PREFERENCE PRIMER

(A) Transfer of an interest of the debtor. Although not always identified as a separate element of a preferential transfer, the transfer must involve the debtor's interest.

One area in which this becomes an issue is in the case of "earmarked funds" which are funds belonging to some third party which are funneled through the debtor, but which the debtor has no right to dispose of other than as required by the third party. In such a case the debtor is made no worse off for the transfer having been made and, arguably, a preference did not occur because the transfer was not really of the debtor's property. See, e.g., In re Kemp Pacific Fisheries, Inc., 16 F.3d 313 (9th Cir. 1994) (acknowledging the validity of the earmarking doctrine generally but finding it inapplicable under the circumstances because the borrowed funds which were the source of the transfer in the case had not been loaned subject to the condition that they be transferred to any particular creditor); Glinka v. Bank of Vermont (In re Kelton Motors, Inc.), 188 B.R. 125 (D. Vt. 1995) (funds lent to debtor for expressed purpose of paying off another oversecured creditor were earmarked funds). To the extent that the payment is made by some jointly obligated third party directly to the creditor, it is not a preference even if the payment otherwise reduces the debt of the jointly obligated third party to the debtor. Wallach v. Reo Distributing Services, Inc. (In re Alumni Enterprises Incorporated), 191 B.R. 554 (Bankr. W.D.N.Y. 1996) (holding that payment that customer of Chapter 7 debtor made to creditor-shipper from monies that would otherwise have become owed to debtor was not avoidable preference; customer, as consignee, became liable for shipping charges upon acceptance of delivery, and no agreement waived consignee liability).

Note, however, that the mere fact that the payment is made directly by a third party does not render the payment "earmarked funds." Unless earmarked in fact, the transfer of borrowed funds is, as a matter of law, the transfer of an interest of debtor in property. See, e.g., In re Smith, 966 F. 2d 1527, 1533 (7th Cir. 1992) (as a general rule a debtor's transfer of borrowed funds is a preferential transfer of the debtor's property under section 547(b)); Manchester v First Bank & Trust Company (In re Moses), 256 B.R. 641, 645 (10th Cir. BAP 2000) (upon execution of loan note the debtor had a legal and equitable interest in the loan proceeds and the transfer of the loan proceeds represented an interest of the debtor in property).

The source of the funds does not determine whether it is property in which a debtor has an interest, it is the debtor's ability to exercise control over the funds that makes it such property. Smith, 966 F. at 1531 (in demonstrating an interest in property the real question is whether the debtor was able to exercise sufficient dominion and control over the funds). See also, Warsco v Preferred Technical Group, 258 F. 3d 557, 564-65 (7th Cir. 2001) (transfer need not be made directly, indirect transfers made by third parties to creditor on behalf of debtor may also be avoidable; further noting that payments made by a third party purchaser of debtor's business directly to debtor's creditors as part of the consideration for the purchase would be an interest of the debtor in property); Hall-Mark Electronics Corporation v Sims (In re Lee), 179 B.R. 149 (9th Cir. BAP 1994) (payment by cashier's check was of an interest of the debtor in property); Official Committee of Unsecured Creditors v. Sharp Electronics Corp. (In re Phelps Technologies, Inc.), 245 B.R. 858 (Bankr. W.D. Mo. 2000) (transfer from a third party of funds it owed to a debtor directly to a debtor's creditor were of an interest of debtor in property); and Gray v The Travelers Insurance Company (In re Neponset River Paper Company), 231 B.R. 829, 833 (1st Cir. BAP 1999) (debtor's ability to direct the distribution of a working capital loan deposited with the debtor's attorneys rendered the payments of an interest of the debtor in property).

(B) Transfer on account of an antecedent debt. Whether a debt is antecedent depends on when it was incurred. A debt is incurred when the debtor first becomes obligated to pay, as opposed to the date on which the payment becomes due. Upstairs Gallery, Inc. v. Macklowe West Development Co., L.P. (In re Upstairs Gallery, Inc.), 167 B.R. 915 (9th Cir. BAP 1994) (holding that a lease termination payment was an antecedent debt even though it was in settlement of future rent payments; the obligation to make the rent payments during the term of the lease arose when the lease was first entered into). The Upstairs Gallery court further observed that a settlement of an antecedent obligation does not create a new obligation outside §547(b)(2) or within §547(c)(1) (the "contemporaneous exchange for new value" defense). 167 B.R. at 919 (distinguishing Lewis v. Diethorn, 893 F.2d 648 (3d Cir. 1990), which held that a payment in settlement of a lis pendens was not on account of an antecedent debt because the property rose in value as the result of the release of the lis pendens and therefore constituted new value).

