I. Preference Actions and their Defenses
This section of the presentation will focus on the defenses to a preference
action. While the first strategy (and sometimes the only strategy) that
a defense attorney learns is “stall, stall, stall” this strategy
cannot be effectively employed in the United States Bankruptcy Court for
the District of South Carolina (the “Bankruptcy Court”). At
least this author has never been able to effectively employ this strategy
in this Bankruptcy Court. Thus, this article will focus on other defenses
to a preference action.
First, to understand the defenses to a preference action, one must know
what a preference action is. Of course, the first defense will be challenging
one of the elements of a preference action and in order to challenge the
elements, one needs to know what those elements are. Thus, this article
will first discuss the elements of a preference action while examining
possible challenges to these elements. Also, in this section, we will
discuss the recent amendments to the choice of forum that may impact the
use of preference actions.
Second, the largest area of litigation concerning preferences is the “ordinary
course of business” defense. 11 U.S.C. §547(c)(2) (title 11
of the United State Code of Laws will herein be referred to as the “Bankruptcy
Code”). This defense will be discussed in the second section of
this article. We will also discuss briefly the change in this defense
resulting from recent amendments to the Bankruptcy Code. While the discussion
will be brief, please understand that the change is an enormous alteration
in the burden of proof on this defense.
Third, one of the most interesting defenses for individuals planning to
receive a payment from a distressed company is the contemporaneous exchange
exception. Many have sought to structure payments received from distressed
companies in such a way as to provide for this defense to any possible
Fourth, one of the most recognized and most easily proved defenses to a
preference action is the new value defense. What constitutes new value
and how to prove this defense will be discussed in the third section of
Lastly, there is an increasingly litigated area in preference actions in
situations where a debtor operates the business under a Chapter 11 between
the filing of the petition and the bringing of the preference action either
by a subsequent Chapter 7 Trustee or by some entity on behalf of a liquidating
trust pursuant to a plan. In these cases, the idea for the defense is
to try to get the court to take into consideration the events that happened
during the Chapter 11 proceeding to decide whether the Trustee or Liquidating
Trust has a cause of action for a preference. These defenses and this
developing area of preference litigation will be discussed in the fourth
section of this article.
Elements of a Preference Cause of Action
Pursuant to section 547(b) of the United States Bankruptcy Code, a Trustee
may avoid any transfer of an interest of the debtor in property:
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such
transfer was made;
(3) made while the debtor was insolvent;
(4) made --
(a) on or within 90 days before the date of the filing of the petition; or
(b) between ninety days and one year before the date of the filing of the
petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such creditor to receive more than such creditor would
receive if --
(a) the case were a case under chapter 7 of this title;
(b) the transfer had not been made; and
(c) such creditor received payment of such debt to the extent provided
by the provisions of this title.
11 U.S.C. § 547(b). It is the plaintiff’s burden to prove each
and every one of these elements by a preponderance of the evidence. 11
U.S.C. § 547(g);
Danning v. Bozek (In re Bullion Reserve of N. Am.), 836 F.2d 1214 (9th Cir. 1988). Failure to satisfy this burden on any
one element precludes a finding that a transfer is a preference.
Hood v. Brownyard-Sharon Park Center Inc. (In re Hood), 118 B.R. 417, 421 (Bankr. D.S.C. 1990);
Norman v. Jirdon Agri Chemicals, Inc. (In re Cockreham), 84 B.R. 757, 761 (D.Wyo. 1988). Further, because the elements above are
objective, the intent of the debtor is irrelevant.
Marathon Oil Co. v. Flatau (In re Carig Oil Co.), 785 F.2d 1563 (11thCir. 1986). Accordingly, it is the
effect of the transfer which is controlling.
Barash v. Public Fin. Corp., 658 F.2d 504, 510 (7th Cir. 1981).
Transfer of an Interest of the Debtor in Property
Section 101 of the Bankruptcy Code defines a “transfer” as
“every mode, direct or indirect, absolute or conditional, voluntary
or involuntary, of disposing of or parting with property or with an interest
in property, including retention of title as a security interest and foreclosure
of the debtor’s equity of redemption.” 11 U.S.C. § 101(54).
This definition is exceptionally broad, and therefore this author previously
thought that it included virtually every conceivable transfer, including
the creation or fixing of judicial liens. 
Apparently, this definition was not broad enough for some courts  and
in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
(the “BAPCPA”), Congress decided to make the definition even
more broad. Under the BAPCPA, a transfer is now:
(A) the creation of a lien;
(B) the retention of title as a security interest;
(C) the foreclosure of a debtor’s equity of redemption; or
(D) each mode, direct or indirect, absolute or conditional, voluntary or
involuntary, of disposing of or parting with -
(i) property; or
(ii) an interest in property
Section 1214, BAPCPA. Precisely because the past definition was so broad
and the new definition is more broad, the true test is not whether a transfer
occurred, but whether the debtor had an actual or constructive ownership
interest in the transferred property.
In re Hood, 118 B.R. 417 at 419;
In re Flooring Concepts, Inc., 37 B.R. 957, 961 (9thCir. 1984).  In this regard, ownership is determined
by the debtor’s ability to control the disposition of the property.
For example, in
In re Cybermech, Inc., 13 F.3d 818 (4th Cir. 1994), the Fourth Circuit Court of Appeals addressed
the question of whether a debtor corporation’s return of another
corporation’s down payment on the purchase of office machines constituted
an avoidable preference. In this case, the court held that the debtor
did have an interest in the payment funds because the debtor, upon receipt
of the funds, could deposit it, commingle it with other funds, withdraw
from it, transfer it or otherwise use the payment funds in anyway it so desired.
Id. at 820. Therefore, the debtor’s “ability to exercise complete
‘dominion and control over the funds’ [was] sufficient to
‘demonstrate an interest in property’ under the preferential
transfer provision . . . was a transfer of an ‘interest of the debtor
Id. at 821 (quoting
In re Smith, 966 F.2d 1527 (7th Cir. 1992)).
Another illustrative case is
In re Hood, 118 B.R. 417 (Bankr. D.S.C. 1990). There, the debtor was facing an imminent
sheriff’s levy when a friend of the debtor’s intervened by
offering to personally pay the debtor’s debts. The debtor’s
creditors, however, refused to accept her checks. The debtor then took
his friend’s personal checks to the bank where they were exchanged
for cashier checks and used to pay off the creditors. After finding that
the transfer satisfied the other elements of a preference, the court turned
to the ultimate question of whether or not the debtor possessed an interest
in the transferred funds. Accordingly, the court held that the debtor
did not have an interest in the funds because the debtor did not and could
not control the disposition of the funds.
In so holding, the court adopted and applied the “earmark” doctrine.
See also, Hovis v. Powers Construction Company, Inc. (In re Hoffman Associates, Inc.), 194 B.R. 943 (Bankr. D.S.C. 1995). This doctrine essentially states that
funds loaned to a debtor by a third party that are “earmarked”
for a particular creditor do not belong to the debtor. Its application requires:
(1) The existence of an agreement between the new lender and the debtor
that the new funds will be used to pay a specified antecedent debt. Where
the payment is made directly by the third party to the creditor, this
requirement is inapplicable;
(2) Performance of that agreement according to its terms; and
(3) Transaction, when viewed as a whole, including the transfer of new
funds out to the old creditor, does not result in the diminution of the estate.
