Understanding and Avoiding Preference Liability

In today's challenging economic environment it is a familiar story: After a protracted period of slow pay and then no pay, your customer (or borrower, joint venturer, counter-party, etc.) files a bankruptcy petition, leaving you holding the bag. You spend valuable time and money in an ultimately futile effort to collect. After a frustrating trip through the counter-intuitive, “through the looking glass” world of the modern business bankruptcy case, you finally resign yourself to losing a customer and holding a claim that will be paid, if at all, at pennies-on-the-dollar.

Think that's disappointing? Just wait until insult turns to injury and you find yourself on the receiving end of a letter or a lawsuit demanding repayment of the paltry amount you received from the bankrupt company during the 90 days prior to bankruptcy. As the defendant in a debtor or trustee's action to avoid and recover a preferential transfer (a “preference”), you may be forced to disgorge money to the debtor's bankruptcy estate.

Notwithstanding the sometimes harsh feeling that results from being the target of a preference claim, the policy goal underlying a trustee or debtor's right to avoid and recover preferences makes sense. The general concept is to avoid “unusual” transfers made on the eve of bankruptcy, so that all creditors are placed on an equal footing and so that no single creditor is preferred by having received more than it would have in an orderly liquidation of the debtor. For example, assume that you and another creditor are each owed $50,000 by the debtor and, two days prior to the bankruptcy filing, the debtor pays the other creditor in full but pays nothing to you. You hold a claim that is worth little if anything while the other creditor has already been made whole and is owed nothing. Preference law is designed to force the other creditor to disgorge the preferential transfer and return it to the bankruptcy estate to be shared by all of the bankrupt's creditors.

The Bankruptcy Code also recognizes several affirmative defenses which, through effective advocacy, may bar preference claims in whole or part. Understanding the contours of the Bankruptcy Code's preference statute, including the metes and bounds of the available defenses, is key to structuring pre- and out-of-bankruptcy transactions in a way that increases the chances of not incurring liability and of successfully defending against any preference claim.

The Basic Elements of a Preference Claim

Section 547(b) of the Bankruptcy Code allows a bankruptcy trustee or a debtor-in-possession to avoid any transfer: 1) made during the 90 days prior to the filing of the bankruptcy petition; 2) of an interest of the debtor; 3) to or for the benefit of a creditor; 4) on account of an antecedent debt owed by the debtor prior to the transfer; 5) made while the debtor was insolvent; 6) which resulted in the creditor receiving more than it would have received in a hypothetical Chapter 7 liquidation of the debtor. The 90-day lookback period is expanded to one year in the case of transfers made to insiders (defined by the Bankruptcy Code to include directors, officers, and persons or entities in control of the debtor).

The potential reach of Section 547 is very broad. The Bankruptcy Code defines “transfer” expansively ' “the creation of a lien; the retention of title as a security interest; the foreclosure of a debtor's equity of redemption; or each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or an interest in property.” Thus, a court judgment obtained during the lookback period might be subject to avoidance as a preference, as might the grant of a security interest. Cash transfers from a debtor to a creditor on an existing debt are always challengeable as a potential preference, and even a foreclosure conducted during the lookback period might be challenged.

Section 547 provides that the debtor is presumed to be insolvent during the 90 days preceding the filing of the debtor's bankruptcy petition. Thus, the evidentiary burden in the first instance is shifted to the transferee. Practically speaking, fighting on this point often means hiring an expert to sift through the debtor's murky (at best), pre-bankruptcy financial records and then winning a battle of the experts in court. Of course, in most cases the company was insolvent.

If the debtor-in-possession or trustee successfully proves the basic elements of a preference, Section 550 of the Bankruptcy Code provides that it may recover the property transferred or the value of such property from any initial transferee, or from a subsequent transferee. If a defendant must repay funds due to a preference claim, Bankruptcy Code Section 502(h) and the procedural rules governing the filing of claims in bankruptcy cases together provide that, so long as the avoided amounts are repaid within 30 days, the defendant shall be entitled to assert a claim for the repaid amount, even if the proof of claims bar date has passed. Thus, if you already have a claim, you can amend that claim to reflect the repaid amount or, if you do not already have a claim, you likely will be eligible to file one.

Affirmative Defenses to Preference Claims

Section 547 gives transferees several affirmative defenses to fight back against preference claims. Three of these defenses are of primary importance in defending against preference claims asserted by corporate (as opposed to individual) debtors: the ordinary course of business defense; the contemporaneous exchange for new value defense; and the subsequent new value defense.