(C) Calculation of 90 day period (for noninsider creditors). One common question which had arisen with respect to the 90 day aspect of a preferential transfer is whether a check delivered outside the 90 day "window," but which is paid by the drawee bank within the 90 day period, is within the preference period. The Supreme Court definitively resolved the question in Barnhill v. Johnson, 112 S.Ct. 1386 (1992), where it held that the transfer occurs on the date that the check is honored by the drawee bank. The reasoning of the Supreme Court was that until that point there was no irreversible (or "perfected") transfer. Cf. In re Lee, 179 B.R. 149 (BAP 9th Cir. 1995) (holding that transfer of a cashier's check occurs when check is delivered to the creditor). Closely related is the question of how the 90 days are calculated , i.e., by counting forward or backward. The issue is significant since, if you count forward, and the 90th day falls on a Saturday, Sunday, or holiday, the party pursuing the avoidance action could argue that the time should be extended to the first business day thereafter. In reliance on the statutory language which states that the preference period is the 90 days before the petition, the Third Circuit has held that the period is calculated by counting backward from the filing date. See Matter of Nelson Co., 959 F.2d 1260 (3d Cir. 1992). See also Research Group v. Kendall (In re Bergel), 185 B.R. 338 (9th Cir. BAP 1995)(holding that procedural rule extending deadline if final date falls on Saturday, Sunday or holiday, did not extend the substantive 90 day preference period).

(D) Presumption of insolvency within 90 days of bankruptcy filing. There is a presumption that the debtor is insolvent during the 90 days prior to the bankruptcy filing. 11 U.S.C. §547(f). The presumption imposes on the party against whom it is directed the burden of going forward with evidence to rebut or meet the presumption, but does not shift to such party the burden of proof in the sense of the risk of nonpersuasion. Fokkena v. Winston, Reuber, Byrne, P.C. (In re Johnson), 189 B.R. 744, 746 (Bankr. N.D. Iowa 1995). The risk of nonpersuasion remains throughout the trial on the trustee. Id. Courts differ on the strength of the evidence necessary to rebut the presumption, the opinions ranging from "substantial" to "some". Id., at 746-47 (settling on the requirement that evidence is sufficient to rebut the presumption if would reasonably support a finding to the contrary). Information from the debtor's schedules has been held sufficient to rebut the presumption of insolvency. Id., at 747 (citing Pembroke Development Corp. v. A.P.L. Window (In re Pembroke Development Corp.), 122 B.R. 610, 612 (Bankr. S.D. Fla. 1991). See also Lawson v. Ford Motor Company (In re Roblin Industries, Inc.), 78 F.3d 30 (2d Cir. 1996).

Two issues which commonly arise when the presumption is challenged are: (i) the impact of the debtor having filed schedules which show assets in excess of liabilities; and (ii) the proper method of valuing the assets. Schwinn Plan Committee v. AFS Cycle & Co., LTD. (In re Schwinn Bicycle Co.), 192 B.R. 477 (Bankr. N.D. Ill. 1996), addressed both issues. Schwinn, following extensive cited authority, held that the debtor's schedules were not dispositive in the determination of insolvency for purposes of an avoidance action. As observed in Schwinn, courts have allowed debtors themselves to introduce evidence to show that their own original schedules filed with the court were incorrect. 192 B.R. at 487-89. On the question of valuation of the assets, the court, again following extensive cited authority, held that the standard is "going concern value" (i.e., some multiple of earnings) unless the business is in a precarious financial condition or on its financial deathbed, in which case an (orderly) liquidation valuation should be used. 192 B.R. at 485-87.

Equally important to the determination of solvency is the valuation of a debtor's liabilities. Issues arise where the liabilities are unliquidated or contingent. Valuation of debts should take into account all relevant factors. Debt due in the future should be valued at its present value (which may be more or less than par depending on the coupon interest rate.) Contingent liabilities (including guarantees) should be discounted by the probability that such contingency will occur as well as the time value of money. See, e.g., Matter of Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir. 1988). Unliquidated debts also somehow need to be valued.

(E) Allows creditor to receive more than it would have received in Chapter 7. With respect to the last element, courts typically hold that the key factor is the percentage the creditor would have recovered from the bankruptcy estate had the transfer not been made and the debtor liquidated under Chapter 7. Committee of Creditors Holding Unsecured Claims v. Koch Oil Company (In re Powerine Oil Company), 59 F.3d 969, 972 (9th Cir. 1995). The fact that the creditor may have had recourse against some other party is irrelevant in the determination of whether this element has been satisfied. Id. (holding that fact that creditor had letter of credit which could have been drawn upon had debtor not paid the obligation is irrelevant). Interestingly, the Ninth Circuit observed in Powerine Oil that the result of its decision was that the creditor would have been better off had the debtor defaulted. As a result of the payment from the debtor, the creditor did not draw on the letter of credit and it lapsed so that the creditor was subject to the recovery of the preference without having retained the right of recourse.

