In January, Mortgage Lenders Network commenced over 65 adversary actions against various defendants, seeking the avoidance and recovery of preferential transfers (read one of the preference complaints here). As reflected in its complaints, Mortgage Lenders filed a chapter 11 bankruptcy petition in the Delaware Bankruptcy Court on February 5, 2007. During the ten years prior to its bankruptcy, Mortgage Lenders grew from a small mortgage company with seven employees, to a residential mortgage provider serving 47 states with over 1,700 employees.
Given the commencement of Mortgage Lenders’ preference program, this post provides a brief summary of the elements and common defenses to preference claims.
Elements to a Preference Claim
In order to establish that a party received a preferential transfer, the plaintiff must prove that payments were received by a creditor on account of an “antecedent debt.” Further, the preferential payments must be made (i.) while the debtor was “insolvent”, (ii.) made within 90 days before the debtor filed for bankruptcy, and (iii.) the payments provide the creditor with more payments than it would receive if the debtor had liquidated under a chapter 7 liquidation.
An antecedent debt arises when a party receives a right to payment from the debtor for goods or services. It is not impossible to prove that a transfer lacked antecedent debt, however, creditors should know that courts often construe the term "debt" broadly.
To qualify as a preference, the payment must be made while the debtor was “insolvent.” Creditors who seek to prove that the debtor was solvent at the time of payment carry the burden of proving solvency. Further, the Bankruptcy Code provides that the debtor is presumed insolvent on or during the 90 days leading up to the commencement of the bankruptcy case (often referred to as the 90 day “preference period”). This presumption places the burden on the creditor being sued for the preference payment, not the debtor, to prove that the debtor was solvent at the time of the transfer. For a more in-depth look at the solvency defense, read here.
To determine whether a payment falls within the 90 day preference period, count back ninety days from the date the debtor filed for bankruptcy (the petition date). For preference claims against "insiders" of the debtor, the preference period extends back one year prior to the petition date.
Finally, the plaintiff must show that the creditor received more than it would have received had it not received the payment, but instead received a distribution in a chapter 7 liquidation. Although this sounds convoluted, the intent is pretty clear – in order to show that a creditor received “preferential” treatment by the debtor, the plaintiff must prove that the creditor’s payment was greater than what the creditor would have received had the debtor liquidated its assets under chapter 7 of the Bankruptcy Code.
Core Defenses to Preference Litigation: Ordinary Course of Business, New Value and Contemporaneous Exchange
Even if the plaintiff can establish that the debtor made a preferential transfer as defined under the Bankruptcy Code, the party receiving the payment may still avoid returning the money by proving the payment was made in the “ordinary course of business.” The ordinary course of business defense is the most widely used defense to a preference claim. Congress created the ordinary course defense in order to protect recurring, customary credit transactions that are incurred and paid in the ordinary course of business of the debtor and the debtor’s customers.
Under the 2005 amendments to the Bankruptcy Code, it is now easier for creditors to prove payments were made in the ordinary course of business. Under the amended Code, a creditor that receives preferential payments must prove that payment was received in the ordinary of business of the debtor and creditor (the “subjective test”). Alternatively, if the creditor cannot prove that the payments were made according to ordinary business terms between the parties, it can still prevail by showing that the payments were made according to ordinary business terms (the “objective test”). Prior to the 2005 amendments, the creditor had to satisfy both the subjective and objective tests in order to satisfy the ordinary course of business defense.
A payment is not considered a preference payment if the creditor who received the payment can show that it gave “new value” to the debtor after it received the preferential payment. To establish a new value defense, the creditor must show that it received a preference payment, the creditor then provided the debtor with new value in the form of subsequent goods or services, and the debtor must not have fully compensated the creditor for this subsequent new value. If you wish to read more on the new value defense, read here.
Creditors can also defend against a preference claim by showing that the payment(s) received from the debtor were contemporaneous exchanges. The contemporaneous exchange defense requires the creditor who received the payments from the debtor provide the debtor with goods or services after receiving payment. Additionally, the creditor and debtor must intend for the payments to be a contemporaneous exchange. Finally, the payments received by the creditor must actually be contemporaneous.
The above provides a generalized introduction to the elements and core defenses of a preference action. Subsequent posts will explore in greater detail the various components of preference claims. Besides looking at substantive legal issues, however, it is also important to understand the Delaware Local Rules and General Orders that govern the procedural flow of these cases from beginning to end. Stay tuned.