Some Modest Proposals on Preferences

Some Modest Proposals on Preferences

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Section 547 of the Bankruptcy Code allows challenges to transfers, whether voluntary or involuntary, that provide pre-petition recipients with more than they would receive if they had not been paid before the bankruptcy and had, instead, received only their proportional share in a later chapter 7 liquidation of the debtor. It is generally accepted that this provision has two main goals. See, e.g., In re Boston Pub. Co. Inc., 209 B.R. 157, 169 (Bankr. D. Mass. 1997). The first is to reduce the incentives for a creditor to push to the front and seize the assets, thereby forcing the debtor into bankruptcy. This is the "Bailey Brothers Building and Loan" theory of bankruptcy prevention—just as George Bailey in It's a Wonderful Life desperately needed his customers not to demand all of their money at once in order to keep the Building and Loan afloat for the benefit of all, so too do debtors need a tool to discourage a few demanding creditors from grabbing payment in full, while all the rest are left to the slim pickings available in a bankruptcy case. In turn, fulfillment of this goal serves the second goal of preference actions—namely, ensuring equality of treatment of creditors. This happens both by keeping the debtor out of bankruptcy so it can pay all of its debts and by ensuring that, if the debtor does file a petition, the favored creditors will be dispossessed of their excessive returns and left to receive their pro rata share with the others.

If equality of treatment of creditors in a bankruptcy case were the paramount goal, the preference section would simply end with allowing the avoidance of all transfers after a certain point. It is clear, though, that the goal of bankruptcy avoidance (which, as noted, also serves the goal of equal treatment) takes precedence, because two of the defenses to an otherwise avoidable transfer are the "ordinary-course-of-business" defense in §547(b)(2) and the "new-value" exception in §547(b)(4). Both are defenses that closely relate to the notion of strongly encouraging parties to continue dealing with the debtor on normal terms, even when the debtor is having financial difficulties. By doing so, those parties can help sustain the business (just as when Mrs. Davis, who only wanted $17.50 from her account—unlike Tom, who insisted on withdrawing his entire $242—earned a kiss from George Bailey. And the result, of course, was that the Building and Loan ended the day with $2 in the bank, and its doors still proudly open).

While it seems simple enough to say to the debtor's suppliers that they can rest assured in continuing to do business with the debtor, because of these defenses, the reality is far more complex. There are several reasons for the problem, and each stems from the current structure of the preference action and defenses, including the burden of proof. After outlining some of the issues, my "modest proposal" will suggest a small (but surely controversial) fix that may resolve several of the issues and allow preference litigation to better serve the goals stated above.

Failing Businesses Don't Operate in the "Ordinary Course"

The first difficulty with the current section is simple: Apart from bankruptcy cases that are precipitated by a sudden massive judgment being entered or natural disaster occurring, debtors who file for bankruptcy protection have usually not been operating in the normal course of business for some time before the filing. Businesses with adequate income, like individuals, ordinarily strive to pay each month's bill before the next one comes due. But also like individuals, as funds become tighter, businesses must juggle their cash flow, and some creditors become "more equal" than others. Just as financially troubled individuals tend to pay their mortgage first, and then the utilities, leaving the bills of doctors and lawyers until last, so too companies are likely to prioritize their bill payments. Some creditors—probably the same ones who the debtor would seek to pay on the first day of the case as critical vendors—are likely to still be paid relatively promptly, but others may find their payments sliding from 30 to 45 to 60 days or more. Yet those accommodating creditors are doing exactly what the Code encourages—continuing to deal with a struggling debtor to help it stay in business, and they are obviously not being preferred by the debtor.

So what happens when a bankruptcy is filed? Are these long-suffering creditors protected? Will they be able to keep the last payment they received some 60 or 78 or 89 days before the bankruptcy? And, if they can do so, will it only be because they continued to ship a new product without being paid, thus increasing their vulnerability in a bankruptcy? Will the debtor at least protect them in a first-day critical vendors' order? Or will they find themselves last in line again? The sad fact, for them, is that the likely answers fly in the face of the stated purposes of the preference and ordinary-course provisions.