In the case where the recipient of the alleged preference would have been an unsecured creditor, the requirement of §547(b)(5) is met simply by a showing that unsecured creditors will receive less than 100% recovery on their claims. Official Committee of Unsecured Creditors v Conceria Sabrina SPA (In re R.M.L., Inc.), 195 B.R. 602, 612 (Bankr. M.D. Pa. 1996). This is often referred to as the "greater percentage" test, i.e., that the creditor received a greater percentage of payment on his debt as a result of the payment than any other creditor similarly situated. Campbell v Equibank (In re Meinhardt Mechanical Service Company, Inc.), 72 B.R. 548, 550 (Bankr. W.D. Pa. 1987). The greater percentage test is satisfied when the debtor's liabilities exceeded its assets at the date of the bankruptcy filing. See, e.g., Corporate Food Management, Inc. v Suffolk Community College (In re Corporate Food Management, Inc.), 223 B.R. 635, 646 (Bankr. E.D.N.Y. 1998) (Court found unsecured creditors would receive less than 100% after taking judicial notice of schedules and filed claims which indicated claims in excess of assets). It is also satisfied by testimony that there is no conceivable scenario under which unsecured creditors will receive 100% of their claims. Official Committee of Unsecured Creditors of Toy King Distributors, Inc. v. Liberty Savings Bank, FSB (In re Toy King Distributors, Inc.), 256 B.R. 1, 96 (Bankr. M.D. Fla. 2000).

(F) Burden of proof. The burden of proving the elements of a preferential transfer is on the trustee or other person or entity seeking the avoidance. See 11 U.S.C. §547(g). This is not, however, typically a difficult matter. As discussed above, there is a presumption of insolvency in the 90 day period preceding the bankruptcy. Thus there is generally no need for the trustee to present any evidence on that element in a case against a noninsider creditor. The last element is, as a matter of mathematics, established by the debtor's insolvency. See, e.g., McCord v. Venus Foods, Inc. (In re Lan Yik Foods Corp.), 185 B.R. 103, 108-09 (Bankr. E.D.N.Y. 1995) (accepting view that as long as the distribution to creditors in bankruptcy is less than 100%, any payment on account to an unsecured creditor during the preference period will enable that creditor to receive more than it would have received in liquidation had the payment not been made). The other three elements are generally established by business records.

(G) Recovery of value transferred. While it is §547(b) which authorizes the avoidance of the a preferential transfer, it is §550 which provides for the recovery, for the benefit of the bankruptcy estate, of the property transferred or, if the court so orders, the value of such property. Pursuant to §550(a) the trustee may recover from the initial transferee, any immediate or mediate transferee of such initial transferee, or the entity for whose benefit the transfer was made, provided, however, that a trustee may not recover from any immediate or mediated transferee of the initial transferee if the immediate or mediate transferee takes for value and without knowledge of the voidability of the transfer. See §550(b). Note that §550(b) does not require that the immediate or mediate transferee give reasonable equivalent value in order to be immune from recovery, only that they give some value. Martin J. Bienenstock, Bankruptcy Reorganization, p. 430-32 (Practicing Law Institute 1987).

Courts typically exclude from the definition of "initial transferee" any person or entity which acts as a mere conduit for the transfer. Whether a transferee is a mere conduit appears to turn on the recipient's ability or right to exercise some degree of dominion or control over the property. See, e.g., Durkin v. Piper Trust Company (In re Denman & Co.), 186 B.R. 707 (Bankr. C.D. Cal 1995) (holding that a trustee of trust receiving fraudulent conveyance is not an initial transferee for purposes of liability under §550 unless the trustee is shown to have exercised control over funds of the trust for its own behalf). From a strategic perspective, where the immediate or mediate transferee takes in good faith and for value, without knowledge of the avoidability of the transfer, the only way the trustee is going to recover is to show that the immediate or mediate transferee was an initial transferee because the initial transferee was a conduit. See, e.g., Gordon v. Westside Bank & Trust Company (In re Combs), 190 B.R. 979 (Bankr. N.D. Ga. 1995). Accordingly, the conduit argument may be used by the trustee as a "sword."

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II. THE DEPRIZIO PROBLEM

No discussion of preferences is complete without mentioning DePrizio. In 1989, the Seventh Circuit Court of Appeals held in Levit v. Ingersoll Rand Financial Corp. (In re V.N. DePrizio Construction Co.), 874 F.2d 1186 (7th Cir. 1989), that a noninsider creditor may be subject to the one-year preference period where it has a guarantee from an insider. The holding of the Court in DePrizio was based on a highly technical reading of the statutory language.

There were ways of potentially getting around DePrizio such as the waiver by the guarantor of subrogation rights. See, e.g., Hostmann v. First Interstate Bank of Oregon, N.A. (In re XTI Xonix Technologies, Inc.), 156 B.R. 821 (Bankr. D. Or. 1993); and Hendon v. Assoc. Commercial Corp. (In re Fastrans, Inc.), 142 B.R. 241 (Bankr. E.D. Tenn. 1992). However, the existence of the doctrine created a risk for creditors demanding guarantees from insiders, particularly where the guarantees were of no substantive value because the insiders were judgment proof.

