The Preference Case Background
It’s your second year as a bankruptcy attorney and a client of the firm receives a preference demand letter from a U.S. Bankruptcy Trustee in a far away city. A partner in the firm asks you to take the file and handle the matter. Your first reaction is excitement that it is your first matter to handle “solo.” Your next reaction….now what do I do!?!

You pick up the Bankruptcy Code and are reminded (in Section 547(b)) of the requirements for a preference: (i) a transfer of any of the property of a debtor (ii) to or for the benefit of a creditor (iii) for or on account of an antecedent debt (iv) made or suffered by the debtor while insolvent (v) within 90 days before the filing of petition and (vi) which enabled the creditor to receive more than the creditor would have received if: (a) the case were a case under chapter 7 of the Bankruptcy Code; (b) the transfer had not been made; and (c) the creditor received payment of the debt as provided for by the provisions of chapter 7. You then file and scan through the demand letter and realize that your client received payments aggregating $1,220,000 in the 90-day preference period.

Remembering back, you pull out an old training course manual to identify all of the statutory defenses to the preference action. These include:
• Transfer intended as a contemporaneous exchange for new value (§547(c)(1))
• Transfers made in the ordinary course of business of both the debtor and creditor and made according to ordinary business terms (§547(c)(2))
• Subsequent new value (§547(c)(4))
• Giving of a security interest to acquire property provided the interest is perfected within 20 days of the bankruptcy filing (§547(c)(3))
• Transfer where there is a perfected interest in inventory or receivables or the proceeds of either provided that the creditor’s position does not improve over the preference period (§547(c)(5))
• Fixing of a statutory lien that is not avoidable (§547(c)(6))

After reviewing the information provided, you determine that the only affirmative defenses available would be new value and ordinary course of business. (These are the most common defenses and thus are addressed in detail herein.) Now that you’ve identified the issues to be addressed, you’re ready to call the client to discuss the claim and obtain information.

Contacting the Client

You call your client and request detailed information from their controller relating to all payments in question: date of payments, amount of payments, due date of payments, date payments cleared the bank and all contractual agreements. In addition, you need the controller to furnish you with any paperwork supporting any potential new value offsets. This would include any invoices and/or credit memos issued to the debtor for refunds, credit, services, or goods during the 90-day preference period. Finally, you will need the debtor’s payment history for the prior two years. All of the information requested will be analyzed and should be charted to determine if a particular payment is a preference and, if so, what defenses may apply. (Sample charts are included as Tables at the end of the article and discussions relating to the Tables follow.)

In addition, you may also want to inquire about any legal and correspondence files your client may have pertaining to this debtor. If available, these files may help you fully understand your client’s relationship with the debtor and introduce information, which will help in your defense. You have requested all the necessary information to structure a good defense. But now the client has some questions for you.

Your client had never received a preference demand and wants to know how a bankruptcy trustee could demand that they return funds for goods provided or work performed. They did what they were supposed to and the debtor paid them. Why would they have to give it back?

The Purposes of Preferences

As a bankruptcy professional, you understand the legal framework of preference litigation, but the client isn’t interested in the Bankruptcy Code or congressional intent. The client has never had to refund money for goods provided and has no desire to do so now. A client may feel that they have "earned" those payments and that losing them will occur only because you are a bad lawyer. Explaining to your client the purpose of preferences--to level the playing field--will probably help.

You explain that unlike many provisions included in the Bankruptcy Code, preference actions are not designed to punish a wrongdoer. Instead, preference actions are a statutory creature intended to ensure that all creditors are treated equally, specifically creditors who might have been treated more favorably on the eve of bankruptcy. You provide a simple example to your client.

On the eve of a bankruptcy filing, D has two creditors, creditor A and creditor B. D has owed each creditor $10,000 for quite some time but decides and has sufficient funds only to pay creditor A in full before commencing the bankruptcy proceedings. Would that be fair to creditor B who would get nothing in the bankruptcy proceedings? Would the answer be different if creditor A and D were neighbors or golfing partners? You explain that preference law says that it is not fair, no matter what the relationship is between the parties and no matter what other reason might be provided, subject to some exceptions, to justify paying one creditor rather than another. This is consistent, you note to your client, with one of the primary purposes of bankruptcy: to prevent the "race to the courthouse" and ensure that all like creditors are treated similarly.

Continuing with your example, you explain that A will be forced to repay the $10,000 it has received because it is a preference. In so doing, A will have created a pool of $10,000 (subject to deductions for expenses like attorney and filing fees) that can then be distributed to all creditors who file claims. Accordingly, as both A and B would then file claims for $10,000 (and are, in this example, the only creditors D has), each will ultimately be paid an equal amount, approximately $5,000, from D's bankruptcy estate.

At this point, you tell your client that they will have the opportunity to submit a claim for any payment deemed a "preference" that must be returned to the bankruptcy estate. While you can’t make any guarantees, there is a chance that the client will receive at least a percentage back on any claim. In addition, you explain that your client is not in the same situation as A because it has certain defenses available to a preference claim.

Ordinary Course Explained

You explain that to take advantage of the "ordinary course" exception that appears to be available, a creditor must demonstrate: (A) the underlying debt on which the payment was made was "incurred in the ordinary course of business or financial affairs" of both parties, (B) the transfer was "made in the ordinary course of business or financial affairs of both parties; and (C) the transfer was made according to ordinary business terms." 11 U.S.C. §547(c)(2). Although different courts have different refinements of the rules that must be examined in each case, you explain to your client that subparagraph (A) requires that the particular transaction at issue not be fraudulent or unusual, subparagraph (C) requires that the particular transaction be consistent with general business practice in the industry, and subparagraph (B) requires that the particular transaction at issue be consistent with the typical transactions between the parties. This last item, you explain, requires a more detailed analysis.

Courts commonly look to four factors when examining subparagraph (B): (1) the length of time the parties were engaged in the transaction at issue; (2) whether the amount or form of tender differed from past practices; (3) whether the debtor or creditor engaged in any unusual collection or payment activities; and (4) the circumstances under which the payment was made. See 5 Colliers on Bankruptcy §547.04[2][a], 547-59 - 61 (15th ed. 2003). If the manner of payment was consistent with past practices, as the client assures you they were, the real analysis (required in most cases) is to determine whether the timing of payments were consistent with the past practices between the parties. For example, you explain, if during the pre-preference period the debtor always paid creditor A approximately 35 days after the invoice was sent and then, during the preference period, started paying creditor A 60 days after the invoice or, alternatively, five days after the invoice was sent, the past and present practices would not be consistent and thus could not be "ordinary course."

Generalities aside, determining whether a transaction is in the ordinary course between parties is an inexact science. As this is an affirmative defense, it is up to the defendant to analyze the situation and present its case. Not surprisingly, the defendant will analyze the historical data and present it in the light most favorable to it. There is no set standard as to how to determine what is ordinary based upon the parties’ history. A defendant relying on the fact that the debtor paid it late 100 percent of the time will not succeed. A breakdown of exactly how late or early invoices were paid on average over a particular time compared to how the alleged preferential payments were made is more appropriate. An example of such an analysis and breakdown is contained in Table A and explained in more detail below.

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