In re Hood, 118 B.R. at 420 (citing
McCuskey v. Natl. Bank of Waterloo (In re Bohlen Enter.), 859 F.2d 561 (8th Cir. 1988)). Applying the doctrine in
Hood, the court found that (1) the debtor and his friend entered into an agreement
that earmarked the funds for the payment of the debtor’s creditors;
(2) the debtor’s friend directly paid the creditors; (3) the agreement
was performed according to its terms; (4) the funds transferred were never
property of the debtor nor did they become property of the debtor; and
(5) the transfer did not diminish the debtor’s bankruptcy estate.
Id. Therefore, the court concluded that the transfer was not an interest
of the debtor in property simply because the debtor did not and could
not control the disposition of the property.
Id. at 421.
Similar to the earmark doctrine, some have argued that if the debtor holds
certain funds in trust, the payment to the beneficiary of the trust should
not be a preference. In addition, in the area of construction contracts
and sub-contracts in South Carolina, we have a statutory scheme as part
of the mechanic’s lien statutes that earmarks certain funds for
payment to subcontractors. Specifically, if a contractor receives a payment
from an owner, the sub-contractors “shall have the first lien on
the money received by such contractor.”
See S.C. Code Ann. § 29-7-10 (Law. Co-op 1991). Because the debtor only
holds the funds subject to this first lien, the theory would be that the
transfer was not of an interest of the debtor, but instead, earmarked,
by statute, for the benefit of the subcontractor.
To or For the Benefit of a Creditor
Section 101 of the Bankruptcy Code defines a “creditor,” in
relevant part, as an “entity that has a claim against the debtor
that arose at the time of or before the order for relief concerning the
debtor.” 11 U.S.C. § 101(10)(A). Further, a “claim” means:
(A) right to payment, whether or not such right is reduced to judgment,
liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed,
undisputed, legal, equitable, secured, or unsecured; or
(B) right to an equitable remedy for breach of performance if such breach
gives rise to a right to payment, whether or not such right to an equitable
remedy is reduced to judgment, fixed, contingent, matured, unmatured,
disputed, undisputed, secured, or unsecured.
11 U.S.C. § 101(5)(A)-(B). In construing these terms, the United States
Supreme Court stated in
Ohio v. Kovacs, 469 U.S. 274, 105 S.Ct. 705, 83 L.Ed.2d 649 (1985) that Congress intended
for them to be used in their broadest possible sense.
The courts have obliged by finding “creditors” in even the
most contingent and remote cases.
e.g., Sigmon v. Royal Coke Co. (In re Cybermech), 13 F.3d 818 (4th Cir. 1994) (buyer was a creditor of the seller because
the buyer had paid for the goods, and therefore had a claim against the
seller for a right to payment or a right to an equitable remedy for breach
Nolden v. VanDyke Send Co. (In re Gold Coast Seed Co.), 751 F.2d 1118 (9th Cir. 1985) (holding that a seller acquired a claim
against the buyer at the time the buyer received and accepted the goods).
The transfer, however, must also benefit the creditor. Accordingly, this
benefit can either be direct,
see, e.g., Bucki v. Singleton (In re Cardon Realty Co.), 146 B.R. 72 (Bankr. W.D.N.Y. 1992) (holding that debtor’s payment
to creditor/assignee of loan obligation benefitted the creditor/assignee,
regardless of what she did with the money after she received it, because
it paid off an antecedent debt), or indirect,
see, e.g., Sommers v. Burton (In re Conrad Corp.), 806 F.2d 610 (5th Cir. 1987) (holding that the debtors’ transfer
of restaurants in exchange for a simultaneous assumption of their debt
by a third party benefitted the creditor, and therefore, constituted a
voidable indirect transfer to the creditor).
Thus, if the creditor received something of value, in a preference action,
the plaintiff can seek the return of that something of value.
For or on Account of an Antecedent Debt
An antecedent debt is simply a debt that the debtor incurs before he makes
the alleged preferential transfer. 4 COLLIER ON BANKRUPTCY § 547.05
(15th Ed. 1991). This element is present to promote the central concept
governing the existence of a preference action -- the preservation of
the debtor’s assets. Accordingly, any transfer to a creditor that
occurs during the preference period on account of an antecedent debt serves
only to deplete the debtor’s bankruptcy estate, and therefore is
in derogation of this policy of preservation.
While the term “antecedent” is easy enough to grasp, the existence
of a “debt” depends upon the existence of a claim. In
In re Cybermech, the creditor, Royal Cake Co. Inc., (hereinafter “Royal”)
entered a sales agreement with the debtor, Cybermech, Inc. (hereinafter
“Cybermech”) whereby Royal paid Cybermech a substantial down
payment for various equipment. Due to financial troubles, however, Cybermech
soon informed Royal that it would be unable to perform the contract and
returned the down payment. Three weeks later, Cybermech filed a voluntary
Chapter 7 petition. The trustee quickly moved to have the returned down
payment set aside as a preference. Royal, however, challenged the trustee
and alleged, among other things, that the returned payment was not an
antecedent debt because (1) Cybermech never owed a debt to Royal and (2)
even if Cybermech did, the debt was not antecedent to the transfer. The
court disagreed and held that because Royal possessed a claim against
Cybermech for performance under the contract, Royal was a creditor, and
Cybermech owed Royal the debt of performance. In so holding, the court
stated that the terms “claim” and “debt” were
coextensive; where one exists then so does the other:
The Code defines “debt” as “liability on a claim.”
11 U.S.C. § 101(12). By making “claim” the operative
term in the definition of debt, “Congress gave debt the same broad
meaning it gave claim.” [Citation omitted]. Indeed, it is clear
that “the terms ‘debt’ and ‘claim’ are coextensive:
a creditor has a ‘claim’ against the debtor; the debtor owes
a ‘debt’ to the creditor.” [Citations omitted]. By defining
debt as “liability on a claim,” Congress did not impose an
additional element, namely that legal liability be established through
litigation. “[W]hen a claim exists, so does a debt.” [Citation
omitted]. They are but different windows in the same room.
Id. at 822. Therefore, Cybermech did owe a debt to Royal and said debt was
antecedent to the transfer because Cybermech contracted the debt well
before it returned the money.
This definition seems consistent with the discussion of whether a recipient
of a payment is a creditor. Again, the definitions are extremely broad.
Simply, if an entity received something of value from the debtor because
of some obligation, chances are, the court is going to find a debt, a
creditor, and the transfer on account of the debt.
Ninety Day Reachback Period; “Insider” Extension of the Preference Period
Subsection (b)(4)(A) of section 547 provides that a transfer can only be
avoided where it was made on or within ninety days before the filing of
the petition. 11 U.S.C. § 547(b)(4)(A). While this is generally an
absolute rule, subsection (b)(4)(B) immediately follows and provides that
where the transfer was made to an “insider,” the time limit
for avoidance is extended to one year pre-petition. An “insider,”
in the conventional sense, is simply someone who stands in a close relationship
with the debtor and who possesses the ability to control the debtor’s actions.
Pineview Care Center, Inc. v. Mappa (In re Pineview Care Center, Inc.), 152 B.R. 703 (D.N.J. 1993).  The most common examples include a relative
or general partner of the debtor in the cases where the debtor is an individual
or a partnership, and the director(s) or officers of the debtor in the
cases where the debtor is a corporation. 11 U.S.C. § 101(31).
As it relates to the time that the transfer is made, the courts generally
look at when the debtor parted with the thing of value. Thus, for checks,
the important date for when the transfer took place is the date that the
debtor’s bank honored the check. If the honoring of the check was
within the preference period, the Court will generally find that the transfer
took place during the preference period.