The 1994 amendments to 11 U.S.C. §550 (by the addition of §550(c)) precluded recovery from a non-insider outside the 90 day period (but did not preclude the avoidance of a preferential lien). In 2005, the 11 U.S.C. §547 was itself amended (by the addition of §547(i)) to deal with the lien avoidance concern. The §547(i) addition provides that if the trustee avoids . . . a transfer made between 90 days and 1 year before the date of the filing of the petition, by the debtor to an entity that is not an insider for the benefit of a creditor that is an insider, such transfer shall be considered to be avoided under this section only with respect to the creditor that is an insider). See also House Judiciary Report to Accompany S. 256, Section by Section Analysis, §1213, p. 143 ("The 1994 amendments . . . failed to make a corresponding amendment to section 547, . . . [and a]s a result, a trustee could still utilize section 547 to avoid a preferential lien given to a noninsider bank . . . .") Neither amendment precludes recovery from the benefited insider. See Gordon v Sturm (In re M2Direct, Inc.), 282 B.R. 60, 63-4 (Bankr. N.D. Ga. 2002).

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III. COMMON TRADE CREDITOR STATUTORY DEFENSES

There are three statutory defenses potentially available to trade creditors. The burden of proving the existence of the statutory defenses are, not surprisingly, on the party asserting the defense. See 11 U.S.C. §547(g). The quantum of proof is by a preponderance of the evidence. McLaughlin v. Hoole Machine and Engraving Corp. (In re Parkline Corp.), 185 B.R. 164, 168 (Bankr. D.N.J. 1994).

(A) Contemporaneous exchange defense

Section 547(c)(1) provides a defense to a preferential transfer to the extent that such transfer: (A) was intended by the debtor and creditor to be a contemporaneous exchange for new value given to the debtor; and (B) was in fact a substantially contemporaneous exchange.

There are five issues that generally arise under this defense, those being:

(a) what was the intent of the parties;

(b) what types of consideration qualify as new value;

(c) whether a defendant must establish the value of the property transferred to the debtor in order to invoke the defense;

(d) whether the transaction is in fact substantially contemporaneous; and

(e) what date is the date of transfer if payment is by check.

See H. Bruce Bernstein and William J. Factor, Defending Preference Litigation: Some Recent Developments, Commercial Law Bulletin, November/December 1994, p. 13.

The intent of the debtor and creditor is important. The courts look for some "manifest desire by the parties that the exchange contemporaneously grant money or money's worth in new credit, goods, services or property to the debtor in order to sustain a finding of intent." Id., p.14, n.11, citing Creditors' Committee v. Spada (In re Spada), 903 F.2d 971, 975 (3d Cir. 1990). The manifestation can result from the express agreement of the parties, their course of dealing, etc. There is, however, a distinction between what is intended as a substantially contemporaneous exchange and that which is intended to be settled up within a short period of time. If an exchange is intended to be contemporaneous, for example, the grant of a security interest, the perfection may be found to be contemporaneous even if there is a three or four week delay in perfection after the exchange. Id., n.16, citing Pine Top Ins. Co. v. Bank of America Nat. Trust and Sav. Ass'n, 969 F.2d 321 (7th Cir. 1992). On the other hand, if it is intended for the creditor to extend a period of credit, regardless of how short, the exchange will not be considered contemporaneous. Id., n.18, citing Wasserman v. Village Assocs. (In re Freestate Mgt. Svcs., Inc.), 153 B.R. 972 (Bankr. D. Md. 1993)(holding that repayment of short term loan was not intended to be a substantially contemporaneous exchange). See also Matter of Anderson-Smith & Associates, Inc., 188 B.R. 679, 688 (Bankr. N.D. Ala. 1995) (an extension of credit, no matter how brief, does not constitute a contemporaneous exchange).

On the question of whether the creditor has provided "new value," the Code defines new value at §547(a)(2) as money or money's worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the trustee or debtor under an applicable law. In addition to those exchanges which clearly evidence new value, courts have also found that new value is provided when a creditor agrees to modify existing loan terms, provides a personal guarantee that enables the debtor to obtain financing from a third party, or dismisses a lawsuit. Bernstein and Factor, notes 23, 24 and 25. Conversely, courts have held that new value is not provided by a creditor's promise to continue to conduct business in exchange for payment of an antecedent debt, payment of an obligation that the creditor had guaranteed, or agreement to forebear. Id., p.15, notes 34, 35, and 36; citing Nordberg v. Arab Banking Corp. (In re Chase & Sanborn Corp.), 904 F.2d 588, 595-96 (11th Cir. 1990) (on affect of promising to conduct business); Lowrey v. U.P.G., Inc. (In re Robinson Bros. Drilling, Inc.), 877 F.2d 32, 34 (10th Cir. 1989) (on affect of paying an obligation the creditor had guaranteed); and United States Lines (S.A.), Inc. v. United States (In re McLean Industries, Inc.), 162 B.R. 410, 424 (S.D.N.Y. 1993), rev'd on other grounds, ___ F.2d___(2nd Cir. 1994) (on affect of forbearance).

