Chapter 11 debtors-in-possession and trustees in Chapter 7 and Chapter 11 bankruptcy cases routinely seek disgorgement of monies paid to creditors when those payments were made by the debtor in the ninety days prior to the filing of the bankruptcy petition.  If you received a payment or other transfer of an asset from the debtor within the ninety-day preference period, while the debtor was insolvent, and you received this transfer on account of a debt that was owed to you, then the payment you received is recoverable unless one or more of the possible defenses applies. The four common “defenses” to a preference action are as follows and each is discussed in greater detail below: 

·        Ordinary Course of Business

·        Subsequent Extension of New Value

·        Contemporaneous Exchange for New Value

·        Security Interest

The Ordinary Course of Business Defense:

Section 547(c)(2) of the Bankruptcy Code provides a defense for transfers occurring within the “ordinary course of business.”  The requirements for this defense will be different for cases filed on or after October 17, 2005 as a result of changes in the new bankruptcy law. 

Under the old law, in order to establish the ordinary course of business defense you must satisfy three separate prongs: 

A.        show that the debt was incurred in the ordinary course of business or financial affairs between you and the debtor,

B.         show that the payments were made in the ordinary course of business or financial affairs between you and the debtor, and

C.        show that the payments were made according to ordinary business terms.

The B and C prongs require more explanation and are at the crux of the battle to successfully establish the defense.  To satisfy the second prong, “made in the ordinary course of business” between you and the debtor, you must establish that the “course of dealing” between you and the debtor did not change in the 90-day preference period from what it had previously been. The most common way of determining whether the course of dealing remained the same requires you to look at payments made by the debtor during the preference period and to calculate the number of days from invoice to payment.  Then you perform the same calculation for a 6-12 month period prior to the 90-day preference period.  The payments are ordinary course if the time for payment is about the same for these two periods.  Said another way, the courts look at what the course of business was between you and the debtor for a period of time prior to the ninety days before the debtor filed bankruptcy.  They then compare the results of this analysis to the course of dealing during the 90-day preference period.  In order to make this comparison, two charts are generally necessary.  One chart will be for the 90-day preference period and contain the payments in that period which the debtor seeks to recover.  The other chart will cover the pre-preference period, and it will generally be for a period of time ranging from three to twelve months prior to the beginning of the 90-day preference period. 

Each chart should contain the following information:  invoice number, date of invoice, amount of invoice, the date payment was received by the creditor, and the number of days between invoice date and payment date.  Frequently one payment will cover multiple invoices.  In that case, each of the invoices covered will be listed separately and will show payment on the same date, but the time period will probably vary because the invoices were likely generated on different days.  A sample chart is shown on Exhibit A.

Once the chart is prepared, we analyze the chart and pull the average number of days in the pre-preference period and compare it to the average number of days in the preferential period.  The goal in establishing a good ordinary course defense is to ensure that these numbers coincide.  Sometimes it is possible to manipulate the period of time covered by the pre-preference chart in order to bring the numbers closer together. 

Another important part of the second prong of the ordinary course defense is other characteristics of the payment.  Were the payments within the preference period of the same type as the pre-preference period?  For instance, were they all regular checks or did the payment methodology switch from regular checks to wire transfers or certified checks?  Were there any special demands or requirements placed on the debtor during the preference period which caused the payment pressures to change? Any changes in the course of dealing will possibly eliminate the ordinary course of business for later transfers. Also of importance is what the actual invoice terms were (i.e. 30 days) and whether the invoices were generally paid in accordance with the invoice terms.

Also important in the ordinary course defense is the third prong relating to the “ordinary business terms.”  This prong refers to the standard in the industry and requires the creditor to compare the payment terms for the potentially preferential transfers to the payment terms in the creditor’s industry for similar sales during the same time period. In some industries this information is easy to obtain and in others it is more difficult.  In any preference case which goes to trial, this information is essential, but it is less important in negotiating a settlement. 

In the new legislation which takes effect on October 17 for cases filed after that date, defendants will be able to establish the ordinary course defense by proving either prong two or prong three.  There is very little guidance right now regarding how this works, but we are optimistic that it will significantly enhance preference defense opportunities. Until more is known, the same analysis should be done as described above.

Subsequent Extension of New Value Defense:

Section 547(c)(4) provides that a creditor who supplies “new value” after receiving a preferential payment may reduce its preference liability by the amount of new value provided to the debtor. Generally, it is also required that the new value remain unpaid.  In order to provide information for this analysis, it is necessary to prepare a chart which begins about five days prior to the date of the earliest preferential payment and list each preferential payment along with each shipment.  These should be put on a single chart in appropriate date order and the chart should include date shipped and date payment received (this is one column and should be the one where you chronologically list payments and shipments), invoice number, date of invoice and some payment or invoice amount.  Obviously, some of the invoices on the list will be from an earlier period but should be included since the critical date for this analysis is the date of the payment.  A sample chart is shown on Exhibit A.

We cannot use a simple net result analysis adding up all the payments received and all the shipments out and subtract one from the other.  Each shipment out must be applied to offset the payment immediately prior to it, and any excess value provided cannot be carried forward to apply to later payments.  Some jurisdictions allow shipments out to apply to all previous payments but, depending on your jurisdiction, that is part of the analysis we will undertake.

Contemporaneous Exchange of the New Value Defense:

Section 547(d)(1) provides the “contemporaneous exchange” defense which occurs when the debtor and creditor have a mutual intent to make an exchange of property at approximately the same time.  This might be the result of a COD delivery where check or cash is simultaneously exchanged for a product or service.  However, if the check is not a cashier’s check, and it ultimately does not clear the debtor’s bank account, and a replacement check is issued, the contemporaneous exchange defense is lost.  Tell us if your shipments were COD.

Security Interest Defense:

Section 547(c)(3) says that the trustee may not avoid a transfer that creates a security interest in property acquired by the debtor so long as the security agreement was signed prior to or at the time of the transfer (payment) and the security interest was perfected within twenty days of the time the debtor received possession of the property.

Other Defenses:

There are additional defenses or issues that we can raise to defeat a preference.  Listed below are several examples.  Please let us know if any of these apply to a payment which is being attacked as preferential:

·        If you received a pre-payment for the shipment prior to the time you shipped the goods.

·        If you received your payment from an entity other than the debtor.

·        If you have reason to believe that the debtor was solvent (based on a balance sheet test of assets against liabilities) at the time you received the payment.

·        If you merely received the payment on somebody else’s behalf and then passed the payment on to that entity, perhaps taking out a commission.

·        If you have factored your account on a nonrecourse basis and the payment was actually made to your factor.

·        If you are owed money post-petition (an administrative claim) that has not been paid.  In some cases we are able to use this unpaid account as a negotiating tool.

Your Post-Settlement Proof of Claim:

You are entitled to file a proof of claim for any amount you disgorge as a preference.  Often we can lower the amount you pay by negotiating away this claim.  If you want us to file a claim for you for the amount you disgorge, please tell us that specifically.  Otherwise we will assume you are filing your own claim.

If you have any questions regarding this article, please contact Judy Thompson at 704.342.5299 or jthompson@poynerspruill.com. 

This electronic publication is published by Poyner & Spruill LLP to provide general information about significant legal developments. Because the facts in each situation vary, the legal precedents noted herein may not be applicable to individual circumstances.