Contractual Obligations Disclosed in Management's Discussion and Analysis

Preferences in Bankruptcy

Financial Executives Research Foundation

Issue Alert

October 2003 Preference in Bankruptcy

Purpose The Bankruptcy Code currently provides that a debtor, a trustee or other authorized estate representative may recover payments made to noninsider creditors within 90 days of a bankruptcy filing, for the benefit of the debtor’s estate. This report reviews the preference provisions of the bankruptcy code and summarizes some of the most commonly invoked defenses employed by creditors who become targets of preference claims. Although the preference provisions of the Bankruptcy Code have not been substantially changed in a number of years, this report is being issued because many financial executives may not be aware of their implications. Introduction Have you found yourself in this situation? You receive a demand letter from a vendor or customer who had filed for bankruptcy, asking you to return all monies that they paid to you within 90 days prior to their bankruptcy filing, even though the monies were received for goods or services provided (and received) in good faith. You then think about all of the money that the vendor or customer did not pay you because of their pending bankruptcy. The letter then offers to allow you to deduct 20% of this total amount, as a discount, if you pay the remaining 80% within the next 15 days. However, it also states that if you do not pay the full amount within 15 days, you will be sued. What did you do? What should you have done? This Issue Alert is intended to provide some basic information to help financial executives understand the complicated preference laws and how they can and should respond to lawsuits with which they may be faced. What is a “Preference”? Section 547 of the Bankruptcy Code implements a bankruptcy policy favoring equality of treatment of similarly situated creditors. Generally, a payment made by a debtor in the 90 days before its bankruptcy filing may be considered a preferential transfer and can be recovered by the debtor, trustee or other duly authorized estate representative. 1

The Bankruptcy Code provides a six-part test for determining whether a payment constitutes a preferential transfer: (1) The transfer must be of an interest of the debtor, (2) To or for the benefit of a creditor, (3) For an account of antecedent debt, (4) Made while the debtor was insolvent (presumed for the 90 days before bankruptcy), (5) Made on or within 90 days of the petition date (one year in the case of transfers to insiders), and (6) That allowed the creditor (i.e. preference target) to receive more than it would have received in a hypothetical Chapter 7 liquidation of the debtor. The debtor or other party prosecuting the preference case has the burden of proof in court to establish these six (6) elements. However, in enacting this statute, Congress did not intend to discourage companies from doing business with financially distressed parties. Accordingly, the Bankruptcy Code provides for various defenses to otherwise avoidable preferential transfers. Of those defenses, the two most commonly invoked are (a) the ordinary course of business defense and (b) the new value defense. The preference defendant (the company that received the allegedly preferential transfers) has the burden of proof to establish its defenses. Ordinary Course of Business Defense Bankruptcy Code Section 547(c)(2) provides that the trustee or debtor may not recover a preferential transfer if it was: (a) In payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; (b) Made in the ordinary course of business or financial affairs of the debtor and the transferee; and (c) Made according to ordinary business terms. In determining whether a transaction is made in the ordinary course of business and according to ordinary business terms, courts must make two analyses. The first analysis is a subjective inquiry of whether the allegedly preferential payments were consistent with the previous payment history between the debtor and the creditor. In applying the subjective approach, bankruptcy courts look to numerous factors before determining whether or not a specific payment is preferential. These factors include, but are not limited to: (1) The length of time the parties have engaged in the type of dealing at issue; (2) Whether the subject payment was in an amount that differed significantly from prior payments; (3) Whether the timing of the payments was different in relation to previous payments; and (4) Whether there appears to be any unusual action by either the debtor or creditor to pay or collect on the debt (i.e. wire transfers when most payments had typically been made by check).