Closely related to the question of whether the value is new is the question of what it was worth. Courts hold that credit or property transferred to the creditor are insulated from avoidance only to the extent such property is equivalent to the amount of new value transferred to the debtor. Id., n.15. See also Committee of Creditors Holding Unsecured Claims v. Koch Oil Company (In re Powerine Oil Company), 59 F.3d 969, 973-74 (9th Cir. 1995) (holding that payment from the debtor in lieu of a draw on a letter of credit which the debtor had given to secure payment was contemporaneous exchange only to the extent that the bank which had issued the letter of credit had itself been secured in assets of the debtor (to secure its contingent reimbursement claim if the letter of credit had been drawn)).

On the question of whether the exchange was substantially contemporaneous in fact, the courts look at the facts and circumstances as well as the temporal proximity between the transfers. This element is closely related to the intent of the parties. Thus, not only must the parties intend for the exchange to be substantially contemporaneous, but the exchange must, in fact, be substantially contemporaneous.

Finally, recent decisions have held that the exchange for purposes of this defense occurs when the check is delivered rather than when it is honored. Id., n. 65, citing Braniff Airways, Inc. v. Midwest Corp., 873 F.2d 805 (5th Cir. 1989). See also Barnhill v. Johnson, 112 S.Ct. 1386 (1992).

(B) Ordinary course of business defense

Section 547(c)(2) provides a defense to a preference action to the extent that the transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—
(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or
(B) made according to ordinary business terms

This represents a change in the prior law. Before 2005, the defense required the proof of both ordinariness between the debtor and the transferee and ordinariness with respect to the industry. As discussed in the legislative comments to the amendment, the change is to provide that a trustee may not avoid a transfer to the extent such transfer was in payment of a debt incurred by the debtor in the ordinary course of the business or financial affairs of the debtor and the transferee and such transfer was made either: (1) in the ordinary course of the debtor's and the transferee's business or financial affairs; or (2) in accordance with ordinary business terms.

As indicated by both the statutory language and the legislative comments, the defense first requires that the debt have been incurred in the routine operation of the debtor and the transferee. See, e.g., See Youthland, Inc. v. Sunshine Girls of Florida, Inc. (In re Youthland, Inc.), 160 B.R. 311, 314 (Bankr. S.D. Ohio 1993).

Provided that the debt had been incurred in the routine operation of the businesses of both the debtor and the transferee, one of two alternative elements must be established. The first of the alternatives requires the court to determine the "ordinariness" of the payment in the relationship between the two parties. This is a factual issue, the resolution of which focuses on a subjective analysis of the parties' business dealings with each other. Youthland, 160 B.R. at 314; Lan Yik Foods, 185 B.R. at 110-11 (the subjective inquiry into ordinariness suggests some consistency with other business transactions between the parties rather than a rigid similarity to past transactions). The court looks at the course of dealings between the debtor and the creditor both before and during the preference period in order to determine whether there was any deviation in conduct during the preference period. If the days outstanding, manner of payment, and other terms and conditions remain essentially the same both before and during the preference period, the payment can be said to have been made in the ordinary course of business or financial affairs of the debtor and the creditor.

Lan Yik Foods, 185 B.R. at 111-12, spoke in terms of the need for the creditor to establish a "baseline of dealings" during a period before the debtor began to get in financial difficulty if the relationship between the debtor and creditor predated the debtor's financial difficulty. In Lan Yik Foods the baseline established a history of payments between 53 and 142 days (with an average of 95 days) after invoicing in 1990, and payments between 63 to 99 days (with an average of 83 days) during the 1991-1992 period. During the preference period there were 4 payments ranging between 104 and 115 days after invoicing. The court held that the average days outstanding during the preference period (which was 15 days later than the 1990 average and 27 days later than the 1991-1992 average) was not alone sufficient to show that the payments did not follow the ordinary course. Absent evidence of any "unusual" action by the creditor (such as a change in form of payments, cessation of business activity between the parties, etc.), and the fact that the payments made during the preference period were roughly within the historical range, the court concluded that the second element had been satisfied. See also McLaughlin v. Hoole Machine and Engraving Corp. (In re Parkline Corp.), 185 B.R. 164, 169-70 (Bankr. D.N.J. 1994) (holding that late payments were not outside the ordinary course where they were still within the prepreference period range of days outstanding, and that the relationship between the parties had otherwise not changed and the creditor had taken no unusual action to collect the payments).