See Barnhill v. Johnson, 503 U.S. 393 (1992).
One of the more interesting situations occurred when the plaintiff attempted
to recover a transfer to a non-insider creditor that benefitted an insider
creditor. Such an action was referred to as a “Deprizio Action.”
The most common example of this scenario exists where the insider creditor
guarantees a loan and then directs the debtor’s payment to the creditor
advancing the loan. In
Levit v. IngersollRand Fin. Corp., 874 F.2d 1186 (7th Cir. 1989), the court examined such a situation and
set forth the “Deprizio” doctrine. This doctrine essentially
allowed the plaintiff to recover from non-insider transferees payments
made during the extended preference period which benefitted insider creditors.
While many courts adopted the “Deprizio” doctrine,
see, e.g., Ray v. City Bank & Trust Co., 899 F.2d 1490 (6th Cir. 1990), other courts vehemently refused to apply
its reasoning. Prior to the Amendments in 1994, South Carolina bankruptcy
courts followed the Deprizio doctrine.
See In re Hoffman Assoc., 179 B.R. 797 (Bankr. D.S.C. 1995).
The drafters of the 1994 Bankruptcy Reform Act thought that they had done
away with the Deprizio doctrine, except in pre-1994 actions. They did
so by adding subsection (c) to section 550. This section states:
(c) If a transfer made between 90 days and one year before the filing of
the petition -
(1) is avoided under section 547(b) of this title; and
(2) was made for the benefit of a creditor that at the time of such transfer
was an insider; the trustee may not recover under subsection (a) from
the transferee that is not an insider.
11 U.S.C. § 550(c). This author thought the resolution was pretty
simple. You cannot recover from a non-insider transferee.
However, some courts continued to apply the doctrine under certain circumstances.
In the case of
Roost v. Associates Home Equity Servs. Inc. (In re Williams), 234 B.R. 801 (Bankr. D. Or. 1999), the debtor and his non-debtor wife
financed the purchase of their mobile home and pledged as collateral the
mobile home and its real property. The secured creditor did not file the
lien contemporaneously but did file the lien more than 90 days before
the bankruptcy. The trustee sought to set aside the transfer because it
benefitted the debtor’s wife, an insider. The trustee argued that
he was not seeking to recover anything, the property was already property
of the estate under Section 541 of the Bankruptcy Code. He was only seeking
to avoid the security interest. The court agreed saying that recovery
of a payment would be precluded by section 550(c) but the avoidance of
the security interest is not a recovery and therefore is not precluded.
The BAPCPA has added yet another anti-Deprezio section. Specifically, sub-section
(i) to Section 547 states:
If the trustee avoids under subsection (b) a transfer made between 90 days
and 1 year before the date of 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 § 1213, BAPCPA. As it relates to this particular section, it applies
to any case that is pending or commenced on or after the date of the enactment
of the BAPCPA. So, this probably means that
Deprezio is no more.
Made While the Debtor was Insolvent . . .
A debtor is essentially insolvent when his liabilities exceed his assets.
4 COLLIER ON BANKRUPTCY § 547.06 (15th Ed. 1991).  In this regard,
there is a presumption of insolvency during the ninety day reachback period.
Id. See Also 11 U.S.C. § 547(f). In
Transit Homes, Inc. v. South Carolina Nat’l Bank (In re Transit Homes, Inc.), 57 B.R. 40 (Bankr. D.S.C. 1985), however, the court held that the presumption
of insolvency can be rebutted by the introduction of the debtor’s
filed schedules. So, if the debtor files schedules saying that the value
of its assets exceed the amount of its liability, the defendant may have
a built-in defense to the preference litigation.
That Enables the Creditor to Receive More Than Such Creditor Would Have
Received in a Hypothetical Chapter 7 Case.
Subsection (b)(5) is merely a codification of the United States Supreme
Court holding in
Palmer Clay Products Co. v. Brown, 297 U.S. 227, 56 S.Ct. 450, 80 L.Ed. 655 (1936). In this case, the court
held that whether a transfer is preferential should be determined “not
by what the situation would have been if the debtor’s assets had
been liquidated and distributed among his creditors at the time the alleged
preferential payment was made,
but by the actual effect of the payment as determined when bankruptcy results.” [Emphasis added]. In this regard, the court in
Elliot v. Frontier Prop./LP (In re Lewis W. Shurtleff. Inc.), 778 F.2d 1416, 1421 (9th Cir. 1985) stated:
This analysis requires that in determining the amount that the transfer
“enables [the] creditor to receive,” 11 U.S.C. § 547(b)(5)
(1982), such creditor must be charged with the value of what was transferred
plus any additional amount that he would be entitled to receive from a Chapter
7 liquidation. The net result is that, as long as the distribution in
bankruptcy is less than one-hundred percent,
any payment “ on account” to an unsecured creditor during the
preference period will enable the creditor to receive more than he would
have received in liquidation had the payment not been made. [Emphasis
This section is also applicable to secured creditors. In
Smith v. Creative Fin. Management, Inc. (In re Virginia Fin. Corp.), 954 F.2d 193, 198-99 (4th Cir. 1992), the court stated:
While the bankruptcy code recognizes and respects the preeminent status
given to the secured creditor by state commercial codes, a creditor is
“secured” under the code only to the extent of the value of
his interest in the property of the estate . . . Section 547(b)(5) does
not, as Creative seems to argue, add any special protections for the secured
creditor. Indeed, the term “secured creditor” is not even
included in that section . . . As the plain language of [section] 547(b)(5)
conveys, the court must focus, not on whether a creditor may have recovered
all of the monies owed by the debtor
from any source whatsoever, but instead upon whether the creditor would have received less than a
100% payout in a Chapter 7 liquidation.
See also 4 COLLIER ON BANKRUPTCY § 547.08 (15th Ed. 1991) (“The analysis
[for unsecured creditors] is similar for secured creditors . . . .”).
Impact of BAPCPA on Elements of Preference Action
The BAPCPA added some procedural hurdles to the elements of a preference
action. Specifically, the BAPCPA provides:
A. Corporate debtors cannot avoid transfers of less than $5,000.
See BAPCPA, § 409 (Oddly, Congress actually adds a paragraph 9 to subsection
547(c) thereby making this limitation an affirmative defense. So technically,
a plaintiff can bring an action to avoid a transfer of less than $5,000
thereby requiring the defendant to raise the affirmative defense.).
B. Plaintiffs must bring an action in the district court for the district
in which the defendant resides where the recovery is for less than
(i) $1,000 against an insider;
(ii) a consumer debt of less than $15,000; or
(iii) a debt against a non-insider of less than $10,000.
See BAPCPA § 410.
C. The 10 day grace period provided for in Section 547(e)(2) for the perfection
of security interests is expanded to a 30 day grace period.
See BAPCPA § 403.
D. The 20 day grace period provided for in Section 5478(c)(3)(B) for perfection
of a security interest in a purchase money security interest is expanded
to a 30 day grace period.
See BAPCPA § 1222.
It is clear from these amendments that Congress wants fewer small preference
actions and wants fewer actions in situations where the timing of the
perfection of a security interest is close to being contemporaneous.
Defense -- The Ordinary Course of Business Exception
While section 547(c) sets forth a number of instances where a trustee cannot
avoid a preference transfer, the most litigated of these “defenses”
is the ordinary course of business exception. This section will discuss
this defense and then discuss the change to this defense adopted in the BAPCPA.