To succeed on an ordinary-course defense, one must satisfy three forms of ordinariness: There must be (1) a debt incurred in the ordinary course of business (this one usually isn't the issue), (2) a payment made in the ordinary course of business between the debtor and the creditor, and (3) payment in accordance with ordinary industry terms. But do those tests really serve the goal of encouraging continued creditor involvement and equal treatment? The reality seems to be, under current case law, that a creditor who is a "critical" vendor, who makes the most demands for payment, who forces the debtor to direct an ever-increasing portion of its scarce resources to making timely payments to keep it satisfied, is probably best situated to defend on an "ordinary-course" basis! The timing of payments to such creditors will be consistent with what the debtor had done before, and consistent with what other non-failing businesses do. To be sure, the debtor might be able to rebut such evidence by showing increasingly strident collection demands from such vendors, but upon first glance, this creditor will readily appear to satisfy the elements of the ordinary-course defense.

And yet, do the uninterrupted and prompt payments being made to such a creditor satisfy either goal of the preference statute? Plainly not. The demand for full and timely payment does not help keep the debtor in business, and the creditor probably is receiving a true preference compared to other pre-petition creditors. Yet such parties will be most able to not only defend their payments during the case but to force an early payment in the case for their last bills that came due pre-bankruptcy.3 On the other hand, the lowly vendor whose forbearance helped the debtor stave off bankruptcy for a while will find that the delays in receiving payment will throw him out of step with the past practice with the debtor and with the practices in the industry.

Moreover, creditors can lose an ordinary-course defense even if the debtor is slowing down payments to all of its creditors in exactly the same fashion. In most preference litigation there appears to be little effort to determine if the timing for accounts payable has been delayed across the board so as to become the new "ordinary course" for this debtor. And even if it were shown that the debtor is uniformly stretching everyone out, the creditors would still likely lose on the third prong of "ordinary business terms" for the industry as a whole. If the economically sound competitors are paying on a 30-day cycle, a business that receives indulgence from all of its creditors to stretch them out to 90 days may be able to turn around and attack all of those payments as preferential, if it later fails to survive. Thus, even though there is no discriminatory aspect to these payments, all of the creditors can lose these cases. If so, though, does this then not make the ordinary-course-of-business defense a hollow mockery for most creditors? And if, as suggested above, most debtors are not operating in the ordinary course for a time prior to bankruptcy, why suggest a defense that will not truly be available in most cases?

How, then, does §547 really serve the goal of encouraging creditors to continue doing business with the debtor and helping to stave off bankruptcy? If a creditor can see that leniency shown to the debtor will be as likely to result in a preference action as an overly stringent collection policy, why not gamble on the latter? The result will be more emphasis on immediate payment and more pressure on the debtor, and not less. This may be particularly true in that the eventual chapter 7 liquidation and the belated flurry of avoidance actions usually come only after the estate assets have been eaten up by professional fees in a failed chapter 11. Thus, the parties whose forbearance did the most to keep the debtor out of bankruptcy find themselves forced to disgorge whatever payments they did eventually receive in order to pay professionals in an unsuccessful case. Such results are unlikely to encourage leniency in the future. These trends are exacerbated by the way in which decisions on bringing preference actions are now considered.

Who Gets Sued? (or, "Where's the Check Register?")

The standard for finding an avoidable transfer is that the creditor receives more from such a transfer than it would in a chapter 7 liquidation. Considering that the liquidation analysis in even a highly viable chapter 11 usually shows that unsecured creditors will receive little or nothing, virtually any transfer then can be initially vulnerable to an attack. Yet the primary criteria for deciding whether to bring avoidance actions appears to be what creditors will receive in the chapter 11 reorganization, not the chapter 7 liquidation. If all creditors are going to receive a respectable sum (but, by no means, 100 percent), then everyone forgets about the long and tedious work of preference analysis, even if such attacks could be legally valid. On the other hand, if the reorganization fails (and particularly if the case is administratively insolvent), suddenly it appears that the amounts received by pre-petition creditors will become prime litigation targets.