The focus of the courts on the prior course of dealing between the debtor and creditor creates an interesting question as to whether a single business transaction can be ordinary course. See, generally, Lisa Sommers Gretchko, Preference Primer: Is once Enough? Is the Isolated Transaction Ordinary?, ABI Journal, September 1995, p. 22. Gretchko's article observed the dearth of case law on the issue and discussed the few available opinions. Among the cases discussed were In re Morren Meat and Poultry Company, Inc., 92 B.R. 737 (W.D. Mich. 1988) (holding that a single transaction could be ordinary); In re Keller Tool Corp., 151 B.R. 912 (Bankr. E.D. Mo. 1993) (following Morren's legal conclusion that a single transaction could still be ordinary course but deciding on very similar facts to Morren that the transaction was not ordinary course); and In re Brown Transport Truckload, Inc., 152 B.R. 690 (Bankr. N.D. Ga. 1992) (concluding that an isolated transaction is per se ineligible for the ordinary course of business defense). Gretchko suggested that as a matter of strict statutory construction Brown Transport appeared correct, but that Morren appeared more consistent with the legislative intent behind the defense (which was to leave undisturbed normal financial transactions involving no unusual action by the debtor or creditor during the debtor's slide into bankruptcy).

The alternative to showing the ordinary course of business as between the debtor and the transferee is to show that the payment was within the range of terms that encompasses the practice in which firms, similar in some general way to the creditor (and, perhaps, the debtor), engage. Under pre-amendment law, only dealings so unusual as to fall outside that broad range are deemed extraordinary for purposes of this element. See, e.g., Roblin Industries, 78 F.3d 38-43; Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044 (4th Cir. 1994); Fiber Lite Corporation v. Molded Acoustical Products, Inc. (In re Molded Acoustical Products, Inc.), 18 F.3d 217 (3d Cir. 1994) (embellishing the rule by finding that the third element countenances a greater departure from that range of terms (representing the industry norm) the longer the pre-insolvency relationship between the debtor and creditor).

It is not crystal clear, however, at this point, that cases dealing with the industry terms element in the pre-amendment statute are still applicable. See In re National Gas Distributors, LLC, 346 B.R. 394 (Bankr. E.D.N.C. 2006) (holding, among other things, that the industry terms must be consistent with both the debtor's and transferee's industries). National Gas held that simple consistency with "industry" terms would not save a transfer that, given the factual circumstances, was not ordinary. The transfer(s) in National Gas were found to have been made in contemplation of the debtor's liquidation and for the benefit of the insiders who had guaranteed the debt. Under, National Gas, the requirements for the "industry term" alternative element has been heightened by having been set apart.

To the extent still applicable, pre-BAPCPA cases held that self-serving testimony by the defendant in the preference action of the range of terms utilized by creditors in the industry may be sufficient when there is no evidence to the contrary. Lan Yik Foods, 185 B.R. at 114 n.32. But see Logan v. Basic Distribution Corp. (In re Fred Hawes Org., Inc.), 957 F.2d 239, 246 (company president's self-serving testimony regarding industry standards was found by court to lack credibility and reliability); Anderson-Smith, 188 B.R. at 687 n.3 (testimony that creditor normally required its customers to personally guarantee unusually large orders or assign the proceeds was self-serving and not determinative of the ordinary course). To the extent accepted, self-serving testimony must represent direct evidence of the practice of other creditors and not simply testimony that the defendant creditor's practice is consistent among its customers. Matter of Midway Airlines, 69 F.3d 792 (7th Cir. 1995).

Midway Airlines provides an excellent outline of the considerations of a creditor preparing to establish the third element of the ordinary course of business defense. Midway Airlines involved an appeal from a determination that the creditor had not sufficiently satisfied the third element of the defense. In that case, the creditor sought to satisfy the third element by testimony from the defendant's president that the defendant's other airline customers' payment history was similar to the debtor's. The president admitted on cross-examination that he had no personal knowledge of his competitors' credit practices. The Seventh Circuit affirmed the lower court's determination that the president's testimony was insufficient to satisfy the third element of the defense. The Court observed that the defendant sought to satisfy the third element indirectly - by using its relationship with the debtor and other airline customers to prove the existence of a unified industry using unified terms. The defendant's practices are alone inadequate since the purpose of the third element is to draw a subjective - objective dichotomy. The defendant's relationship with the debtor (and other firms in the industry) is the "subjective" aspect contained within the second element. The third element requires direct competent evidence the range of terms utilized by other creditors doing business with the debtor and other customers in the industry.

Evidence of what other creditors in the industry are doing can come from testimony of other creditors, experts, or from trade associations. However, as pointed out by the Seventh Circuit, it can also come from the defendant's own employees provided they have direct personal knowledge of what other creditors in the industry are doing.

Midway Airlines is also instructive on the question of how to define the relevant industry. The defendant, which was a millwork company engaged in making custom cabinetry for the airline industry, asserted that the relevant industry was "airline custom millwork." The Bankruptcy trustee, who was pursuing the preference action, asserted that the relevant industry was "millwork firms doing some business with the airlines" (a much larger number of companies). Although the Seventh Circuit apparently found it unnecessary to directly address this issue, it did observe that the defendant's evidence that most of its customers were airlines did not satisfactorily define the industry. The defendant's evidence did not address, in any meaningful way, the customer bases of its competitors or the capacity of those competitors to serve other industries. 69 F.3d at 799 n 10.