The Ordinary Course of Business Exception
This exception is embodied in the text of subsection (c)(2) which provides
that a trustee cannot avoid a transfer:
(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 or the transferee; and
(C) made according to ordinary business terms.
The essential purpose of this exception is “to leave undisturbed
normal financial relations because it does not detract from the general
policy of the section to discourage unusual action by either the debtor
or its creditors during the debtor’s slide into bankruptcy.”
Morrison v. Champion Credit Corp. (In re Barefoot), 952 F.2d 795, 801 (4th Cir. 1991). In this regard, the creditor who claims
the exception also possesses the burden of proof.
Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044, 1047 (4th Cir. 1995). Further, the creditor must satisfy
its burden by a preponderance of the evidence.
In the case of
Harman v. First American Bank of Md. (In re Jeffrey Bigelow Design Group), 956 F.2d 479 (4th Cir. 1992), the Fourth Circuit Court of Appeals held
that subsection (c)(2)(A) and (B) are analyzed pursuant to a subjective
test. The Fourth Circuit states that the “‘focus of [the]
inquiry must be directed to an analysis of the business practices which
were unique to the particular parties under consideration.’”
Id.at 486 (quoting
Waldschmidt v. Ranier (In re Fulghom Constr. Corp.), 872 F.2d 739, 743 (6th Cir. 1989)). This inquiry is “‘peculiarly
factual, . . .’”
First Software Corp. v. Curtis Mfg (In re First Software Corp.), 81 B.R. 211, 213 (Bankr. D.Mass. 1988)), and “[a]ttention should
be drawn to the reality of the situation and not the formal structure.”
Jeffrey Bigelow 956 F.2d at 488. In this regard, the court emphasized that “form
must not be elevated above substance.”
Basically, the formal structure is the contractual relationship between
the parties. The Fourth Circuit is basically saying, just because an invoice
says pay within 30 days, does not mean a payment received more than 30
days after the invoice is outside of the ordinary course of business.
Also, if the parties do not have a long history upon which to determine
their prior practices, the contractual terms of the agreement become more
important in determining the ordinary course of business between the parties
under (c)(2)(B). The Honorable John E. Waites, United States Bankruptcy
Court for the District of South Carolina, analyzed this situation in
Hovis v. Aerospace Solutions, Inc., (In re Air South Airlines, Inc.), 99-80256 (January 14, 2000). In this opinion, the Bankruptcy Court states:
ASI and Debtor had never, prior to those two transfers, entered into transactions
on similar payment terms; thus, there is no prior course of dealings between
the parties on such terms. Where the debtor and creditor do not share
a pre-preference course of dealing, some courts have held that the ordinary
course of business exception cannot be used as an affirmative defense.
See e.g., Miller v. Kibler (In re Winters), 182 B.R. 26, 29 (Bankr. E.D. Ky. 1995) (“It is clear that §547(c)(2)
applies if the debtor and the transferee have an ongoing, ‘recurring’
business relationship. It does not apply to single, isolated transactions
such as the one between the debtor and the defendants herein.”);
Brizendine v. Barrett Oil Distributors, Inc. (In re Brown Transport Truckload), 152 B.R. 690, 691 (Bankr. N.D. Ga. 1992) (“If there is no prior
course of dealings between the parties, the transferee cannot satisfy
[§547(c)(2)(B)], and the transfer may be avoided.”). As the court in
Gosh v. Burns (In re Finn) concluded, “[o]bviously every borrower who does something in the
ordinary course of her affairs must, at some point, have done it for the
In re Finn, 909 F.2d 903, 908 (6thCir. 1990). This Court holds that, as a general
rule, a transaction between the parties may be deemed to be in the ordinary
course of financial affairs” of the parties even if there is no
prior history of dealings and the transaction is the first to take place
between the creditor and the debtor.
Remes v. ASC Meat Imports, Ltd. (In re Morren Meat & Poultry Co.), 92 B.R. 737 (W.D. Mich. 1988) (“[T]his Court is not convinced that
§ (B) requires a history of prior dealings as a sine qua non in order
to afford a transferee the protections of §547(c)(2).”);
see also Tomlins v. BRW Paper Co. (In re Tulsa Litho, Co.), 229 B.R. 806, 808 (10thB.A.P. 1999).
The next issue to be resolved is what indicia courts may consider in determining
whether the transaction took place in the “ordinary course of business.”
Courts in various jurisdictions have come up with different views on the issue.
When there are no prior transactions with which to compare, the court may
analyze other indicia, including whether the transaction is out of the
ordinary for a person in the debtor’s position,
In re Finn, 909 F.2d 903, or whether the debtor complied with the terms of the contractual
Payne v. Clarendon Nat’l Ins. Co., (In re Sunset Sales, Inc.), 220 B.R. 1005, 1021 (10th Cir. BAP 1998), generally looking to the conduct
of the parties,
see Remes v. ASC Meet Imports, Ltd. (In re Morren Meat & Poultry Co.), 92 B.R. 737, 741 (W.D. Mich. 1988), or to the parties’ ordinary
course of dealing in other business transactions,
Riske v. C.T.S. Systems, Inc. (In re Keller Tool Corp.), 151 B.R. 912, 914 (Bankr. E.D. Mo. 1993).
Meeks v. Harrah’s Tunica Corp. (In re Armstrong), 231 B.R. 723, 731 (Bankr. E.D. Ark. 1999). This Court adopts the view
set forth in
In re Morren Meat & Poultry Co. and holds that the preprinted terms in the invoices that ASI sent to Debtor
do not definitely define the ordinary course of business between the parties;
rather, the Court considers the conduct of the parties to determine whether
any unusual conduct took place which would require the Court to set the
subject transaction aside as preferential transfers.
Id. at 13-14. Judge Waites then examined the invoices and finds that the
three preference payments that were made either within the terms of the
invoice (within 30 days) or close to the terms of the invoice (34 days)
were in the ordinary course and the single payment made well outside of
the invoice terms (54 days) was outside of the ordinary course of business.
Id. at 15.
Compared to §547(c)(2)(B), the Fourth Circuit and the Bankruptcy Court
utilizes a different approach when examining subsection §547(c)(2)(C). In
Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044 (4th Cir. 1995), the creditor was a direct mail advertising
firm that required its customers to prepay for its services. In the ninety-day
period preceding the debtor’s bankruptcy petition, the debtor made
twelve payments to the creditor. Two of the payments were prepayments
while the remaining ten payments were for services previously rendered.
The creditor had waived the requirement for pre-payment on the last ten
payments and had allowed the debtor to pay when able. Shortly after the
debtor filed for Chapter 11 protection, the trustee moved to avoid the
latter ten payments as preferences. The creditor countered that said payments
fell within the ordinary course of business exception, and therefore,
The court began its analysis by refusing to apply subsection (c)(2)(A)
and (B)’ s subjective test for subsection (C).
Id. at 1048 (“[b]ecause subsection B and C are written in the conjunctive,
the use of subsection B’s subjective approach under subsection C
would render subsection C superfluous . . . [w]e refuse to say that Congress
wrote a separate subsection for no reason at all.”). The court then
held that subsection (C) should be analyzed under an objective test whereby
a court looks to the industry norms for the determination of “ordinary
Id. The court then explained the application of this test:
[T]he extent to which a preference payment’s credit terms can stray
from the industry norm yet still satisfy [section] 547(c)(2)(C) depends on
the duration of the debtor-creditor relationship. “[T]he more cemented (as measured by its duration) the pre-insolvency
relationship between the debtor and the creditor, the more the creditor
will be allowed to vary its credit terms from the industry norm yet remain
in the safe harbor of [section] 547(c)(2)(C).”
