Bankruptcy 2005 New Landscape for Preference Proceedings

Bankruptcy 2005 New Landscape for Preference Proceedings

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Though largely noted for its reform of consumer bankruptcy law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (New Code) makes notable changes to non-consumer bankruptcy law. Among these are three substantial changes to preference law. The ordinary-course defense becomes more defendant friendly, and a de minimis threshold acts as a defense to certain small cases and creates defense-favorable venue requirements in other small cases. Finally, the right of a trustee to use the one-year "reach-back" to sue non-insider creditors for payments on obligations guaranteed by insiders has been further curtailed. Though potential issues may arise when preference actions become governed by the New Code, the altered landscape of preference law is certainly more defendant-oriented.

The Ordinary-course Defense: Ordinary Just Got Easier

Under the existing Bankruptcy Code (Old Code), one of the many statutory defenses to a preference claim was the "ordinary course" defense. Combining elements of culpability1 with the desire to leave "normal financial relations" undisturbed,2 the Old Code allows a preference defendant to keep an otherwise preferential payment if that defendant is able to show that the payment was made in the ordinary course of the debtor and defendant's business or financial affairs (the "subjective test") and made in accordance with ordinary business terms of the defendant's industry (the "objective test"). Thus, under the subjective test, the defendant must show that the manner and method of the allegedly preferential payments roughly matches the historical payment practices between the parties. Once that element is met, the objective test requires that the defendant show that the payments at issue were made in accordance with industry standards.

Ordinary course is easier raised than proved. One of the problems in using this defense under the Old Code was the evidentiary hurdles in meeting the objective test. Generally speaking, all companies have employees with at least basic knowledge of the payment norms established in their industry—be it the agonizingly lengthy payments pervasive in the automotive-supply chain, the rapid payment by wire common in the food industry, or somewhere in between. From an evidentiary perspective, though, the hearsay exclusion threatened much of this testimony since it was inevitably based on knowledge learned through conversations with industry peers, garnered through trade seminars or conventions, or gleaned through the reading of industry journals. Unless a company had an employee with personal or direct knowledge of the industry customs, usually obtained by prior employment with or acquisition of a competitor,3 a preference defendant was forced to either hire an expert or present evidence of a competitor's payment practices to meet this objective test. However, experts are expensive and potentially problematic,4 and getting evidence of competitors' payment practices in a fragmented or highly proprietary industry presents its own unique challenges.

Section 547 of the New Code, though, eliminates the need for a preference defendant to meet both the subjective and objective tests. Rather, a defendant who shows one or the other will prevail on the ordinary-course defense. The legislative history to §547 of the New Code states 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. Present law requires the recipient of a preferential transfer to establish both of these grounds in order to sustain a defense to a preferential transfer proceeding.5

Non-insider creditors wary of the Deprizio problem can be comforted that the one-year reach-back for insiders should not apply to non-insiders.

From a practical standpoint, most preference defendants using the New Code's version of the ordinary-course defense will defend their case using the subjective test, since it lacks the evidentiary hurdles required by the objective test. As with defending a case under the Old Code, defendants will attempt to show conformity between payments made in the preference period and the parties' prior practices and further show that the payments made in the preference period were made without undue influence or control by the defendant.

However, the objective test shouldn't be forgotten as a defense. Evidentiary issues aside, cases under the Old Code show that only payments that are idiosyncratic,6 aberrant7 or unusual8 in the defendant's industry fail to meet the objective test. A defendant unable to meet the subjective test due to oddities in the manner or method of payment may still be able to prevail under the objective test if the payments at issue fall within the "outer limits of normal industry practice."9 It will be interesting to see if this relaxed standard applies to use of the objective defense as a singular defense under the New Code.

Protection for Defendants in De Minimis Cases

One problem for many preference defendants was the cost-benefit analysis in defending very small cases, especially when those cases were in far-away venues with high-cost legal markets. After all, spending $10,000 in legal fees to defeat a $5,000 preference is a Pyrrhic victory.10 As a result, many defendants in these smaller preferences chose to settle otherwise defendable claims. Two provisions in the New Code or its related venue provisions will help these small-dollar amount defendants.

