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Beneficial Changes to Bankruptcy Preference Defenses

Ira P. Goldberg

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“Act”) was signed into law by President Bush on April 20, 2005. Subject to some exceptions, the Act will take effect in bankruptcy cases filed on or after October 17, 2005. The Act contains many changes to the Bankruptcy Code (“Code”). One change, which will be beneficial to parties conducting business with companies that may be heading into bankruptcy, is broadened defenses to preference actions.

A preference action is one in which a Trustee or bankrupt seeks to avoid and recover certain transfers made to a non‑insider within 90 days of the filing or to an insider within a year of the filing. The Act broadens the defenses available to vendors who have done business with a company which becomes a debtor in a bankruptcy case.

The typical preference is a payment received by a vendor within 90 days of the filing of a bankruptcy petition on an outstanding and overdue invoice (arguably an expedited payment can also be preferential). The debtor or its bankruptcy Trustee can avoid certain of these payments. The preference recovery provisions of the Code are designed to achieve fairness. The law presumes that the debtor is insolvent. It is deemed unfair that certain vendors are lucky enough to be preferred and receive a payment on an overdue invoice while there are other creditors who do not receive any payment whatsoever in the 90 days prior to bankruptcy. Therefore, preference payments can be recovered and returned to the bankruptcy estate for redistribution to the entire creditor body.

In theory, the preference provision of the Code is fair. However, in practice, every person who receives a dreaded Trustee letter seeking the return of monies paid within the 90 days prior to a bankruptcy case feels victimized. However, the Trustee’s letter is not the end of the story. When you receive such a letter, you should explore available defenses, not write a check. The initial demand for a return of a preference is the beginning of a process and the commencement of a negotiation. The Code provides several defenses to those who regularly transact business with a debtor company. In the majority of situations which we encounter, we are able to achieve for our clients significant reductions, if not total defenses, to the supposedly avoidable preference asserted by the Trustee.

One of the most common Code defenses is the “ordinary course of business” defense. Under the amendments to the law which go into effect on October 17, 2005, the ordinary course of business defense will be much easier to establish. The crux of the broadened preference defenses is that the prior law required that payments be made in the ordinary course of business of both the transferee and the debtor and in addition that the transfer be made according to ordinary business terms (i.e. ordinary terms according to the relevant industry standard). Under the prior law, you had to meet both a “subjective” (business practices of the parties) and an “objective” (business practices of the industry) test. The Act makes these tests an either/or proposition. Under the old law preference defendants often had trouble meeting the objective industry standard. In order to prove the industry standard, courts frequently required them to present testimony from an industry expert or a competitor. This burden was not only difficult, but also costly or impractical. The ordinary course of business may be established by proof of an established business relationship (several years or many transactions) together with a showing that normal payment terms were followed as to the alleged preferential transfers at issue. For example, regardless of the fact that invoices provide that payments are due in 30 days, if it is the parties’ routine custom, over a relatively long period of time, to have payments made within 60 to 90 days of invoice, this should establish the ordinary course of business. Therefore, in circumstances where there is an established history between the parties and the payments are made within those terms it would be easier to defend a preference action. When the relationship is a first‑time one, or it has not been very long, some proof that industry standards were followed will be required. Other common defenses are: a) providing subsequent new value to a debtor after the receipt of the alleged preferential transfer, b) exchanges that are intended to be and in fact are substantially contemporaneous, and c) the fact that pre‑payments are not preferential since an antecedent debt is not being paid.

For cases involving primarily commercial debt (not consumer debt) the Act precludes avoidence if the aggregate value of the property that constitutes or is affected by such transfer is less than $5,000.00. However, it is possible that a Trustee might still sue (forcing this defense to be raised as an “affirmative defense”) or still send a demand letter for a sum under $5,000.00. For cases involving primarily consumer debt, the threshold is $600.00.

If you receive a Trustee demand letter, you should consult with bankruptcy counsel rather than issuing a check. In most circumstances you can settle (but only with court approval) for a percentage of your exposure. Please contact us about any questions you may have concerning this or other provisions of the Act.

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