Id. at 225. A “sliding-scale window” is thus placed around the
industry norm. On the one end of the spectrum, “[w]hen the relationship
between the parties is of recent origin, or formed only after or shortly
before the debtor sailed into financially troubled seas, the credit terms
will have to endure a rigorous comparison to credit terms used generally
in a relevant industry.”
Id. In such a case, only those “departures from [the] relevant industry’s
norms which are not so flagrant as to be ‘unusual’ remain
within subsection C’s protection.”
Id. at 226.
On the other end of the spectrum, “when the parties have had an enduring,
steady relationship, one whose terms have not significantly changed during
the pre-petition insolvency period, the creditor will be able to depart
substantially from the range of terms established under the objective
industry standard inquiry and still find a haven in subsection C.”
Id. at 1049 (quoting
Fiber Lite Corp. v. Molded Acoustical Products, Inc. (In re Molded Acoustical
Products, Inc.), 18 F.3d 217 (3d Cir. 1994)). In so holding, the court also emphasized
that “subsection C never tolerates a gross departure from the industry
norm, not even when the parties have had an established and steady relationship.”
Applying their “newly adopted” sliding scale approach to subsection
(c)(2)(C), the court found that the creditor had failed to meet its burden
of satisfying subsection (c)(2)(C). Because the creditor’s normal
business practice was to require prepayment, their waiving of the requirement
for the debtor constituted a gross departure from their industry norm.
Therefore, and despite their longstanding relationship with the debtor,
the creditor was held liable for the preference payment.
In performing the analysis for the ordinary course of business defense,
it is important to note that the date of the transfer for checks is different
under this analysis than the previous analysis dealing with whether the
transfer was within the ninety day reach back period. In the previous
analysis, one looks at when the debtor’s bank honored the check.
See Barnhill v. Johnson, 503 U.S. 393 (1992). “For the purpose of section 547(c)(2)(B) of
the Bankruptcy Code of 1978, a transfer of funds by check is effective
on the date that the creditor receives the check so long as the debtor’s
bank honors it within the 30-day requirement of U.C.C. §3-503(2).”
Durham v. Smith Metal & Iron Co. (In re Continental Commodities, Inc.), 841 F.2d 527, 528 (4th Cir. 1988). In his opinion in
Hovis v. Aerospace Solutions, Inc. (In re Air South Airlines, Inc.), Adv. Proc. No. 99-80256-W, (January 14, 2000, John E. Waites), Judge
Waites discusses this aspect of the preference law and the fact that the
date of the “transfer” under §547(c)(2) is different
than the “transfer” under §547(b). Thus, in presenting
the ordinary course of business defense, one would attempt to determine
when the creditor received the payment by check and examine the pattern
of conduct between the parties based upon this date. However, if the debtor’s
bank does not honor the check within the ordinary period provided for
in the Uniform Commercial Code, then the date of delivery becomes irrelevant
to the analysis.
The Amendment to this Section by the BAPCPA.
Remember that little “and” between subsection (B) and subsection
(C)? The BAPCPA changed that little “and” to an “or.”
Prior to BAPCPA, the defendant had to prove (A) and (B) and (C). Now,
the defendant has to prove former subsections (A) and (B) or (C). Specifically,
§547(c)(2) will read:
to the extent that such 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.
BAPCPA, § 409. Under the new law, the debt must still be incurred
in the ordinary course of business. Once this element is established,
the defendant can show either that the practice was ordinary between the
parties or is ordinary in the industry.
In so amending the current law, it appears that Congress has abandoned
the sliding scale approach found in
Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044 (4th Cir. 1995). Instead, Congress appears to have adopted
the analysis of
In re Tolona Pizza Products Corp., 3 F.3d 1029 (7th Cir. 1993) (allowing the defendant to establish either
ordinary course between the debtor and transferee or according to ordinary
business terms). It is likely that initially, in examining the meaning
of the amended statute, courts will use the analysis provided by the Seventh Circuit.
Defense -- The Contemporaneous Exchange Defense
Another defense worthy of mention is the contemporaneous exchange defense.
It is embodied in section 547(c)(1)(A)-(B) which provides:
(c) The trustee may not avoid under this section a transfer --
(1) to the extent that such transfer was --
(1) intended by the debtor and the creditor to or for whose benefit such
transfer was made to be a contemporaneous exchange for new value given
to the debtor; and
(B) in fact a substantially contemporaneous exchange.
The exception’s existence and purpose is to protect transactions
that do not diminish the bankruptcy estate.
ALFA Mutual Fire Ins. Co. v. Memori (In re Martin), 188 B.R. 689 (M.D.Ala. 1995). In this regard, it is the intent of the
parties which constitutes the most critical element.
See In re Hersman, 20 B.R. 569 (Bankr. N.D. Ohio 1982) (“The key inquiry, therefore,
is whether the parties at the outset intended the exchange to be contemporaneous.”).
Legislative history reveals the type of transaction that this exception
was designed to cover:
However, for the purposes of this paragraph, a transfer involving a check
is considered to be “intended to be contemporaneous,” and
if the check is presented for payment in the normal course of affairs
... that will amount to a transfer that is “in fact substantially
H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 373 (1977), U.S. Code Cong.
& Admin. News, p. 5787 (1978). A check, then, is the classic example.
See Gover v. Ford Motor Credit Co. (In re Davis), 22 B.R. 644 (Bankr. M.D. Ga. 1982) (holding that the only type of credit
transaction which would result in a transfer under the new value exception
is a check transaction, which is for all practical intents and purposes
really a cash transaction). Conversely, a credit card transaction is the
classic bad example. In
In re Hersman, the court explained:
Where goods are paid for by a check, the payor had funds in the banking
institution upon which the check is drawn when he makes the check payable
to the person furnishing the goods. The payee need only present the check
for payment . . . When using a credit card to pay for goods, a consumer
is generally seeking that which its name implies -- the extension and
receipt of credit. By using a credit card, the credit card consumer does
not intend a contemporaneous exchange for value. Instead, what is generally
intended is the receipt of goods or services presently and time to pay
for the same in the future . . . .
In re Hersman, 20 B.R. at 573.
A transaction, however, need not only be contemporaneous, but it must create
new value as well. While the question of new value is always a question of fact,
Creditors’ Committee v. Spada (In re Spada), 903 F.2d 971 (3d Cir. 1990), its form can be virtually anything.
See Dowder v. Sharp Lumber Co. (In re Prescott), 805 F.2d 719 (7thCir. 1986) (stating that new value includes new credit,
goods, services and property). In
Babitzke v. Mantelli (In re Townsend-Robertson Lumber Co.), 144 B.R. 407 (Bankr. E.D. Ark. 1992), the court found new value in the
retention of fees for the storing of a Chapter 7 debtor’s lumber. In
In re Mantelli, 149 B.R. 154 (9th Cir. BAP Cal. 1993), however, the court held that a
debtor’s payment to his wife of a civil contempt sanction did not
create new value because the payment was not made for goods or services,
but in lieu of a five day jail sentence.
Thus, for the exchange to be contemporaneous, the court examines whether
the exchange was intended to be substantially contemporaneous and whether
new value (not the satisfaction of an old value) was given in exchange
for the preferential treatment. If both of these elements have been met,
then the defendant has shown the affirmative defense of contemporaneous exchange.
