It’s your worst nightmare: you provided goods and services to a financially struggling company, only to find out that it filed for bankruptcy, leaving your company with a large unpaid balance.  Worst yet, after the debtor filed for bankruptcy, you receive a demand letter in the mail threatening a lawsuit if you do not return payments that you received from the debtor, even though you earned that money by providing goods or services to that entity.  What sense does that make?

Unfortunately, this is the reality that many companies face when transacting business with an entity in the months prior to its bankruptcy filing.  Section 547 of the Bankruptcy Code allows a debtor to avoid and recover transfers that it made in the 90 days prior to its bankruptcy filing, regardless of whether it received anything in return. This section was enacted to preclude a debtor from paying off its favorite creditor(s), while leaving nothing for the rest of the debtor’s creditors.  Hence the term preference payment.

Where does this leave your company after receiving a demand letter or complaint in the mail for the return of such alleged preferential transfers?  Rest assured, the Bankruptcy Code also provides numerous defenses that you can raise in response to such a demand.  This post provides a brief summary of the elements of, and common defenses to, preference claims.

Elements of a Preference Claim

To establish that a defendant received a preferential transfer under Section 547 of the Bankruptcy Code, plaintiff must prove the elements of 11 U.S.C. §547(b).  These elements include that payments were received by a creditor on account of an “antecedent debt”, and that 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.  11 U.S.C. § 547(b).

An antecedent debt arises when a party receives a right to payment from the debtor for goods or services provided to the debtor.  This means that transfers which were “prepayments” do not qualify as preferential transfers under Section 547. 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. This means that 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.

Affirmative 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, there are several affirmative defenses available to creditors under Section 547(c).  The more common defenses include the subsequent new value defense, ordinary course of business defense, and the contemporaneous exchange of new value defense, which are discussed below.

  • Ordinary Course of Business Defense – Section 547(c)(2)

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 provisions of the 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.

  • Subsequent New Value Defense – Section 547(c)(4)

Exposure to a preference action can be reduced by the amount of “new value” provided by the defendant to the debtor subsequent to receipt of 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.

  • Contemporaneous Exchange of New Value Defense – Section 547(c)(1)

Creditors can also defend against a preference claim by showing that the payment(s) received from the debtor were contemporaneous exchanges for subsequent new value.  The contemporaneous exchange defense requires the creditor who received the payments from the debtor provide the debtor with “new value” after receiving payment, which can include the value of goods or services.  Additionally, the creditor and debtor must intend for the payments to be a contemporaneous exchange.  Finally, the payments received by the creditor and the exchange of new value must actually be substantially contemporaneous.

Conclusion

The above is a brief introduction to the elements and core defenses of Section 547 preference actions.  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 Local Rules and General Orders that govern the procedural flow of these cases from beginning to end.

Carl D. Neff is a bankruptcy attorney with the law firm of Fox Rothschild LLP.  Carl is admitted in Delaware and regularly practices before the United States Bankruptcy Court for the District of Delaware. You can reach Carl at (302) 622-4272 or at cneff@foxrothschild.com.

Summary

In an opinion issued January 4, 2012, Judge Sontchi of the Delaware Bankruptcy Court provided an easy to follow primer in preference law in the course of granting in part and denying in part a preference defendant’s motion for summary judgment. Judge Sontchi’s opinion is available here (the “Opinion”).  The Opinion provides an excellent framework for all preference defendants to understand why preference laws are in place and the reasoning behind their existence. The first half of the Opinion would make a fantastic introduction to any discussion of two of the most common preference defenses, the “ordinary course of business” and “new value” defenses. Please bear in mind, however, that the Opinion was issued in response to a motion for summary judgment, which applies different standards than an opinion written following a complete trial. The below blog posts address other opinions written in response to motions for summary judgment:

SemCrude Decision Delineates the Process for Analyzing Motions for Continuance vs. Motions for Summary Judgment

