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Timing Is Everything: How to Make a Rough Assessment of Potential Preference Defenses (PART 2)

By Robert C. Maddox

Editor’s Note: Part 1 of this article laid out the prima facie case a plaintiff needs to have in order to sue for a preference, outlined the major defenses and explained the importance and use of certain key documents in assessing and maintaining a defense. Part 2 now delves into the major defenses in greater depth.

Contemporaneous Exchange Defense

Consider whether the transfer was made in a manner other than on credit. That is, determine whether your company received the transfer before the debtor received goods or services in exchange or whether there was a contemporaneous exchange. If there was a prepayment arrangement, a preference claim would fail.

The Bankruptcy Code requires a debtor to have made a preferential transfer on account of an antecedent debt “owed by the debtor before such transfer was made.” (11 U.S.C. 547(b)(2)) If the debtor paid for the goods or services in advance, then there was no antecedent debt and a preference claim cannot be substantiated. (See, e.g., Anderson News, LLC v. The News Group, Inc. (In re Anderson News, LLC), 2012 WL 3638785 at *2-3 (Bankr. D. Del. Aug. 22, 2012)  

Similarly, where the debtor received new value for a transfer, and the transfer was intended to be and was made substantially contemporaneously with the delivery of the new value, the Bankruptcy Code provides a defense against a preference claim for that transfer. (See 11 U.S.C. § 547(c)(1)

“New value” means money or money’s worth of goods, services, new credit or a non-void and non-voidable release (See 11 U.S.C. § 574(a)(2)) and “substantially contemporaneous” may encompass a period of several days or more (See, e.g., Pine Top Ins. Co. v. Bank of Am. Nat’l Trust & Sav. Ass’n, 969 F.2d 321, 328 (7th Cir. 1992))

For example, where a supplier agreed to provide a debtor with goods if the debtor provided immediate payment, and the debtor agreed, took delivery of goods, and immediately paid, the transaction was protected by the contemporaneous exchange defense. (See H.R. Rep. No. 95-595, U.S. Code Cong. & Admin. News, 1978, p. 6329; In re Payless Cashways, Inc., 306 B.R. 243, 251 (B.A.P. 8th Cir. 2004))  

Ordinary-Course-of-Business Defense

Review the number of days that invoices to the debtor were outstanding, both prior to and during the preference period. While other factors may affect the assessment of whether the preference period transfers were “ordinary,” including whether there were increased collection efforts by the creditor or changes in payment method by the debtor, payment timing is the principal attribute of the parties’ relationship that courts consider. (See, e.g., In re Sierra Concrete Design, Inc., No. 08-12029 (CSS), 2015 WL 4381571, at *8 (Bankr. D. Del. July 16, 2015)  

Using the previously assembled payment records, the next step would be to calculate the number of days from invoice to receipt of the check. (See, e.g., In re Am. Home Mortg. Holdings, Inc., 476 B.R. 124, 138 n.17 (Bankr. D. Del. 2012)) From there, calculate the days to payment for the year prior to the debtor’s petition date, or longer if sufficient payment history is available, and note the following:

  • The range comprised of the lowest and highest number of days to payment
  • The average number of days to payment, and the standard deviation of that average

The payment history, related range, and average will provide the basis for comparison against the timing of preference period payments. (See, e.g., In re Waterford Wedgwood USA, Inc., 508 B.R. 821, 835-836 (Bankr. S.D.N.Y. 2014)) Accordingly, you should also calculate the days to payment for invoices paid during the preference period.

Next, compare the payment time for each transaction made during the preference period against the prepetition days to payment range and against the prepetition average days to payment range (that is, the range comprised of the prepetition average less the standard deviation to the prepetition average plus standard deviation). (See In re Sierra Concrete Design, Inc., 2015 WL 4381571, at *3)

Payments that fall outside of either range, which may not be protected by the ordinary course defense. In addition, consideration should be given as to whether the debtor changed its payment methods during the preference period (e.g., from check to electronic transfer) and whether your company increased its attempts to collect unpaid invoices from the debtor during the preference period.

As noted above, both of these additional factors may be considered in assessing whether a transfer was “ordinary.”

Subsequent New Value Defenses

Look at the invoices for “new value” that your company provided to the debtor during the preference period and arrange these statements by date.

As noted above, new value is defined as money or money’s worth of goods, services, new credit, or a non-void and non-voidable release.  The subsequent advance of new value defense is timing contingent; your company will only receive credit for new value that is provided after receipt of an otherwise preferential payment (note that in some jurisdictions the new value also must remain unpaid on the petition date). (See 11 U.S.C. 547(c)(4))

So:

  • Arrange the list of unprotected transfers from your ordinary course of business analysis by date. Use the earliest payment as your starting point.  
  • Total the value of the payment(s) (the “potential preference amount”) on that date and for each subsequent date until the date of the first “new value” your company provided to the debtor.  
  • Reduce the potential preference amount by the value of that and any subsequent new value through the date of the next payment by the debtor (note that the potential preference amount cannot go below $0, so depending upon the timing of the debtor’s payments and your company’s provision of new value, it may have provided value that does not reduce your overall preference exposure).
  • That payment (and any subsequent payments) should be added to the remaining potential preference amount and then should be reduced by any new value provided after the payments.  
  • This process should be repeated through the debtor’s petition date.  

(See, e.g., In re Frey Mech. Grp., Inc., 446 B.R. 208, 219 (Bankr. E.D. Pa. 2011))

An example of this analysis is reflected in the chart below. The remaining potential preference amount represents a reasonable estimate of the amount of transfers from the debtor that  potentially may not be protected by the ordinary course or subsequent new value preference defenses.

Screen Shot 2018-04-23 at 2.19.57 PM

Additional Considerations

When considering potential defenses to a preference complaint, you should also deal with the obvious. For example:

  • Are the parties named in the complaint correct?
  • Were the transfers listed in the complaint received by the named entity within the preference period?

Preference actions normally occur later in the life cycle of a bankruptcy proceeding and often are handled by outside law firms that do not have direct experience with the debtor’s business. Because of this, the debtor’s records may not be as readily accessible or understood as they were at the beginning of the bankruptcy case, and many (if not all) of the debtor’s employees may be gone.

Accordingly, preference complaints sometimes include transfers that were not made “to or for the benefit” of the defendant. Thus, it is important to confirm whether the specific entity that is named in the complaint actually received the transfers or the benefit of the transfers.

Conclusion

Taking the steps outlined above should provide a reasonable assessment of the potential preferential transfers that your company received and the defenses that your company may have in a preference action. There are a couple of additional things to note, however.

First, while there may be reasons not to do so, filing a proof of claim preserves your claim against the debtor and may help in resolving any preference action that is brought against you. That is particularly true if your company provided goods or services to the debtor after the petition date that would entitle it to an administrative claim.

Second, if the debtor assumed or assigned your company’s contract during the bankruptcy that will provide a complete defense to any preference action (at least in some circuits).

Finally, while having a rough assessment of your company’s defenses is helpful, it cannot replace the value of good counsel. After you have made your initial assessment, locate competent legal counsel and use the documents that you gathered and your assessment of your company’s defenses as a starting point for mounting a fulsome defense.

About Robert C. Maddox

Robert C. Maddox is an associate at Richards, Layton & Finger, P.A., in Wilmington, Delaware. The views expressed in this article are those of the author and not necessarily those of Richards, Layton & Finger or its clients.