First, for business bankruptcies, the New Code bars recovery of preference claims with an aggregate value less than $5,000. S. 256 §409. Importantly, this $5,000 requirement is a defense to a preference claim, not part of the trustee's prima facie case. But for Bankruptcy Rule 9011,11 a trustee is not completely prohibited from demanding payment or filing suit in these situations.

Second, venue requirements for small preferences will change, requiring those actions seeking $10,000 or less to be brought in the venue where the defendant resides. S. 256 §410. Under the current version of 28 U.S.C. §1409(b), proceedings "arising in or related to" the bankruptcy case seeking less than $1,000 must be brought in the district where the defendant resides. Some courts found that this provision included preference defendants.12 Other courts disagreed, holding that preference actions were properly brought in the bankruptcy court, since preferences did not "arise in" a bankruptcy case, but rather "arose under" the Bankruptcy Code.13 As noted by the legislative history to the New Code, §1409(b) has been amended "to provide that a proceeding to recover a debt (excluding a consumer debt) against a non-insider of the debtor that is less than $10,000 must be commenced in the district where the defendant resides."14

Paydown on Insider-guaranteed Obligations: Correction of the "Deprizio Problem"

In Deprizio15 and its progeny, the Seventh Circuit held that the one-year preference period for "insiders"16 allowed recovery from a non-insider creditor if the preferential payment(s) at issue reduced a secondary obligation of an insider. The classic Deprizio scenario is a bank loan secured by an insider's personal guaranty. The Bankruptcy Reform Act of 1994 attempted to protect banks by adding a safe-harbor provision to §550 of the Code, preventing recovery from a non-insider for transfers made between 90 days and one year prior to the bankruptcy.17

Despite this amendment, commentary to the New Code suggests that "a trustee could still utilize §547 to avoid a preferential lien given to a non-insider bank, more than 90 days but less than one year before bankruptcy, if the transfer benefited an insider guarantor of the debtor's debt."18 Accordingly, the New Code amends §547 "to provide that if the trustee avoids a transfer given by the debtor to a non-insider for the benefit of an insider creditor between 90 days and one year before filing, that avoidance is valid only with respect to the insider creditor."19

Effective Date for Preference Changes under the New Code

An interesting question is raised as to when preference actions will be governed by the New Code. Certain provisions of the New Code were immediately activated on its enactment date, April 20, 2005. The Deprizio amendment falls into this category, being "intended to apply to any case, including any adversary proceeding, that is pending or commenced on or after the date of enactment of" the New Code. Other provisions of the New Code, the ordinary-course and de minimis amendments ostensibly included, though, are controlling for cases filed on or after the "effective date" of Oct. 17, 2005. However, the two-year statute of limitations with preference actions and these proceedings' relationship with the overlying bankruptcy case may muddy the application of this effective date.

Assume a hypothetical chapter 11 case filed on Oct. 3, 2005. With the exception of those provisions of the New Code effective as of the enactment date, that case is subject to the Old Code, since it was filed prior to the effective date. However, what about a preference action related to that case filed on Oct. 2, 2007? The preference action itself was filed after the effective date, and the defendant to that case could argue that the New Code is applicable. However, the actual chapter 11 case was filed before the effective date, so the trustee will argue that the Old Code is the controlling law. A civil case arising during the administration of the case, like a preference action, is technically a "proceeding," not a "case."20 Therefore, the trustee will have an argument that a preference action commenced after the effective date of the New Code, but related to a bankruptcy case filed before the effective date, will be subject to the Old Code, with the exception of the New Code provisions effective as of the enactment date. However, one questions whether Congress intended for preference actions filed in October 2007 to remain bound by the Old Code.