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For example, your company continues to ship product to a customer, even though past due invoices have not been paid. You threaten to stop shipping product until you are paid. The customer then pays all past due invoices, but files for bankruptcy soon after. Payments of invoices less than 30 days old could be considered to be payments made in the ordinary course of business, and, if sued, you could invoke the ordinary course of business defense against the debtor trying to recover these payments as preferential transfers. However, the ordinary course of business defense would not be used against recovery of payments for invoices over 30 days old. New Value Defense Bankruptcy Code Section 547(c)(4) provides that the trustee/debtor may not avoid a preferential transfer to the extent that after such transfer, such creditor gave new value to or for the benefit of the debtor. The purpose of the new value defense provided by Section 547(c)(4) is to protect creditors who have continued to do business with the debtor after having received an allegedly preferential transfer and to encourage creditors to continue to extend unsecured credit to debtors in financial trouble, thus reducing the number of bankruptcy filings by keeping marginal businesses afloat. The courts have endorsed two different interpretations of the new value defense under Section 547(c)(4): (a) paid new value and (b) unpaid new value. Unpaid New Value Under the unpaid new value interpretation of Bankruptcy Code Section 547(c)(4), a creditor has a defense to a preferential payment if: (1) The creditor received a transfer that is otherwise voidable as a preference under Section 547(b); (2) After receiving the preferential transfer, the preferred creditor advanced "new value" to the debtor on an unsecured basis; and (3) The debtor did not fully compensate the creditor for the "new value" as of the date that it filed for bankruptcy. For example, assume that Creditor X was given a payment of $10,000 on May 1, 2001 (within the 90-day period prior to the Debtor’s bankruptcy filing) and then shipped goods worth $10,000 to the Debtor within the preference period for which Creditor X was never paid. Creditor X would have a complete defense to the preferential transfer and would have no Section 547 liability to the Debtor. Paid New Value Under the paid new value interpretation of Section 547(c)(4), a creditor would have a defense to a preferential payment if: (1) New value was given to the debtor after a preferential transfer; (2) The new value given was unsecured; and (3) The new value was paid for by an otherwise unavoidable transfer. Instead of barring the new value defense altogether anytime new value has been repaid, this approach allows the new value defense if the trustee or debtor can recover the repayment by some other means. For example, if the creditor was paid for its advance of new value on terms which resulted in the unavailability of any recognizable preference defense (such as payment of the invoice within terms which means the transfer is protected by the ordinary course of business defense), such a creditor could still use its advance of new value to offset its receipt of any prior preferential payments.

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Conclusion As you can see, the preference laws are highly technical, and whether or not your company will have a valid preference defense will depend on a careful analysis of the facts and circumstances surrounding your company’s dealings with the debtor in question. Accordingly, it is imperative that you consult with your legal counsel if you receive that dreaded letter or preference complaint in the mail. The information provided in this Alert is for informational purposes only, and should not be construed or relied upon as legal advice. This Issue Alert was authored by Mark A. Berkoff, Esq., and Deborah M. Gutfeld, Esq., of Piper Rudnick LLP http://www.piperrudnick.com/ Copyright © 2003 by Financial Executives Research Foundation, Inc. All rights reserved. No part of this publication may be reproduced in any form or by any means without written permission from the publisher. Financial Executives Research Foundation, Inc. is an affiliate of Financial Executives International. The purpose of the Foundation is to sponsor research and publish informative material in the field of business management, with particular emphasis on the practice of financial management and its evolving role in the management of business. Order this and other Research Foundation publications by logging on to www.fei.org/rfbookstore/. Discounts available to FEI members and Foundation donors. The FEI Research Foundation is a 501(c)(3) independent nonprofit educational organization. The Foundation relies on voluntary, tax-deductible contributions from corporations, FEI chapters and individuals. The Foundation receives no portion of FEI membership dues. BECOME A CORPORATE SUBSCRIBER TODAY WITH A 100% TAXDEDUCTIBLE PLEDGE OF $250 TO FERF AND RECEIVE ALL FUTURE PUBLICATIONS, AS WELL AS MONTHLY TOPICAL AND ISSUE ALERTS, FREE OF CHARGE FOR ONE FULL YEAR.

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