In a further refinement of this defense, the Tenth Circuit recently concluded that ordinary business terms refers to terms that are used in usual or ordinary situations when debtors are financially healthy. See Bernstein and Factor article, p.18, citing Clark v. Balcor Real Estate Fin. Inc. (In re Meridith Hoffman Partners), 12 F.3d 1549, 1552-53 (10th Cir. 1994), cert. denied, 114 S.Ct. 2677 (1994). Thus, abnormal collection arrangements used when a debtor is in default or is otherwise financially unhealthy is outside the scope of this defense even if those arrangements are customary in the industry when dealing with troubled debtors. Id. But compare Roblin Industries, 78 F.3d at 41 (declining to adopt a rule that payments made pursuant to debt restructuring agreements, even when the debt is in default, can never be made according to ordinary business terms as a matter of law; that determination is a question of fact that depends on the nature of industry practice in each particular case). The Second Circuit suggested in Roblin Industries that there are circumstances where frequent debt rescheduling is the ordinary and usual practice within the industry, and that creditors operating in such an environment should have the opportunity to assert the ordinary course of business exception. The Court went on to find that the creditor in the case before it failed to establish the industry practice and, therefore, failed to show that the restructuring agreement it had entered into with the debtor was ordinary in the industry as required by §547(c)(2)(C).

(C) New value defense

Section 547(c)(4) provides a defense to a preference action to the extent that after the preferential transfer was made the creditor gave new value to or for the benefit of the debtor that was: (A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.

The concept of "new value" was discussed above in relation to the contemporaneous exchange defense. The definition of new value remains the same for purposes of this defense. Two reoccurring issues under this defense are related to the "subsequent advance rule" and the "remains unpaid" requirement.

The subsequent advance rule requires that the creditor establish that the new value was extended after the preferential transfer. Application of the rule typically involves a detailed analysis of the payment and shipment history between the debtor and the creditor. Each payment to the creditor must be matched, and offset, against a subsequent advance of credit to the debtor. See Bernstein and Factor article, p.19, citing among other cases, Bash v. American Tool Cos. (In re George Worthington Co.), 163 B.R. 115, 117 (Bankr. N.D. Ohio 1994). As with the ordinary course of business defense, the date of transfer in the case of checks is ordinarily treated as the date the check is delivered, rather than the date it is honored by the drawee bank. See Bernstein and Factor article, p.19, n.118.

The issue under the "remains unpaid" requirement pertains to the question of whether a payment for the subsequent advance which is itself avoidable negates the availability of the new value defense. As one court has observed, imposing a "remains unpaid" requirement could expose a creditor to double liability, once for the original payment and then for the payment for the subsequent advance. Id., n.123, citing Allied Companies, Inc. v. Broughton Foods Co. (In re Allied Companies, Inc.), 155 B.R. 739, 744-45 (Bankr. S.D. Ind. 1992). This result seems inequitable, although courts have gone both ways on the "remains unpaid" requirement. Id., notes 121 - 124. Cases cited within the notes include: Laker v. Vallette (In re Toyota of Jefferson, Inc.), 14 F.3d 1088 (5th Cir. 1994) (holding that the new value need not remain unpaid); and Kroh Bros. Dev. Co. v. Continental Construction Engineers, Inc. (In re Kroh Bros. Dev. Co.), 930 F.2d 648 (8th Cir. 1991) (holding that a creditor may not assert the new value defense to the extent the creditor has been paid for the new value). See also In re IRFM, Inc., 52 F.3d 228 (9th Cir. 1995) (holding that new value need not remain unpaid as long as the transfer by which it has been paid is not itself unavoidable).

(D) Nominal preference (less than $5000) defense

Under post-2005 BAPCPA cases, only transfers aggregating $5000 or more in the case of debtor whose debts are primarily nonconsumer can be avoided. See 11 U.S.C. §547(c)(9).


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IV. "PROCEDURAL" DEFENSES

It is important to note that the procedural defenses, while potentially preventing the avoidance and/or recovery of the preferential transfer, may not act as a total shield. This arises from the potential impact of §502(d) which provides for the disallowance of any claim of an entity which received, but did not relinquish, a preferential or other avoidable transfer. While there are cases going the other way, the majority view is that §502(d) is available to disallow a claim of the recipient of a preferential transfer whether or not the transfer is itself avoidable. See, e.g., United States Lines, Inc. v. United States (In re McLean Industries, Inc.), 184 B.R. 10 (Bankr. S.D.N.Y. 1995).

(A) Statute of limitations

For bankruptcy cases initiated after October 22, 1994, preference actions (as well as other types of avoidance actions) may not be commenced after the earlier of:

(a) two (2) years after the entry of the order for relief, plus up to one (1) extra year after the appointment of a trustee provided the trustee was appointed before the end of the initial two (2) year period; or

(b) the time the case is closed or dismissed.