The result of this calculus means that preference actions are increasingly pushed to the end of the case, with several problematic results. For instance, the Code explicitly makes the failure to return a preference a defense to allowance of a claim—and yet, in many cases, debtors do not bother to perform that analysis for even the largest claims at the time that they are being reviewed and resolved. As a result, there have been a flurry of recent cases dealing with whether there is some sort of res judicata or estoppel bar to raising the preference issue after the claim has been resolved.4 There are valid arguments to be made on both sides of that debate, but the point is that preference decisions are not made on the merits of that litigation, but only as part of a far larger reorganization strategy—and one that cannot review even a limited number of potential avoidance actions in isolation on their own merits. See also, In re Toledo Equipment Co. Inc., 35 B.R. 315, 319-20 (Bankr. N.D. Ohio 1983), which notes that the debtor may not wish to bring avoidance actions to avoid alienating certain creditors—a useful goal in a reorganization, but not one that supports the principle of equal treatment of all creditors.

Similarly, because the only real criteria is whether the chapter 11 plan succeeds or fails, the two-year deadline in §546 is often largely eaten up by the time the plan is confirmed and the determination is made of what unsecured creditors will get. Indeed, the time may pass before a plan is even in the offing. It would not be that difficult to comply with the deadline if the only issue were what the result of a liquidation would be, because the liquidation analysis is likely to be relatively stable in the case, even though a reorganization figure may change. Thus, if one were to look solely at liquidation results, there would be no reason to delay proceeding on the actions well within the deadline. But, as noted, that is not what happens. Thus, we have the spectacle of nothing happening on preferences until just prior to the deadline, and then a flurry of dozens, hundreds or even thousands of such complaints being filed. See, e.g., In re Outboard Marine Corp., 2003 WL 22835009, *6 (Bankr. N.D. Ill. Nov. 24, 2003) (1,400 actions filed); In re Hechinger Inv. Co. of Delaware Inc., 296 B.R. 323 (Bankr. D. Del. 2003) (denying request to transfer venue of proceeding because allowing it would be a "precedent for hundreds, if not thousands of transfers"); In re Stone & Webster Inc., 2003 WL 21356088 (Bankr. D. Del. June 10, 2003) (same).

In turn, this leads to many other systemic flaws. The need to take such action in a mad rush leads to what many opine darkly as the "check register" form of preference analysis—i.e., open up the register at the 90th day pre-petition and start filling out the caption of the complaints. The value of filing blunderbuss complaints is greatly aided by several factors inherent in filing such complaints: The factors to show for the prima facie case are minimal for all but the smallest of cases; the venue of the proceeding is in the district where the bankruptcy was filed, although that district may not be the primary location of the debtor's businesses and its debts;5 and the issues involved in proving ordinary course (under the Code's current language) are complex and often involve elaborate and costly investigation of factual issues involving third parties who have no particular obligation to provide the requisite information. Moreover, because the "ordinary-course" issue is an affirmative defense, the courts are generally reluctant to impose any strong investigative obligation on the debtor in order to find that it has met its duty under FRCP 11. See, e.g., In the Matter of Excello Press Inc., 967 F.2d 1109 (7th Cir. 1992); In re Berger Industries Inc., 298 B.R. 37, 41-42 (Bankr. E.D.N.Y. 2003), In the Matter of Leeds Bldg. Products Inc., 181 B.R. 1006, (Bankr. N.D. Ga. 1995).