Defense - New Value
Under Section 547(c)(4) the plaintiff cannot avoid a preferential transfer
“to the extent that, after such transfer, such creditor gave new
value to or for the benefit of the debtor - (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.” 11 U.S.C. § 547(c)(4). The new value provided
can be in the form of goods or services. Basically, the courts will deduct
from the preference amount the amount still due to the recipient of the
payment from the debtor. In this analysis, it is important to note that
(1) the new value is credited against only those payments that occur prior
to the new value being given, and (2) the new value must remain unpaid
at the time of the bankruptcy petition. To illustrate, the following chart
may be helpful.
|Day - 80
||Preference Payment 1
|Day - 70
|Day - 60
|Day - 50
||Preference Payment 2
|Day - 40
The value given on Days minus 70 and 60 are credited against the preference
payment that occurs on Day minus 80. But no credit is carried forward.
Preference Payment 2 on day minus 50 is only offset by the new value given
on Day minus 40. Thus, the preference amount is $2,000 (the $5,000 Preference
Payment minus the subsequent New Value).
Judge Waites has an opinion that does raise a question as it relates to
the following fact pattern:
|Day - 80
||Preference Payment 1
|Day - 70
|Day - 60
||Preference Payment 2
|Day - 50
|Day - 40
Judge Waites states that the new value exception is “netted only
against the immediately preceding preference.”
Hovis v. Powers Construction Company, Inc. (In re Hoffman associates, Inc.), 194 B.R. 943, 956 (Bankr. D.S.C. 1995). In this scenario, applying that
logic, only the new value provided for in Day minus 70 would apply to
the Day minus 80 preference payment. Thus, even though new value was extended
in our scenario after both preference payments far in excess of those
payments, it is possible that the Plaintiff still may recover for the
$5,000 of the first preference payment.
This author believes that the use of the words “only” and “immediately”
was inadvertence. Further, in examining the analysis actually performed
in this opinion, one easily sees that Judge Waites does not apply the
new value “only against the immediately preceding preference.”
Instead, he applies it against all preceding preferences, not just the
immediately preceding preference.
In fact, Judge Waites cites
Crichton v. Wheeling Nat’l Bank (In re Meridith Manor, Inc.), 902 F.2d 257, 258-59 (4th Cir. 1990) for this proposition. In
Meridith Manor, that bankruptcy court netted the new value “only against the immediately
Id. at 258. The district court then reversed this decision and opted to “off-set
only prior (although not necessarily immediately prior) preferences.”
Id. When faced with the decision as to which method was correct, the Fourth
Circuit agreed with the district court. Thus, the correct analysis would
allow the use of all subsequent new value extensions to be applied against
all prior preference payments, not necessarily only the immediately prior one.
In addition to this bit of peculiarity in South Carolina, there is also
a split of authority nationwide as it relates to the impact of actions
that occur post petition. Specifically, is the new value exception eliminated
if the new value is paid post-petition?
SeeRosenthal, York and Coffey,
The Impact of Post-Petition Events on Preference Liability,AMERICAN BANKRUPTCY INSTITUTE JOURNAL, Vol XXIV., No. 1, at page 28, (February 2005).
Some argue that because courts do not allow post-petition extensions of
new value to be offset against preferences, that this argument should
work both ways.
See TennOhip Trans. Co. v. Felco Commercial Serv. (In re TennOhio Trans. Co), 255 B.R. 307, 310 (Bankr. S.D. Ohio 2000) (post-petition advances of
new value may not be applied to offset preference payments). If credits
cannot be used, then payments should not be used either. However, the
case law seems to be split on this question.
See Sun Bank/North Central Florida v. Estate of Thurman (In re Thurman
Const. Inc.), 189 B.R. 1004, 1014 (Bankr. M.D. Fla 1995) (the new value must only remain
unpaid as of the petition date, not when the court adjudicates the preference actions);
contra Moglia v. American Psychological Ass’n. (In re Login Bros. Book Co.), 294 B.R. 297 (Bankr. N.D. Ill. 2003) (post petition payment does operate
to reduce new value defense). South Carolina’s Bankruptcy Court
does not appear to have weighed in on this subject.
Post-Petition Events Providing a Possible Defense
In situations where a debtor files a Chapter 11 proceeding, there are three
events that could possibly provide a defense to later brought preference
actions: (a) the critical vendor order; (b) the assumption of an executory
contract and (c) the confirmation of a plan. Prior to the adoption of
a plan, the logic is the same. Simply, if the pre-petition payment that
is the subject of the preference action had not been made, then the cure
required under the post-petition event would have been greater. Because
the debtor cured the default during the Chapter 11 proceeding, and would
have cured the greater default had the pre-petition payment not been made,
then it does not seem appropriate to allow the court to reach back to
recover pre-petition payments that were an integral part of the cure.
After the confirmation of the plan, the defense seems to focus on whether
the plan is sufficiently specific so as to preserve the preference action.
Treatment as a Critical Vendor
Similarly, under the critical vendor defense, the theory is that because
the vendor is critical, the debtor would have cured any pre-petition default
under its order authorizing payments to the critical vendor. Thus, the
debtor should not be allowed to continue to deal with critical vendors
during the Chapter 11 and then, recover pre-petition payments from them
in a preference action. First, the courts appear to distinguish between
the hypothetical critical vendor and the real critical vendor. Second,
the courts seem to be less and less willing to imply a waiver of a preference
action in the approval of a critical vendor payment.
In the case of
Official Committee of Unsecured Creditors v. Medical Mutual of Ohio (In
re Primary Health Systems, Inc.), 275 B.R. 709 (Bankr. D. Del. 2002), the Delaware Bankruptcy Court had
approved a critical vendor order that allowed the debtor to pay pre-petition
wage and benefits claims. Subsequently, the unsecured creditors committee
brought an action against one of the providers of the benefits package
for payments that it received pre-petition. The court held that its Order
authorizing these critical vendor payments provided the defendant with
a defense to the preference action.
Since 2002, the entire landscape of the law dealing with critical vendors
Co-Serv. The question of whether the critical vendor defense was available was
then addressed in the case of
Zenith Industrial Corp. v. Longwood Elastomers, Inc. (In re Zenith Industrial Corp.), 319 B.R. 810 (D. Del 2005). In
Zenith, the Delaware Bankruptcy Court had entered an order giving the debtor
the discretionary authority to pay vendors that it deemed to be critical.
The critical vendor order did not identify the critical vendors by name.
Because it was discretionary, because no critical vendor was identified,
and because the order was based more on the alleged relatively small size
of the critical vendor claims rather than the actual “critical”
nature of the vendor, the court found that the critical vendor defense
was not available. In so doing, the
Zenith court followed the logic of
HLI Creditor Trust v. Export Corp. (In re Hayes Lemmerz International Inc.), 313 B.R. 189 (Bankr. D. Del. 2004). In
Hayes Lemmerz, the court considered the following factors in deciding whether the critical
vendor order provided a preferential defense: (a) whether the preferential
payments were considered in issuing the critical vendor order; (b) whether
the order was discretionary with the debtor; and (c) whether the defendant
was explicitly named in the critical vendor order. After examining these
Hayes Lemmerz Court declined to apply the critical vendor defense. Both
Hayes Lemmerzdistinguished themselves from
Primary Health Systems by stating that
Primary Health Systems dealt with claims that would be given an unsecured priority status in
the bankruptcy proceeding whereas the claims that
Hayes Lemmerz were dealing with were general unsecured creditors.