See 11 U.S.C. §546(a), amended October 22, 1994. Accordingly, under the amended §546, the longest the trustee would have to initiate a preference action is 3 years after the filing provided that the trustee was appointed before the initial two year period ended. A debtor would, at most, only have two years.

This is a significant change from the pre-amendment §546 which appeared to set no limitation on the initiation of an avoidance action by a debtor in possession, and which appeared to further give a trustee two (2) years from his or her appointment to file the action regardless of how old the case was when the trustee was appointed. Notwithstanding, this apparent reading of the pre-amendment §546, a number of courts of appeals, including the Third Circuit, held that a two year statute would be imposed on a debtor in possession. However, even with this conclusion, it still appears that for pre-amendment cases, whether or not the debtor in possession is precluded, a trustee still has two years from his or her appointment.

(B) Standing and other related defenses

The standing defense arises out of the requirement that: (1) any party, other than the trustee (or debtor in possession in a Chapter 11), must have been expressly authorized by court order, or by the plan, to purse avoidance actions; and (2) that the Code (specifically 11 U.S.C. §550(a)) requires that the avoidance powers be exercised for the benefit of the estate. Accordingly, challenges to standing typically arise where the party prosecuting the preference (or other avoidance) action is neither the debtor in possession or the trustee and/or where the proceeds are to be distributed to parties other than the general unsecured creditors.

Courts use a two-part test to determine if a party other than the debtor in possession or trustee has standing to assert avoidance actions: is the party an appointed representative and does the party represent the estate. The first element is ordinarily straightforward, i.e., was there something done by the court or in the confirmed reorganization plan which would constitute an appointment. The second element often turns on the court's perception of whether the estate is being benefited. Most courts hold that payment to any party associated with the case benefits the estate. See, e.g., Trans World Airlines, Inc. v. Travelers Int'l AG (In re Trans World Airlines), 163 B.R. 964 (Bankr. D. Del. 1994) (finding benefit to estate where proceeds of preference recovery would be paid to secured lender); Winston & Strawn v. Kelly (In re Churchfield Mgmt. & Inv. Corp.), 122 B.R. 76 (Bankr. N.D. Ill. 1990) (finding benefit where proceeds would be paid to a party acquiring right to pursue action). There is, however, some authority for the proposition that the proceeds of the preference actions, at least in the case of those pursued by the reorganized debtor or other entity after confirmation of a plan, must be committed to the unsecured creditors in order for there to be a benefit to the estate. See Harstad v. First Am. Bank (In re Harstad), 155 B.R. 500 (Bankr. D. Minn. 1993).

Somewhat related to the defense of standing are the defenses of equitable estoppel, judicial estoppel, lack of subject matter jurisdiction, and res judicata. All four of these defenses potentially arise in the context of the pursuit of a preference (or other action) after plan confirmation. In the case of equitable and judicial estoppel, the issue arises where the existence of the cause of action was not adequately disclosed either in the plan or disclosure statement or in other bankruptcy filings. The second two, lack of subject matter jurisdiction and res judicata, potentially arise where the plan failed to expressly retain the right to pursue the actions.

(C) Demand jury trial

A strategic option available to the creditor if it did not file a proof of claim (and thereby submit to the court's jurisdiction to determine claims), is to demand a jury trial in response to a preference action. The ability to avoid and recover preferences has nothing to do with any wrongdoing on the part of the creditor. It is possible that a jury may have some difficulty grasping the concept of the avoidance of preferences where a creditor has done nothing wrong (and in fact may even have somehow been the victim of the debtor's wrongful conduct.) In any event, this may be a viable maneuver where there is a significant issue of fact (e.g., what is ordinary course of business, what was the parties intent where the contemporaneous exchange defense is asserted, were the funds earmarked, etc.), and there is a reason to believe that the court will be much less sympathetic to the defendant's arguments than would a jury.

(D) Venue

The 2005 BAPCPA amended 28 U.S.C. §1409(b) (the venue section) to require actions seeking less than $10,000 (against non-insiders) to be filed in the district court in the district in which the defendant resides.

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V. FILE PROOF OF CLAIM IF TRANSFER AVOIDED

If all else fails, and the transfer is avoided and recovered, the creditor is entitled to assert a claim for that amount. However, in order to assert the claim, the creditor must file a proof of claim within 30 days of the date that the judgment against the creditor became final. See Fed. Rule Bankr. Proc. 3002(c)(3). Failure to timely file the claim will constitute grounds to disallow it. See, e.g., In re International Diamond Exchange Jewelers, Inc., 188 B.R. 386 (Bankr. S.D. Ohio 1995). Note further, however, that if the judgement is not satisfied, the claim, although timely filed, will be disallowed. See 11 U.S.C. §502(d) and Rule 3002(c)(3).