And of course, having filed so many complaints at one time, counsel may then find that they cannot actually handle them, or that they do not, in fact, intend to litigate the cases if it may be possible that the reorganization can succeed. Thus, there is the interesting spectacle of the Safety-Kleen case, Case No. 00-2303 (PJW). The debtor filed its chapter 11 case in June 2000, and just prior to the two-year deadline, filed complaints against 421 defendants. It then asked the court to let it delay service of the complaints beyond the 120 days set out in Bankruptcy Rule 7004, because serving the complaints on their "current vendors could result in substantial harm to the estates and the debtors' ability to complete the reorganization," and leaving the matter in limbo would avoid forcing the defendants to "engage counsel and undertake the time and expense of defending against a proceeding that may ultimately be resolved in a plan of reorganization without the need for litigation." That process of receiving additional extensions has been repeated through March 23, 2004, and an additional extension was requested so that it would be some four years from the date the case was filed before the complaints were actually being served. It is doubtful that Congress really intended a two-year deadline to become, effectively, an unlimited period of time to actually institute suit.

A number of creditors finally opposed that last extension and moved to vacate the prior extensions, and Safety-Kleen is vigorously opposing them. See its April 15, 2004, response to objections to its motion filed on March 22, 2004, Docket No. 8369, to further extend the time for service. It may be correct that the creditors waited until it was too late to raise their issues, but what the case does illustrate well, though, is the dynamic here. The decision to bring a preference action turns not on whether the creditors really have been preferred, or whether they assisted the debtor's pre-petition efforts to stave off bankruptcy, but rather how such actions will fit into the post-petition reorganization efforts.

What Happens When the Complaints Start to Fly

If the reorganization does fail, then creditors are faced with a newfound appetite by the debtor to bring such actions. Indeed, the appetite may be even stronger in that such actions may well be turned over to an outside party that does nothing but pursue such actions on a contingency-fee basis. The hunger for the payments, when combined with the formidable advantages detailed above for the pursuit of such actions (minimal initial showing, costly and difficult burden of proof on the creditor to prove both not only its own practices but those of the industry as a whole, distant venue and the like), provides a strong incentive for assembly-line litigation. File a large number of complaints, wait to see who responds, default any small parties that do not know how to navigate the system, and let the creditors spend the time and money to assemble the records about the timing of their transactions with the debtor (information that is equally within the debtor's knowledge). Then, either drop the complaints that are most clearly without merit or, more likely, offer first to settle for a relatively small amount of money—perhaps a quarter, perhaps a third of the claim. For many creditors, being let out of difficult litigation at what seems to be a relatively low cost will likely prove appealing, and they will choose not to fight back. Only the ones with the largest amount at stake may find it worthwhile to litigate.

Thus, the result is that the debtor or estate representative may find that it is able to bring in money from a large number of creditors with relatively little effort—regardless of the merits of the actual litigation. There is an element of coercion in all of this and, while the Code favors the maximization of the assets, does it really intend that this should be done by bludgeoning funds out of all of the parties that did business with the debtor pre-petition? Is this, in any event, a method of operation that will encourage such creditors to continue doing business with struggling entities?

The problem is particularly acute for states and state taxing authorities. Taxes are almost surely one of the last things business debtors will attempt to avoid paying, in light of the large penalties and liabilities that can accrue and the potential for personal liabilities for corporate officers. Moreover, there is a clearly established statutory due date for such payments—and most crucially, a Code provision (§547(a)(4)), which provides that a tax debt is not even "due" until the last date that it can be paid without penalty. Thus, any tax payment that is made within the proper statutory payment dates is not even a preference to begin with. Yet the taxing agencies may well find themselves defendants in omnibus preference actions for all taxes filed in the 90-day period, despite the debtor's obvious ability to match up the statutory filing date and the date of the payments, as well as to conduct a more traditional ordinary-course analysis. Moreover, ignored in that process is the likelihood that, as the tax would otherwise qualify as priority under §507(a)(8), the trustee cannot prove that the tax creditor got more than they would have gotten in a chapter 7 liquidation. If an estate is administratively insolvent to the extent that full payment would not ultimately extend to such priority debt, an argument can be advanced that no chapter 11 plan should be considered in the first place. See, e.g., In re Southwestern Water Corp., 227 B.R. 262 (Bankr. W.D. Tex. 1998). See, also, In re Calvanese, 169 B.R. 104 (Bankr. E.D. Pa. 1994); In re Holmes (Holmes v. United States), 301 B.R. 911 (Bankr. M.D. Ga. 2003). Many of the taxes may not be overly large, and given the fiscal straits in which most states find themselves, it can be difficult to justify trying to make appearances in a distant courtroom to defend such matters. If debtor's counsel immediately rescinds the complaint upon being given the requisite information, the burden is lessened, although not eliminated. But in light of the "sue-and-settle" mode of preference resolution, it is often difficult for the taxing authorities to convince the other side that they do not intend to meekly cough up the 25 or 30 percent being demanded of them. The result can be a protracted battle in a distant jurisdiction before the actions finally disappear. In addition, mandatory alternative dispute resolution mechanisms in larger districts can further muddy the waters by even unintentionally suggesting that a claim should always be settled, even where it has no merit.

