs taken by a creditor against debts owed by a debtor are generally protected under the Code and are not preferential. See, e.g., In re Jet Florida Systems, Inc., 59 B.R. 886 (Bankr. S.D.fla. 1986).

However, creditors should be aware that installment loan contracts, whereby a debtor initially receives full consideration and is obligated for the full amount, are not considered contemporaneous exchanges for new value, and therefore not within the purview of the new value exception. Similarly, credit extensions and interest payments are not encompassed within the new value exception to the extent that they are not considered contemporaneous exchanges for new value.

Settlement Agreements

One interesting facet of preferential transfer avoidance for a creditor to consider involves settlement agreements between a debtor and creditor as related to the new value or the ordinary course of business exceptions. As a preliminary matter, settlement payment agreements that satisfy the seven elements of section 547(b) of the Code may be considered an avoidable preferential transfer unless an exception applies. See, e.g., Matter of American Securities and Loan, Inc., 78 B.R.930 (Bankr. S.D. Iowa 1987). To that end, a debtor's payment to a creditor in accordance with a settlement agreement is generally not considered a payment made in the ordinary course of business, and thus a debtor could recover such a payment as preference. See, e.g., In re Durant's Rental Center, Inc., 116 B.R. 362 (Bankr. D. Conn. 1990). However, the effect of a pre-petition settlement on the “new value” exception is analyzed on a case-by-case basis. Significantly, a payment pursuant to a settlement may be considered new value to the extent that a debtor's freedom from the risk of litigation in connection with debt owed to a creditor may be considered “new value.” See, e.g., Lewis v. Diethorn, 893 F. 2d 648 (3rd Cir. 1990), cert. denied, 111 S.Ct. 369. Conversely, a reduction of creditor's claims against a debtor in exchange for debtor's payments during the preference period in connection with a settlement agreement will likely not constitute “new value”, and thus is an avoidable preferential payment. e.g., In re Maloney-Crawford, Inc. 144 B.R. 531 (N.D. Okl. 1992). Thus, the effect of a settlement agreement on the avoidance of a preference transfer often becomes an issue of fact.

Jury Trial

Aside from disputing the debtor's prima facie case and asserting various statutory defenses, a defendant-creditor may move to withdraw the reference of the preference action so that the matter may be heard in district court before a jury. Notwithstanding the substantive difficulties of surviving such a motion to withdraw to district court, which includes the requisite showing of the applicability of federal law aside from bankruptcy law, a defendant-creditor may want to reserve this option as a strategic last resort. Specifically, trying the matter before a jury will likely add litigation expense, and the district judge may be less than interested in a matter that is essentially bankruptcy related.

On the other hand, a defendant-creditor may view the transfer of a preference action to district court as a way of avoiding a decision by a bankruptcy judge when the judge appears skeptical of the defendant's defenses or position.

Part Two of a Two-Part Article

Last month, we explained that when a once steady and reliable customer becomes delinquent in payment and eventually files for bankruptcy protection, your client becomes one of many creditors trying to recover a portion of its investment. We explained how, whenever a creditor receives a benefit from a debtor shortly before the debtor files for bankruptcy, a preferential transfer may occur. And we showed how section 547(b) of the Bankruptcy Code permits a trustee to avoid pre-bankruptcy transfers as “preferences.” The first tactic we discussed for defending such preference actions was to dispute plaintiff's prima facie case. In this month's installment, we discuss preference avoidance by statutory exception, and the availability of a jury trial.

Preference Avoidance By Statutory Exception

Notwithstanding the debtor's satisfying the preference elements, a defendant in a preference action may assert individually or in tandem eight exceptions enumerated in section 547 (c) of the Bankruptcy Code. Specifically, a transfer which satisfies the elements of section 547(b) may be avoided if 1) there was a substantially contemporaneous exchange for new value; 2) the transfer represented a payment in the ordinary course of business; 3) the transfer was a purchase money security interest; 4) the creditor gave new value after the transfer; 5) the transfer resulted from a security interest in inventory or receivables, thereby creating a floating lien, and there was no “improvement in position” of the creditor during the preference period; 6) the transfer involved the fixing of a statutory lien not avoidable under section 545; 7) the transfer was a payment for alimony, maintenance or support; or 8) the transfer was consumer related and was less than $600.

Of the eight exceptions of 547(c), two of the most commonly asserted defenses are the ordinary course of business and the subsequent new value defenses. These two defenses, which are mutually exclusive, essentially forward the same objectives underlying the purpose of a preference transfer to the extent that these defenses help alleviate a debtors downward slide into bankruptcy by encouraging creditors to continue short-term credit dealings with the financially troubled debtor.

Section 547 (c)(2) of the Bankruptcy Code outlines the payment in the ordinary course of business defense to an otherwise avoidable preferential transfer. In order to be protected by this exception, a creditor/transferee must show that: 1) the transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and creditor; 2) the transfer was made in the ordinary course of business between the debtor and creditor; and 3) the transfer was made in accordance with ordinary business terms. The purpose of this exception it to protect recurring customary credit transactions which occur during the ordinary course of business between the debtor and the creditor/transferee. It should be noted that the 1984 amendment to the Code, which eliminated the 45-day rule requiring payment within 45 days after the debt was incurred, affords creditors greater protection since payments on long-term debts may now qualify under this exception.