Decision in DBSI Delays Motion for Summary Judgment

Decision in New Century TRS Holdings, Inc. Holds That Publication in 2 Newspapers is Insufficient to Grant a Motion for Summary Judgment

Background

In 2008, Sierra Concrete Design, Inc. and Trevi Architectural, Inc. (the “Debtors”) filed for bankruptcy in the District of Delaware. As a part of their bankruptcy proceedings, the Trustee who was appointed to handle their bankruptcy proceedings, Jeoffrey L. Burtch, filed a number of preference actions against entities which had been paid by the Debtors within the ninety-day period prior to the Debtors’ bankruptcy filings. In one of these preference cases, Revchem Composites, Inc. was a named defendant. Revchem eventually filed a motion for summary judgment, arguing that the payments made to it were protected from recovery by exceptions built into the Bankruptcy Code – the “ordinary course of business” and “subsequent new value” defenses. Opinion at *4.

Judge Sontchi’s Opinion

Judge Sontchi begins the Opinion by asking, “Why is there a preference law?” Opinion at *1. He then spends the next several pages explaining what would happen in the absence of preference laws and how the ensuing strong-arm tactics and efforts by creditors to collect payment would harm businesses in general.

The two preference defenses discussed in the Opinion are (1) the ordinary course of business defense and (2) the subsequent new value defense. The ordinary course of business defense has two ways in which in can be applied. First, did you treat the Debtor the same way you always did, and did the Debtor pay you the same way they always did? If you can answer this two-part question yes, and you have a history of working with this company, you are likely protected. In this case, Judge Sontchi opines that “17 checks covering approximately 68 invoices over an 11 month period” is “insufficient evidence….” Opinion at *7. The second way in which the ordinary course of business defense can apply, is if your interactions with the Debtor were ordinary for your industry. This requires a defendant to present evidence relating to standard industry practice. This evidence will normally be provided by an expert witness who has studied the preference defendant’s industry and who testifies in court, under oath, that the interactions were ordinary. Take note, however, that “a one-paragraph, conclusory allegation” is insufficient evidence to uphold the ordinary course of business defense. Opinion at *7.

The new value defense allows a creditor to limit their preference exposure before a bankruptcy occurs. If, for example, a debtor has a line of credit for $1,000 that it maxes out and repays four times in the ninety-day period before declaring bankruptcy, it would make no sense for the creditor to be liable for $4,000 of preferences. On page 9 of the Opinion, Judge Sontchi provides an example of how the new value defense is applied, and I have recreated the chart here:

Date Preference Payment New Value Preference Exposure
1/1/2010 $1,000 $1,000
1/5/2010 $1,000 $0
1/10/2010 $1,000 $1,000
1/15/2010 $2,000 $0 (not -$1,000)
1/30/2010 $3,000 $3,000
2/5/2010 $1,000 $2,000
2/10/2010 $1,500 $3,500
Net Result $3,500

As illustrated by the chart, any value provided after a payment will reduce (or eliminate) the preference exposure. However, this defense only tracks new value, so any new value provided will not be applied to later payments. Applying the new value analysis is an exercise based entirely on the record of payments to the preference defendant and the record of goods/services provided to the debtor by the preference defendant. In the Opinion, Judge Sontchi applied this analysis to limit the maximum preference liability of the defendant. Opinion at *10. Thus, this motion for summary judgment was allowed in part and denied in part.

The preference discussion in the Opinion is comparatively easy to follow, and I highly recommend anyone with an interest in preference actions review this decision. Not only is it an explanation suited to attorneys, but its marked lack of technical jargon makes this an opinion accessible to those who would consider themselves legal novices. Ultimately, it comes down to this – If you do business and get paid the same way you always have, you may not have to repay the preference. Or, if you provide the Debtor with some value after you get paid, you may not have to repay all of the preference. Just remember, every situation is different, and getting a professional’s help early in a preference case may save you money in the end.