The "Modest Solutions"

So, what changes might be suggested? To some extent, of course, the answer depends on what one really hopes to accomplish with the preferential-transfer provisions. If one is trying to encourage creditors to continue dealing with the debtor, then one might well suggest cutting back substantially on what needs to be shown to prove ordinary course, recognizing the problems by showing that any of the debtor's dealings prior to the bankruptcy were really "ordinary." The pending bankruptcy legislation suggests that one can show that payments are made either in the ordinary course of business with the debtor or are ordinary under industry terms. That might even be expanded to establish that the debtor's ordinary course should be looked at in terms of whether it is changing over time. Under such an analysis, the real issue would be whether this creditor is receiving any more than others during the preference period.

Alternatively, or in addition, another solution might be to change the burden of proof on the ordinary-course defense. If it were not so easy and simple to set up the prima facie case, it is likely there would be more investigation, more winnowing of the actions brought so that they do focus on those creditors who really have pushed to the front of the line and grabbed more by virtue of their pressure on the debtor—and less funds received simply by virtue of the blackmail potential of the current system. Under current law, a failure to make any investigation of the merits of ordinary-course payments will rarely, if ever, be enough to invoke sanctions, because it is a defense. If the burden were on the debtor to establish that the payments were not in the ordinary course, this could change that calculus considerably.

And finally, as a true "systems-engineering" approach, if it does seem important to ensure that, in a liquidation, all parties dealing with the debtor pre-petition should suffer at least some pain, then why not simply write in a provision that everyone must automatically give back a set percentage (say, 25 percent?) of the payments they have received? It's quick, it's easy, it doesn't require litigation costs in the main (thus leaving the estate with more net funds), and it at least has the virtue of predictability. Indeed, at least one other virtue that non-state creditors will surely appreciate is that it might obviate sovereign immunity issues as to state creditors! While presently the states can generally assert an immunity defense to a stand-alone avoidance action brought as a judicial action against them, the situation could be different if the requirement to pay was simply set up as a statutory obligation. Just as the stay applies to states under the Supremacy Clause and can be enforced by a suit against state officials if they fail to comply, so too, it might be better to argue that the obligation to return the payments could also be enforced by injunctive action. To be sure, I'll probably argue the opposite side of that issue if the change were ever made, but I present the thought gratis.

Thus, here are a few "modest solutions." Any takers?


1 With apologies to Jonathan Swift and his "Modest Proposal" of 1729 for avoiding the problems of poor children in Ireland by selling them off to be fed to the landlords. Return to article

2 The views expressed herein are those of the author and should not be taken as the position of the National Association of Attorneys General, any individual attorneys general or any members of their staffs. Return to article

3 This assumes that, despite the Seventh Circuit's decision in In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004), it will still be possible for at least some really important vendors with a good factual record to be able to obtain early payments. Return to article

4 See discussion in "TWA Evens the Score on the Availability of the §502(d) Claim Preclusion Defense in Delaware," April 2004 ABI Journal, p. 44. Return to article

5 Under Title 28, §1409(b), an action must be commenced in the creditor's district only if the amount at issue is under $1,000 for a business debt. Return to article

Journal Date: 
Tuesday, June 1, 2004