Litigation Law Alert: Preference Litigation Changes Expected Under the Amended Bankruptcy Code

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This bulletin advises you of some of the changes that are expected to affect litigation of preference claims after the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act") becomes effective next week. The changes discussed in this bulletin are applicable in actions to recover preferential transfers commenced in bankruptcy cases filed on or after October 17, 2005.

What is a Preferential Transfer?
Under the Bankruptcy Code, the party filing a bankruptcy petition (called the "debtor"), a bankruptcy trustee or, in some cases, a committee of creditors can file a "preference action." In a preference action, the plaintiff seeks to recover property or money the debtor transferred to a creditor. To be recoverable, the transfer must have been made within 90 days before the bankruptcy petition was filed (one year if the payment was made to a relative, affiliate or other "insider" of the debtor), and the transfer must have been made on account of a pre-existing debt and while the debtor was insolvent. (It is presumed that the debtor was insolvent during the 90 days before filing a bankruptcy petition, but this can be rebutted.) Also, to be considered preferential, the transfer must have resulted in the creditor receiving more than it would have received by filing a claim in the bankruptcy case.

The Bankruptcy Code allows such "preferential transfers" to be recovered so they can be used to pay bankruptcy administrative expenses and unsecured creditors’ claims. The underlying theory is that all creditors should be treated equally and should receive an equal percentage of their claims, based on the amount of money available, and that the debtor should not be able to favor, or "prefer," one creditor over another by making payments to certain creditors on the eve of bankruptcy that put one or more of the creditors on better footing than others.

Preference Actions
When a customer of any business files bankruptcy, the business creditor is almost always concerned about whether the outstanding receivables owing from the customer are going to be paid. That is bad enough, but it is especially frustrating for businesses that have been diligent in pursuing and obtaining payment from customers to find themselves being sued to give back money that was validly due and owing, when the only reason for a delay in payment was the customer’s internal cash flow problems. Yet, lawsuits filed in bankruptcy court to recover preferential transfers are very common.

Scores of preference actions are often filed in a particular case, based on the debtors’ databases showing dates of invoices and dates of corresponding payments made within the 90-day period before bankruptcy. Many of the preference actions seek to recover very small amounts of money, but have been fairly cost-effective for debtors, trustees and committees to pursue, because they could all be filed in the court where the debtor filed its bankruptcy petition.

The Bankruptcy Code provides a number of defenses to preference actions, but often the amount demanded is less than the costs of defending the action. The action can be particularly daunting if the jurisdiction where the debtor’s bankruptcy is pending is far from the creditor’s business operations, forcing the creditor to obtain local counsel and raising the prospect that the creditor’s witnesses would need to travel to the bankruptcy court if the case were tried. The alternative - videotaped deposition and trial testimony - is itself costly and often has tactical limitations. Accordingly, in many cases the only cost-effective option has been to settle the case, usually by paying all or a substantial portion of the amount demanded.

Effect of the Act
The Act may have the dual effect of reducing the number of preference complaints and making it easier for creditors to defend those complaints successfully.

  • Changes to the "Ordinary Course of Business" Defense

    Section 547(c)(2) of the Bankruptcy Code has provided a creditor with a defense to a preference complaint if the creditor could prove that the payment was (a) for a debt incurred in the ordinary course of business between the debtor and the creditor; (b) made in the ordinary course of business between the debtor and the creditor; and (c) made according to ordinary business terms in the relevant industry. The creditor has had to prove all three of these elements in order for the defense to be successful. Proving that the debt was incurred in the ordinary course of business is generally not difficult. The debtor usually has ordered the goods or services from the creditor, which was in the business of providing such goods or services. The creditor performed as agreed and delivered the goods or services, thus giving rise to a debt for payment. Simple enough. Proving that payment of the debt is ordinary as between the creditor and debtor requires analysis of the history and variation of payment practices between the debtor and creditor. It can be fact-intensive, but usually creditors have the data to determine whether the debtor routinely was a "slow pay" and whether the alleged preferential payments were within the creditor’s usual payment experience with the particular debtor, including the method of payment (e.g., standard company check versus cashier’s check or wire transfer). Of course, if such data do not exist, or if the evidence shows that the debtor had previously been fairly punctual and then slowed down within the 90-day period before filing a bankruptcy petition, or if the creditor suddenly paid by cashier’s check for the first time in the parties’ relationship, then the creditor would not be able to prove this element of the ordinary course of dealing defense. Proving this prong of the defense is thus tougher than the first one. An even harder prong to prove is that payment of the debt was ordinary in the relevant industry. This often requires expert testimony or external evidence from the creditor’s competitors, as testimony from the creditor’s own employees may be considered self-serving and given little weight. Obtaining such information can be problematic, because it is often considered proprietary in a competitive industry. If one can establish the industry norm and finds that the standard is payment within, say, 60 to 75 days, the debtor’s payment of a 70-day old invoice is within ordinary industry terms, even if it is longer or shorter than the payment history between the debtor and the creditor. However, if the form of payment was a cashier’s check or wire transfer, which was standard in the debtor’s relationship with the creditor but not common in the industry, the defense will likely fail.