However, these cases seem to focus more on protecting the Judge’s
failures, than on protecting either the creditors, the bankruptcy act
or commercial practices. In
Hayes Lemmerz, the Court is concerned about its decision to give a debtor discretion,
its failure to consider the impact of the critical vendor order on preference
actions and its failure to even require the debtor to provide it with
the names of the alleged critical vendors. If a vendor is actually “critical”
there is no justification to preserve the preference action and allow
a debtor to (1) beg and plead with the vendor to continue to do business
with and extend credit to the debtor, (2) pay post-petition for pre-petition
debts, and (3) give a creditor assurances that they will be paid if the
creditor continues to do business with the debtor. This is especially
true when the creditor is likely not represented by counsel and likely
does not even receive notice of the critical vendor proceedings.
In distinguishing themselves from
Primary Health Systems, the Courts in
Hayes Lemmerz seem to recognize their own failings in determining whether the creditor
is “critical.” In bankruptcy, unsecured priority creditors
are given a higher status. They are more “critical” to business
and are therefore treated better in our bankruptcy system. Thus, the
Hayes Lemmerz courts treat these critical vendors better than unsecured creditor vendors.
But unsecured priority creditors have to wait, just like regular unsecured
creditors, for distributions. “Critical” vendors are supposed
to be of a higher priority than either general unsecured or unsecured
priority creditors, because “critical” vendors get paid and
do not have wait. If the creditor truly is “critical,” whether
the creditor would also be general unsecured or unsecured priority is
a distinction without a difference.
If a waiver of preference actions is not implied in a critical vendor order
than it should be expressly stated in the order.
See In re Tropical Sportswear Int’l Corp., 320 B.R. 15 (Bankr. M.D. Fla 2005) (expressly waiving preference claims
against critical vendors). To do any less would be to allow a debtor,
through the auspices of the Court, to perpetrate a fraud upon the very
vendors that the debtor and the Court has deemed to be “critical”
to the reorganization of the debtor’s business.
Assumption of an Executory Contract as a Defense.
The Fourth Circuit Court of Appeals does not appear to have addressed this
situation. Four other circuits have. The Eleventh Circuit addressed this
situation in the case of
Seidle v. GATX Leasing Corp., 778 F.2d 659 (11th Cir. 1985). In
Seidle, the executory contract involved the lease of an aircraft. The debtor
was allowed to retain possession of the aircraft because of the cure of
the default pre-petition. The court disallowed the trustee’s preference
action using the following logic:
Under the trustee’s proposed interpretation, the debtor, anticipating
his impending bankruptcy filing, could make all payments to the financer
of the aircraft, creating no pre-petition defaults that would have to
be cured under a stipulation. After entering into the stipulation and
securing possession of the aircraft, the debtor or trustee could simply
reclaim the payments made during the ninety-day pre-petition preference
period. This result nullifies the financer’s guarantee that the
debtor meet all previous contractual obligations in order to retain possession
of the aircraft.
Id. at 664.
The court reasoned that it would be incongruous to allow the debtor to
make payments pre-petition, thereby lessening the amount needed to cure
defaults post-petition, continue operation of the executory contract during
the chapter 11 proceeding, assign the executory contract as part of a
sale to the purchaser of the debtor’s property curing all defaults
in this process and then recover the pre-petition payments using a preference action.
The Ninth Circuit addressed a similar situation in the case of
Alvarado v. Walsh (In re LCO Enterprises), 12 F.3d 938 (9th Cir. 1993). In that case, the court specifically addressed
whether the fifth element of a preference action had to take into consideration
the events that transpired during the Chapter 11 proceeding. The fifth
element is the hypothetical chapter 7 liquidation analysis. The Ninth
Circuit specifically held that the Chapter 11 events must be taken into
consideration during the Chapter 7 liquidation analysis. In
LCO Enterprises, the debtor had made partial rent payments in the ninety days prior to
the bankruptcy petition. In the Chapter 11 proceeding, the debtor continued
to rent the space from the landlord and sought to assume the executory
contract. The court held that in bringing the preference action, the debtor
sought “to obtain the benefits of both assumption and rejection,
i.e. continued possession of the property and recovery of the prepetition
rent. That would not be possible in Chapter 7. It is not possible in chapter
Id. at 943.
In the case of
In re Superior Toy & Manufacturing Co., 78 F.3d 1169 (7th Cir. 1996), the Seventh Circuit addressed this area
of the law. Again, payments were made prepetition on an executory contract,
this time to cure a default in royalty payments that were due. When the
case was converted, the trustee sought to set aside the payments as a
preference. The court held that Section 365 “was clearly intended
to insure that the contracting parties receive the full benefit of their
bargain if they are forced to continue performance . . . ‘full benefit
of his bargain’ must refer to the full amount due the contracting
parties, not just the amount they are entitled to for future performance.”
Id. at 1174. Thus, the Seventh Circuit joined the Eleventh Circuit and the
Ninth Circuit in dismissing the preference action based upon pre-petition
payments under an executory contract that was later cured, assumed, and
assigned in a Chapter 11 proceeding.
Recently, in the case of
Kimmelman v. The Port Authority of New York (In re Kiwi Int’l Air
Lines, Inc.), 344 F.3d 311, 318-19 (3rd Cir. 2003), the Third Circuit joined in the
logic of the other circuits and stated that:
The trustee’s characterization of the defendant’s claim as
unsecured on the filing date seems to presuppose that a hypothetical Chapter
7 trustee would have elected to reject the debtor’s agreements with
them. . . . However, the agreements here were not rejected, and they would
not necessarily have been rejected in a hypothetical Chapter 7 liquidation.
Once the debtor assumed the agreements, the defendants . . . were entitled,
pursuant to § 365 to full payment of the amounts owed under the agreements.
The court reasoned that because the creditor would have been entitled to
full payment, the preference action should be dismissed.
Thus, it seems that the assumption of the executory contract provides a
pretty good defense to any preference action, even in situations where
the possible preference action is never mentioned during the assumption
process or the order allowing the assumption of the executory contract.
Preservation of a Preference Action in the Plan
This defense started in cases that did not deal with avoidance actions. In
Eubanks v. Federal Deposit Insurance Corp., 977 F.2d 166 (5th Cir. 1992), the court was examining a post confirmation
lender liability claim brought by the reorganized debtor against his secured
lender based upon the secured creditors pre-petition actions. The Court
held because the secured lender was a creditor under the plan, his claim
was determined by the confirmation of the plan and any challenge to this
claim could have been brought prior to confirmation.
Id. at 174. The court went on to hold that the confirmed plan was
res judicata as to the lender liability action.
Id. Similarly, in
Browning v. Levy, 283 F.3d 761, 774 (6th Cir. 2002), the Sixth Circuit held that the plan’s
“blanket reservation” of causes of action did not preserve
a malpractice claim and breach of fiduciary duty claim against a law firm
that was also a creditor of the debtor. Both the Fifth and Sixth Circuits
seem to hold that Section 1123(b)(3) requires plans to provide for settlement,
adjustment or retention of some entity to prosecute the claims belonging
to the debtor. This plan requirement, combined with the disclosure statements
requirement of “adequate information,” seem to require some
notice as to what claims are being settled, adjusted or retained. Both
the Fifth and Sixth Circuits held that the blanket reservation failed
to provide the sufficient notice and therefore, the action was not retained.
Some bankruptcy courts have applied this same logic to preference actions.