Common Defenses

In order to be successful under the ordinary course of business defense, defendants typically bifurcate the analysis by addressing the ordinary course of dealing between the parties and the industry norm. First, the record must reflect that there was nothing “unusual” about the subject transactions underlying the preferential payment in relation to prior course of dealing between the parties. In other words, an important factor will be the extent that the transaction between the debtor and creditor, both before and during the preferential period, were consistent. In making this determination, courts will examine the duration that the parties were engaged in the transaction in issue, whether the amount or form of payment differed from past practices, the customary collection and payment practice between parties, and the circumstances under which the subject payment was made.

Second, a defendant must show that the subject payment was ordinary in relation to the industry of the debtor and creditor. To that end, courts often afford a defendant-creditor some latitude and flexibility in defining what the relevant industry is, in light of the inherent difficulty in precisely and objectively identifying an industry and its ordinary practice. Moreover, the degree of compliance with industry standards that a court will require often depends on the duration and nature of the relationship between the parties. In particular, the Third Circuit noted that “when the parties have had an enduring, steady relationship, one whose terms have not significantly changed during the pre-petition insolvency period, the creditor will be able to depart substantially from the range of terms established under the objective industry standard.” Fiber Lite Corp. v. Molded Acoustical Prods., Inc. , 18 F. 3d 217, 226 (3d Cir. 1994).

The other commonly asserted defense, the subsequent new value defense, protects the creditor that made further extensions of credit in reliance on past payments. This defense is grounded in the principle that the transfer of new value to a debtor will offset payments, and therefore debtor's estate will not be depleted to the detriment of other creditors. In order to satisfy the subsequent new value defense, a defendant-creditor must show: 1) receipt of a preference payment by the creditor (ie, preferential transfer); 2) after receiving the preference payment, the creditor advances additional unsecured credit to the debtor; and 3) the additional unsecured credit is unpaid in whole or in part on the petition date.

Significantly, the new value defense protects transfers only up to the value of the contemporaneously exchanged new value. Moreover, for the purpose of this exception the specific valuation is determined as of the date of the alleged preferential transfer, which generally occurs at the time payment is received by the creditor.

Importantly, “contemporaneous” as referenced in the new value exception of the Code is not textually defined. To that end, a creditor may successfully assert the new value exception even where a creditor receives a preferential payment after it forwards new value. For example, in In re Coco, the court held that a Chapter 7 debtor tenant's rent payments, which were as much as 7 days late, were substantially contemporaneous exchanges for new value, and therefore a trustee could not avoid such payments as preferences. 67 B.R. 365 (Bankr. S.D.N.Y. 1986). In fact, certain courts have held that a 7-day delay is presumptively contemporaneous. In re Mason, 189 B.R. 932 (Bankr. N.D.Iowa 1995).

Accepting Setoffs

In addition, a creditor may avoid a preferential transfer under the new value exception by accepting setoffs. In particular, setoffs taken by a creditor against debts owed by a debtor are generally protected under the Code and are not preferential. See, e.g., In re Jet Florida Systems, Inc., 59 B.R. 886 (Bankr. S.D.fla. 1986).

However, creditors should be aware that installment loan contracts, whereby a debtor initially receives full consideration and is obligated for the full amount, are not considered contemporaneous exchanges for new value, and therefore not within the purview of the new value exception. Similarly, credit extensions and interest payments are not encompassed within the new value exception to the extent that they are not considered contemporaneous exchanges for new value.

Settlement Agreements

One interesting facet of preferential transfer avoidance for a creditor to consider involves settlement agreements between a debtor and creditor as related to the new value or the ordinary course of business exceptions. As a preliminary matter, settlement payment agreements that satisfy the seven elements of section 547(b) of the Code may be considered an avoidable preferential transfer unless an exception applies. See, e.g., Matter of American Securities and Loan, Inc., 78 B.R.930 (Bankr. S.D. Iowa 1987). To that end, a debtor's payment to a creditor in accordance with a settlement agreement is generally not considered a payment made in the ordinary course of business, and thus a debtor could recover such a payment as preference. See, e.g., In re Durant's Rental Center, Inc., 116 B.R. 362 (Bankr. D. Conn. 1990). However, the effect of a pre-petition settlement on the “new value” exception is analyzed on a case-by-case basis. Significantly, a payment pursuant to a settlement may be considered new value to the extent that a debtor's freedom from the risk of litigation in connection with debt owed to a creditor may be considered “new value.” See, e.g., Lewis v. Diethorn , 893 F. 2d 648 (3rd Cir. 1990), cert. denied, 111 S.Ct. 369. Conversely, a reduction of creditor's claims against a debtor in exchange for debtor's payments during the preference period in connection with a settlement agreement will likely not constitute “new value”, and thus is an avoidable preferential payment. e.g., In re Maloney-Crawford, Inc. 144 B.R. 531 (N.D. Okl. 1992). Thus, the effect of a settlement agreement on the avoidance of a preference transfer often becomes an issue of fact.

Jury Trial

Aside from disputing the debtor's prima facie case and asserting various statutory defenses, a defendant-creditor may move to withdraw the reference of the preference action so that the matter may be heard in district court before a jury. Notwithstanding the substantive difficulties of surviving such a motion to withdraw to district court, which includes the requisite showing of the applicability of federal law aside from bankruptcy law, a defendant-creditor may want to reserve this option as a strategic last resort. Specifically, trying the matter before a jury will likely add litigation expense, and the district judge may be less than interested in a matter that is essentially bankruptcy related.

On the other hand, a defendant-creditor may view the transfer of a preference action to district court as a way of avoiding a decision by a bankruptcy judge when the judge appears skeptical of the defendant's defenses or position.