Under the new law, the ordinary-course defense will be easier to prove. Defendants in cases seeking less than $5,000 will have a complete defense to the action, and defendants in cases seeking less than $10,000 will have that suit litigated in a less-remote venue. Non-insider creditors wary of the Deprizio problem can be comforted that the one-year reach-back for insiders should not apply to non-insiders. When it does take effect, the new law will give the preference defendant a more favorable landscape to defend these claims.


1 At pages 382-85 of his book The Law of Bankruptcy, Prof. Charles Tabb of the University of Illinois College of Law has an interesting discussion noting that the ordinary-course defense arguably violates "the bankruptcy distributional scheme...predicated on equality between creditors" by allowing the culpability of a preference defendant to impact this distribution. Return to article

2 See S. Rep. No. 989, 95th Cong., 2d Sess. 88 (1978); H.R. Report No. 595, 95th Cong., 1st Sess. 373 (1977). Return to article

3 In re Hechinger Inv. Co. of Del. Inc., 320 B.R. 541, 550 (Bankr. D. Del. 2004) (noting testimony of preference defendant's president to establish objective standard proper since, inter alia, defendant had acquired competitor which had similar payment practices as defendant). Return to article

4 See, e.g., In re Roberds Inc., 315 B.R. 443 (Bankr. S.D. Ohio 2004) (discussing limine challenges to expert testimony in preference action). Return to article

5 H.R. Rep. 109-31(I), H.R. Rep. No. 31(I), 109th Cong., 1st Sess. 2005, 2005 WL 832198. Return to article

6 In re Tolona Pizza Prods. Corp., 3 F.3d 1029, 1033 (7th Cir. 1993). Return to article

7 In re Carled Inc., 91 F.3d 811, 818 (6th Cir. 1996). Return to article

8 FiberLite Corp. v. Molded Acoustical Prods. Inc. (In re Molded Acoustical Prods. Inc.), 18 F.3d 217, 224 (3d Cir. 1994). Return to article

9 In re Tolona Pizza Prods. Corp., 3 F.3d 1029, 1033 (7th Cir. 1993). Return to article

10 According to the online encylopoedia Wikipedia, the term Phyrric victory "alludes to King Pyrrhus of Epirus, who defeated the Romans at Heraclea and Asculum in 279 BC, but with severe casualties of his own. Pyrrhus's famous statement 'one more such victory and I am lost' led to the term 'Pyrrhic victory' for any victory so costly as to be ruinous." See Return to article

11 Like Federal Rule of Civil Procedure 11, Bankruptcy Rule 9011 requires a reasonable belief that the claim is allowable and warranted by existing law. Accordingly, a trustee with knowledge that a preference claim subject to the New Code had an aggregate value of less than $5,000 would not be able to bring that claim under the New Code without being sanctioned. However, a trustee with a good-faith basis for believing that the claim was worth $5,000 or more might be able to bring such claim. Return to article

12 See, e.g., In re Little Lake Industries Inc., 158 B.R. 478, 484 (9th Cir. BAP 1993). Return to article

13 See, e.g., In re Guilmette, 202 B.R. 9, 13 (Bankr. N.D.N.Y 1996). Return to article

14 H.R. Rep. 109-31(I), H.R. Rep. No. 31(I), 109th Cong., 1st Sess. 2005, 2005 WL 832198. Return to article

15 Levit v. Ingersoll Rand Financial Corp. (In re V.N. Deprizio Construction Corp.), 874 F.2d 1186 (1989). Return to article

16 11 U.S.C. §101(31). Return to article

17 11 U.S.C. §550(c). The legislative history to §550(c) notes that it "overrules" Deprizio, preventing use of the one-year reach-back to recover from "non-insider transferees." H.R. Rep. 103-835, 103rd Cong., 2d Session (1994). Return to article

18 H.R. Rep. 109-31(I), H.R. Rep. No. 31(I), 109th Cong., 1st Sess. 2005, 2005 WL 832198. Return to article

19 Id. Return to article

20 28 U.S.C. §157(b)(2)(F) (noting "core proceedings" include "proceedings to...recover preferences"). Return to article

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Wednesday, June 1, 2005