In the case of
Mickey’s Enterprises, Inc. v. Saturday Sales, Inc. (In re Mickey’s
Enterprises, Inc.), 165 B.R. 188 (W.D. Tex. 1994), the court was examining a preference action
against a creditor of the estate. The court held that the preference action
stemmed from the same nucleus of operative facts as the debtor’s
proof of claim, the “existing and continuing business relationship.”
Id. at 192. The court went on to hold that
res judicataapplied. As it relates to the same nucleus of operative facts, the superficial
treatment of this analysis by this court suggests a lack of understanding
of preference litigation. One only has to look at the elements of a preference
action and compare them to an action on an invoice or open account to
realize these two distinct legal theories do not stem from the same nucleus
of operative facts.
Further, most Federal Courts do not even use the general term
res judicata. Federal Courts examine the preclusive effects of prior determinations
in terms of either claims preclusion or issue preclusion. See 18 FEDERAL
PRACTICE AND PROCEDURE, § 4402, at 6 (1981) (“the distinctive
effects of a judgment [are] separately characterized as ‘claim preclusion’
and ‘issue preclusion’”).
Claims preclusion has the “effect of foreclosing any litigation of
matters that never have been litigated, because of a determination that
they should have been advanced in an earlier suit.”
see also Kaspar Wire Works, Inc. v. Leco Engineering & Mach., Inc., 575 F.2d 530, 535-36 (5th Cir. 1978). Under claims preclusion, a judgment
does not preclude everything that may have been disputed between the parties,
it only precludes matters within a certain sphere. 18 Federal Practice
and Procedure, § 4406
, at 45 (1981). “Claim preclusion cannot extend beyond the limits
of an action that can be brought before a single court.” 18 Federal
Practice and Procedure, § 4407 at 51 (1981).
The contemporary approach uses a “transactional definition of a claim
or cause of action” to determine the scope of claims preclusion.
18 Federal Practice and Procedure, § 4407 at 55 (1981);
see also Restatement Second of Judgments, Section 24 (1981). Basically, a claim extinguished by a first judgment includes:
all rights of the plaintiff to remedies against the defendant with respect
to all or any part of the transaction, or series of connected transactions,
out of which the action arose. 18
Federal Practice and Procedure, § 4407, at 55 (1981);
see also Restatement Second of Judgments, § 24 (1981).
Thus, the Court must examine the transactions associated with the claim,
specifically the elements of the cause of action that would create the
claim, and compare those with the elements of the cause of action or claim
seeking to be precluded.
Issue Preclusion has the “effect of foreclosing relitigation of matters
that have once been litigated and decided.” 18 FEDERAL PRACTICE
AND PROCEDURE, § 4402, at 6 (1981);
see also Kaspar Wire Works, Inc. v. Leco Engineering & Mach., Inc., 575 F.2d 530, 535-36 (5th Cir. 1978). Issue preclusion involves the determination
of the following issues:
Issue preclusion arises in the second action on the basis of a prior decision
when the same “issue” is involved in both actions;
The issue was “actually litigated” in the first action, after
a full and fair opportunity for litigation;
The issue was “actually decided” in the first action, by a
disposition that is sufficiently “final,” “on the merits,”
It was necessary to decide the issue in disposing of the first action and
- in some decisions - the issue occupied a high position in the logical
hierarchy of abstract legal rules applied in the first action;
The later litigation is between the same parties or involves non-parties
that are subject to the binding effect or benefit of the first action;
The role of the issue in the second action was foreseeable in the first
action, or it occupies a high position in the logical hierarchy of abstract
legal rules applied in the second action; and
There are no special considerations of fairness, relative judicial authority,
changes of law, or the like, that warrant remission of the ordinary rules
18 FEDERAL PRACTICE AND PROCEDURE, § 4416 at 138-39 (1981). Since
the argument is that the avoidance action was not disclosed prior to the
confirmation of the plan, it can hardly be argued that the preference
action was actually litigated.
Thus, neither claims preclusion nor issue preclusion should be a basis
upon which a court should hold that an avoidance action is not preserved
by a blanket reservation. However, the requirement for adequate information
provides a more difficult analysis.
In the recent case of
Elk Horn Coal Co., L.L.C. v. Conveyor Mfg & Supply, Inc. (In re Pen
Holdings, Inc.), 316 B.R. 495 (Bankr. M.D. Tenn. 2004), the Court was addressing a similar
challenge against preference actions. In
Pen Holdings, the plan defined “avoidance actions” as, among other things,
the actions under sections 510, 541, 544, 545, 546, 547, 548, 550 and
553 of the Bankruptcy Code.
Id. at 497. It then went on to retain the right to prosecute these avoidance actions.
Id. The Middle Tennessee bankruptcy court found that the adequate information
needed to retain actions was for creditors, not for defendants.
Id. at 504. Therefore, naming specific defendants was not necessary.
Id. That seems to be a pretty good argument. Adequate information means:
information of a kind, and in sufficient detail, as far as is reasonably
practicable in light of the nature and history of the debtor and the condition
of the debtor’s books and records, that would enable a hypothetical
reasonable investor typical of holders of claims or interests of the relevant
class to make an informed judgment about the plan ...
11 U.S.C. §1125(a)(1). So technically, adequate information is not
directed at a creditor, it is directed at a “hypothetical reasonable
investor typical of holders of claims.”
Id. Clearly, adequate information is not directed toward defendants in avoidance actions.
Pen Holding court found that avoidance actions are “fundamentally different”
than the malpractice and breach of fiduciary duty claims found in
Browning. 316 B.R. at 504. The court reasoned that they are fundamentally different
because (a) they are so numerous that typically debtors do not even complete
their preference analysis prior to proposing a plan and to require a debtor
to do so is “not practicable,” (b) it is a common practice
to simply preserve these actions in plans; and (c) nothing in Section
1123 requires that the matters be set out more specifically.
Id. The court concluded that “preserving the value of preferences for
distribution to creditors after confirmation should be easily accomplished
in the plan without magic words or typographical traps.” 316 B.R. at 505.
Prosecuting and defending preference litigation is not for the generalist.
The elements of a preference action pose a complex web of potential hazards
for the one prosecuting and potential loopholes for the one defending.
Similarly, the defenses are developing into ever more complex areas as
the fact intensive and case specific holdings are sought to be generalized
into principals that can be understood and implemented.
See 4 COLLIER ON BANKRUPTCY § 547.03 (15th Ed. 1991) (“Any judicial
proceeding that creates or fixes a lien upon the debtor’s property
will constitute a preference.”). In South Carolina, a lien on real
property is created when the judgment is enrolled in the county where
the property is located. S.C. Code Ann. § 15-35-810 (1976).
See Thompson v. Margen (In re McConville), 110 F.3d 47, 49 (9th Cir. 1997) (Under section 549, the attachment of
a lien on real property is not a transfer of property that could be set aside.).
 In determining whether a debtor has an interest in property, state
 A more exact definition of the term appears in 11 U.S.C. § 101(31).
 For a more extensive definition,
see 11 U.S.C. § 101(32).
 The Supreme Court demonstrated this principle in
Palmer with the following example:
[W]here the creditor’s claim is $10,000, the payment on account of
$1,000, and the distribution in bankruptcy is 50%, the creditor to whom
the payment on account is made receives $5,500, while another creditor
to whom the same amount was owing and no payment on account was made will
receive only $5,000.
Palmer, 297 U.S. at 229, 56 S.Ct. at 451, 80 L.Ed. at 656.