    The Act amends § 547(c)(2) to make the ordinary course defense available if the creditor can prove that the debt was incurred in the ordinary course of business and either of the other two prongs of the defense is satisfied. So, in a case where the debtor had always paid the creditor within 30 days following receipt of an invoice and then paid a 70-day old invoice within 90 days before filing its bankruptcy petition, the creditor would not be able to establish the second prong of the defense, but might still establish the third prong and assert a successful course of business defense if the industry standard is 60 to 75 days. Alternatively, if the debtor had routinely paid 120 days after receiving invoices and then paid a 120-day old invoice within the 90-day preference period, sending a company check as usual, the second prong of the defense can be met without questioning whether the payment falls outside industry payment standards.

  • Limits on Smaller Preference Claims

    The Act has a special provision that applies to bankruptcy cases filed by a debtor whose debts are primarily business debts, as opposed to consumer debts. (Consumer debts are those incurred primarily for a personal, family or household purpose. Business debts are all other types of debts.) In cases involving primarily business debts, the Act prohibits actions to recover preferential transfers unless the total of all of the allegedly preferential transfers received by a particular creditor is at least $5,000. This will eliminate smaller preference actions and is a welcome change for creditors that extend credit to their business customers.

  • Limits on Venue

    The Act provides that complaints seeking to recover preferential payments on non-consumer debt of less than $10,000 (in cases involving non-insiders), consumer debt of less than $15,000, a money judgment of less than $1,000, or property (other then money) worth less than $1,000, can only be filed in the jurisdiction where the defendant resides. (A corporate creditor "resides" in any district where it is has sufficient contacts to subject itself to jurisdiction, so there may be multiple districts where a corporate defendant may be sued.) Such actions can no longer be filed in the bankruptcy court where the debtor’s bankruptcy case is pending, which often may be an inconvenient forum for the defendant. This change can be expected to discourage the filings of such cases due to the need to locate local counsel and the logistics of filing preference claims against various creditors in multiple jurisdictions.

Summary and Conclusion
With the changes made by the Act, Stoel Rives’ business clients will have a better chance to use the ordinary course of business defense to defeat preference actions. They will have to defend preference actions in a district other than where they reside only if there is at least $10,000 at stake. They are likely to see a substantial reduction of cases alleging receipt of preferential payments totaling between $5,000 and $10,000 and, when such cases are filed, the clients should expect them to be filed in a jurisdiction where the creditor resides (and can move to dismiss any case if it is not filed in a proper venue). They should see no cases alleging aggregate preferential payments of less than $5,000 (and can move to dismiss any such case if one is filed). A number of other defenses to a preference action remain unchanged by the Act. If you receive a preference complaint or a demand letter in advance of a preference complaint, a bankruptcy litigator can help you identify and make the most of all of the defenses available under the Bankruptcy Code, as amended by the Act, including those highlighted above. Stoel Rives has a number of experienced bankruptcy litigators who can assist, including the lawyers named below, and whom we encourage you to contact if you have bankruptcy-related litigation needs.

This Litigation Bulletin contains an overview of certain changes to the preference provisions of the Bankruptcy Code. It states general principles and concepts and is not intended to be legal advice. For application of the Bankruptcy Code or changes effected by the Act to any particular set of facts, we recommend that you consult with legal counsel.

Key Contributors

David B. Levant
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