The Ordinary Course of Business Defense: Pursuant to Section 547(c)(2), a debtor or trustee may not avoid, as a preference, a transfer, to the extent that: a) such transfer was in payment of a debt incurred in the ordinary course of the business or financial affairs of the debtor and the defendant; and b)(i) such transfer was made in the ordinary course of the business or financial affairs of the debtor and the defendant, or (ii) made according to ordinary business terms. Under this defense, a transfer made in payment on a debt incurred in the ordinary course of the business and financial affairs between the defendant and the debtor will not be avoided if it can be shown to have been in the ordinary course of the dealings between the parties (this is the so-called “subjective test”) or within the range of ordinary course dealing norms established for the relevant industry (this is the so-called “objective test”).

From an evidentiary standpoint, analyzing the transfers under the subjective test requires evidence of the prior dealings and payments between the debtor and the defendant ' evidence most preference defendants likely possess. It will almost certainly be simpler and less expensive to prove the actual course of dealings the defendant had with the debtor before bankruptcy, in contrast to analyzing those dealings and comparing them to business dealings of other companies in the respective industry. Unless the defendant has an employee with direct knowledge of industry norms, proving ordinary course under the objective test will likely require the expense of employing an industry expert. Even though it requires a fact-intensive inquiry that potentially leaves room for interpretation and disagreement, the ordinary course of business is a powerful weapon with which to fight preference claims.

The Contemporaneous Exchange for New Value Defense: Pursuant to Section 547(c)(1), a debtor-in-possession or trustee may not avoid, as a preference, a transfer that was intended by the debtor and the defendant to have been a contemporaneous exchange for new value and that was in fact a substantially contemporaneous exchange. New value is defined to include “money or money's worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee,” but specifically does not include an obligation substituted for an existing obligation. In short, if the challenged payment was not made to pay an old invoice, but instead was made to pay for new goods or services at about the same time as the challenged payment, that will establish this defense.

The Subsequent New Value Defense: Pursuant to Section 547(c)(4), a debtor-in-possession or trustee may not avoid, as a preference, a transfer, to the extent that, after the transfer, the defendant gave new value to or for the benefit of the debtor, which new value was not secured by an otherwise unavoidable security interest, and on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of the defendant. To bring a transfer within this defense, the defendant will have to prove that it provided new value and that new value either remained unpaid or was paid through an otherwise unavoidable transfer. Even if the challenged payment was a potential preference because it paid an old invoice, that payment will be protected to the extent the defendant can show that it later provided additional goods or services that remain unpaid.

Preparing for Potential Preference Liability

• An understanding of the basic elements of a preference claim and the affirmative defenses are essential in both defending against an asserted claim and structuring pre- and out-of-bankruptcy transactions to minimize the chance of incurring liability in the event of a bankruptcy filing. If you are concerned that a customer or other key business constituent may be sliding into distress, and the transfers you receive from that party may be in danger of being avoided as preferences, there are certain tangible steps that competent bankruptcy counsel can help you take to minimize your exposure: Understand the historical course of dealing between you and the transferor (i.e., the subjective test for the ordinary course of business defense) and stay within that range.
• Understand the typical course of dealing within the relevant industry (i.e., the objective test for the ordinary course of business defense) and stay within that range.
• Require the customer to buy from you on cash-on-delivery (COD) terms. This potentially eliminates the presence of an antecedent debt.
• Understand the ramifications of aggressive collection efforts. Often, a demand followed by quick payment (or an unusual payment) will appear to an impartial finder of fact to be out-of-the-ordinary course and may be subject to avoidance.
• In the case of the workout, get payments from a third party rather than from the debtor itself. If successfully structured, this potentially eliminates the presence of a transfer from the debtor.
• In the case of a workout, get a general third-party guarantee or one covering specific payments to enhance your position against a later preference action.
•  In addition to potentially serving as a scarecrow against a bankruptcy filing, action on a third-party guarantee usually is not stayed by the filing of a bankruptcy case of the debtor.

Conclusion

The specter of preference liability haunts virtually every transaction that takes place in the shadow of bankruptcy. Evaluating preference liability is an important component of understanding the effect that the bankruptcy of a customer or a key business constituent may have on your company. While disgorging a preference is never pleasant, there are many steps that can be taken prior to the bankruptcy filing and in response to the assertion of the preference claim that can help limit the damage. Through effective understanding and implementation of these steps you can go some distance toward minimizing your preference exposure and minimizing the adverse effects that your company will realize from the bankruptcy of its customer or key business constituent.

David Lee Tayman is an attorney in the bankruptcy and creditor's; rights department of Dickstein Shapiro LLP. He has significant experience representing clients (including secured and unsecured lenders, creditors, debtors, trustees, financial sponsors, and equity holders) in a wide variety of bankruptcy, commercial litigation and troubled company transactional engagements. He can be reached at 202-420-4728 or [email protected].

In today's challenging economic environment it is a familiar story: After a protracted period of slow pay and then no pay, your customer (or borrower, joint venturer, counter-party, etc.) files a bankruptcy petition, leaving you holding the bag. You spend valuable time and money in an ultimately futile effort to collect. After a frustrating trip through the counter-intuitive, “through the looking glass” world of the modern business bankruptcy case, you finally resign yourself to losing a customer and holding a claim that will be paid, if at all, at pennies-on-the-dollar.

Think that's disappointing? Just wait until insult turns to injury and you find yourself on the receiving end of a letter or a lawsuit demanding repayment of the paltry amount you received from the bankrupt company during the 90 days prior to bankruptcy. As the defendant in a debtor or trustee's action to avoid and recover a preferential transfer (a “preference”), you may be forced to disgorge money to the debtor's bankruptcy estate.

Notwithstanding the sometimes harsh feeling that results from being the target of a preference claim, the policy goal underlying a trustee or debtor's right to avoid and recover preferences makes sense. The general concept is to avoid “unusual” transfers made on the eve of bankruptcy, so that all creditors are placed on an equal footing and so that no single creditor is preferred by having received more than it would have in an orderly liquidation of the debtor. For example, assume that you and another creditor are each owed $50,000 by the debtor and, two days prior to the bankruptcy filing, the debtor pays the other creditor in full but pays nothing to you. You hold a claim that is worth little if anything while the other creditor has already been made whole and is owed nothing. Preference law is designed to force the other creditor to disgorge the preferential transfer and return it to the bankruptcy estate to be shared by all of the bankrupt's creditors.

The Bankruptcy Code also recognizes several affirmative defenses which, through effective advocacy, may bar preference claims in whole or part. Understanding the contours of the Bankruptcy Code's preference statute, including the metes and bounds of the available defenses, is key to structuring pre- and out-of-bankruptcy transactions in a way that increases the chances of not incurring liability and of successfully defending against any preference claim.

The Basic Elements of a Preference Claim

Section 547(b) of the Bankruptcy Code allows a bankruptcy trustee or a debtor-in-possession to avoid any transfer: 1) made during the 90 days prior to the filing of the bankruptcy petition; 2) of an interest of the debtor; 3) to or for the benefit of a creditor; 4) on account of an antecedent debt owed by the debtor prior to the transfer; 5) made while the debtor was insolvent; 6) which resulted in the creditor receiving more than it would have received in a hypothetical Chapter 7 liquidation of the debtor. The 90-day lookback period is expanded to one year in the case of transfers made to insiders (defined by the Bankruptcy Code to include directors, officers, and persons or entities in control of the debtor).

The potential reach of Section 547 is very broad. The Bankruptcy Code defines “transfer” expansively ' “the creation of a lien; the retention of title as a security interest; the foreclosure of a debtor's equity of redemption; or each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or an interest in property.” Thus, a court judgment obtained during the lookback period might be subject to avoidance as a preference, as might the grant of a security interest. Cash transfers from a debtor to a creditor on an existing debt are always challengeable as a potential preference, and even a foreclosure conducted during the lookback period might be challenged.

Section 547 provides that the debtor is presumed to be insolvent during the 90 days preceding the filing of the debtor's bankruptcy petition. Thus, the evidentiary burden in the first instance is shifted to the transferee. Practically speaking, fighting on this point often means hiring an expert to sift through the debtor's murky (at best), pre-bankruptcy financial records and then winning a battle of the experts in court. Of course, in most cases the company was insolvent.

If the debtor-in-possession or trustee successfully proves the basic elements of a preference, Section 550 of the Bankruptcy Code provides that it may recover the property transferred or the value of such property from any initial transferee, or from a subsequent transferee. If a defendant must repay funds due to a preference claim, Bankruptcy Code Section 502(h) and the procedural rules governing the filing of claims in bankruptcy cases together provide that, so long as the avoided amounts are repaid within 30 days, the defendant shall be entitled to assert a claim for the repaid amount, even if the proof of claims bar date has passed. Thus, if you already have a claim, you can amend that claim to reflect the repaid amount or, if you do not already have a claim, you likely will be eligible to file one.

Affirmative Defenses to Preference Claims

Section 547 gives transferees several affirmative defenses to fight back against preference claims. Three of these defenses are of primary importance in defending against preference claims asserted by corporate (as opposed to individual) debtors: the ordinary course of business defense; the contemporaneous exchange for new value defense; and the subsequent new value defense.

The Ordinary Course of Business Defense: Pursuant to Section 547(c)(2), a debtor or trustee may not avoid, as a preference, a transfer, to the extent that: a) such transfer was in payment of a debt incurred in the ordinary course of the business or financial affairs of the debtor and the defendant; and b)(i) such transfer was made in the ordinary course of the business or financial affairs of the debtor and the defendant, or (ii) made according to ordinary business terms. Under this defense, a transfer made in payment on a debt incurred in the ordinary course of the business and financial affairs between the defendant and the debtor will not be avoided if it can be shown to have been in the ordinary course of the dealings between the parties (this is the so-called “subjective test”) or within the range of ordinary course dealing norms established for the relevant industry (this is the so-called “objective test”).

From an evidentiary standpoint, analyzing the transfers under the subjective test requires evidence of the prior dealings and payments between the debtor and the defendant ' evidence most preference defendants likely possess. It will almost certainly be simpler and less expensive to prove the actual course of dealings the defendant had with the debtor before bankruptcy, in contrast to analyzing those dealings and comparing them to business dealings of other companies in the respective industry. Unless the defendant has an employee with direct knowledge of industry norms, proving ordinary course under the objective test will likely require the expense of employing an industry expert. Even though it requires a fact-intensive inquiry that potentially leaves room for interpretation and disagreement, the ordinary course of business is a powerful weapon with which to fight preference claims.

The Contemporaneous Exchange for New Value Defense: Pursuant to Section 547(c)(1), a debtor-in-possession or trustee may not avoid, as a preference, a transfer that was intended by the debtor and the defendant to have been a contemporaneous exchange for new value and that was in fact a substantially contemporaneous exchange. New value is defined to include “money or money's worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee,” but specifically does not include an obligation substituted for an existing obligation. In short, if the challenged payment was not made to pay an old invoice, but instead was made to pay for new goods or services at about the same time as the challenged payment, that will establish this defense.

The Subsequent New Value Defense: Pursuant to Section 547(c)(4), a debtor-in-possession or trustee may not avoid, as a preference, a transfer, to the extent that, after the transfer, the defendant gave new value to or for the benefit of the debtor, which new value was not secured by an otherwise unavoidable security interest, and on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of the defendant. To bring a transfer within this defense, the defendant will have to prove that it provided new value and that new value either remained unpaid or was paid through an otherwise unavoidable transfer. Even if the challenged payment was a potential preference because it paid an old invoice, that payment will be protected to the extent the defendant can show that it later provided additional goods or services that remain unpaid.

Preparing for Potential Preference Liability

• An understanding of the basic elements of a preference claim and the affirmative defenses are essential in both defending against an asserted claim and structuring pre- and out-of-bankruptcy transactions to minimize the chance of incurring liability in the event of a bankruptcy filing. If you are concerned that a customer or other key business constituent may be sliding into distress, and the transfers you receive from that party may be in danger of being avoided as preferences, there are certain tangible steps that competent bankruptcy counsel can help you take to minimize your exposure: Understand the historical course of dealing between you and the transferor (i.e., the subjective test for the ordinary course of business defense) and stay within that range.
• Understand the typical course of dealing within the relevant industry (i.e., the objective test for the ordinary course of business defense) and stay within that range.
• Require the customer to buy from you on cash-on-delivery (COD) terms. This potentially eliminates the presence of an antecedent debt.
• Understand the ramifications of aggressive collection efforts. Often, a demand followed by quick payment (or an unusual payment) will appear to an impartial finder of fact to be out-of-the-ordinary course and may be subject to avoidance.
• In the case of the workout, get payments from a third party rather than from the debtor itself. If successfully structured, this potentially eliminates the presence of a transfer from the debtor.
• In the case of a workout, get a general third-party guarantee or one covering specific payments to enhance your position against a later preference action.
•  In addition to potentially serving as a scarecrow against a bankruptcy filing, action on a third-party guarantee usually is not stayed by the filing of a bankruptcy case of the debtor.

Conclusion

The specter of preference liability haunts virtually every transaction that takes place in the shadow of bankruptcy. Evaluating preference liability is an important component of understanding the effect that the bankruptcy of a customer or a key business constituent may have on your company. While disgorging a preference is never pleasant, there are many steps that can be taken prior to the bankruptcy filing and in response to the assertion of the preference claim that can help limit the damage. Through effective understanding and implementation of these steps you can go some distance toward minimizing your preference exposure and minimizing the adverse effects that your company will realize from the bankruptcy of its customer or key business constituent.

David Lee Tayman is an attorney in the bankruptcy and creditor's; rights department of Dickstein Shapiro LLP. He has significant experience representing clients (including secured and unsecured lenders, creditors, debtors, trustees, financial sponsors, and equity holders) in a wide variety of bankruptcy, commercial litigation and troubled company transactional engagements. He can be reached at 202-420-4728 or [email protected].