The rise in corporate bankruptcy filings has heightened the angst of defendant companies searching to understand why they have to return money to a company that already stuck them with a large write-off. While much theoretical analysis exists on defending a preference suit, today's economy dictates practical, straightforward approaches to resolving threatened avoidance actions. This article sets forth 10 practical steps to assist in the efficient, cost-effective resolution of these claims.

Know the Facts

It is critical at the outset to properly evaluate the case against your client. You should assume that the plaintiff's lawyers and accountants have fully analyzed the transfers in the case. In properly defending the action, it is imperative to gather all the facts underlying the transfers at issue and the underlying bankruptcy case. The tendency for some defense counsel in a preference action is to go straight to the ordinary-course-of-business and new-value defenses. This practice can cause you to overlook a key defense to the action, including problems in the plaintiff's case-in-chief. The time and effort spent early on in understanding the file and the transactions at issue will pay dividends in the ultimate resolution of the matter.

Chart the Factual History

Most attorneys prefer to receive and process information visually. Creating a chart analyzing the transfers at issue organizes the information and provides ready assistance in resolving the case. Even if the case is not settled, the charts are useful at trial as an effective way to present evidence to the court. This approach is especially helpful in proving subjective ordinariness under §547(c)(2)(B) by comparing transfers in the preference period with the pre-preference period. A sample ordinary-course-of-business chart is set forth in Tables 1 and 2.

An analysis of these charts shows that with one exception (92 days), all transfers in the preference period fall within the pre-preference period range. Although the average number of days shifts later in the preference period, most transfers fall within the amount and timing of the pre-preference period. This analysis provides evidence of subjective ordinances to assist resolution of the case.

Charting the subsequent new-value defense is fairly straightforward. There is no netting of the transfers and the new value, but rather the information is charted chronologically. A sample subsequent new-value chart is set forth in Table 3.

Often, there is little or no dispute on the subsequent new-value analysis. Depending on the jurisdiction, the new value may need to remain unpaid to qualify under the defense. Compare In re IRFM Inc., 52 F3rd 228 (9th Cir. 1995) (new value need not remain unpaid but rather must be paid for by an otherwise unavoidable transfer), with In re Jet Florida Systems Inc., 841 F.2d 1082 (11th Cir. 1988) (new value must remain unpaid); In re Kroh Bros., 930 F.2d 648 (9th Cir. 1991) (creditor may not assert new-value defense to extent that creditor has been paid for new value by debtor). However, once you know the law of the jurisdiction, a subsequent new-value chart with supporting documentation should resolve any issues as to that defense.

Write a Detailed Settlement Letter

Once you have analyzed the facts and know the law in the jurisdiction where your case is pending, the possible outcomes start to become clear. In order to move the matter to resolution, a detailed settlement letter to plaintiff's counsel outlining why the defendant will prevail in the matter helps initiate settlement talks. The letter should analyze the facts as investigated, attach the charts organizing the defenses and generally set forth the best argument for why the case should be dismissed, or at least settled for a nominal amount. Even if the letter and information does not result in a dismissal or settlement, this type of analysis and discussion will frame the issues involved in the case and focus the litigation as you proceed toward trial.

Raise Affirmative Defenses in the Answer

It is easy to fall into the trap of resorting to a form answer that hits the big three defenses for preferential transfers—contemporaneous exchange, ordinary course and subsequent new value—and ignoring other possible winning defenses. A recent decision of the Eleventh Circuit points to the fact that it is critical to raise all possible defenses, even if prior judicial opinions within your district indicate that such defense may not apply. In re Finance Federated, 309 F.3d 1325 (11th Cir. 2002). In Finance Federated, the trustee sought to avoid fraudulent conveyances made pursuant to an alleged ponzi scheme. The defendant raised as an affirmative defense that she took the transfers "for value and in good faith" pursuant to §548(c). The plaintiff argued that established case law prevented a participant in an alleged ponzi scheme from relying on the good-faith affirmative defense to an avoidance action. Based on the reported precedent, the bankruptcy court and district court agreed with the plaintiff. The Eleventh Circuit reversed, holding that the defendant was not barred as a matter of law from asserting the affirmative defense that she received the transfers "for value and in good faith." If defendant's counsel in Finance Federated had relied on the established case law that the plaintiff (and the bankruptcy court and district court) found persuasive, and not raised the defense, the defendant would have missed an opportunity to limit her exposure.

Barriers to Recovery

Another fertile area of attack for a defendant in an avoidance action is to raise barriers to the plaintiff's action. These include (1) standing to pursue the action, (2) lack of benefit to the estate and (3) res judicata. The Third Circuit, en banc, has confirmed its position (contrary to an earlier withdrawn panel opinion) that a creditors' committee has derivative standing to prosecute an avoidance action. Official Committee of Unsecured Creditors of Cybergenics Corporation v. Chinery, 330 F.3d 548 (3d Cir. 2003). Even though the initial panel decision holding otherwise was withdrawn, the earlier analysis in opposition to derivative standing may prove helpful in other circuits. In the initial opinion, the panel concluded that the plain language of the statute, read in conjunction with the Supreme Court's interpretation of §506(c) in Hartford Underwriters, prohibits a creditor or creditors' committee from maintaining standing to prosecute an avoiding action. As a result, a creditor sued in an avoidance action by a creditor or creditors' committee in a circuit that has not previously addressed derivative standing can raise the plaintiff's lack of standing in response to the complaint.

Section 550(a) of the Bankruptcy Code states that the trustee may recover "for the benefit of the estate" the property transferred. 11 U.S.C. §550(a). In a case where only the professionals or secured creditors will share in any avoidance recovery, a defendant can argue that avoidance of the transfer will not benefit the estate. Courts have come to varying results on this issue. Compare In re S&D Foods Inc., 110 B.R. 34 (Bankr. D. Colo. 1990) (no benefit to estate where only secured creditor will recover proceeds); In re Huntsville Small Engine Inc., 228 B.R. 9 (Bankr. N.D. Ala. 1998) (full and total assignment of avoidance action proceeds to secured creditor for no consideration resulted in no benefit to estate if creditor prevailed in avoiding the transfer) with In re Trans World Airlines Inc., 163 B.R. 964 (Bankr. D. Del. 1994) (benefit to the estate is construed broadly; no requirement that avoidance action recovery be distributed in whole or in part to creditors). Investigation into the facts underlying the bankruptcy case and what, if any, benefit to the estate will result from the avoidance may provide the defendant an opportunity to move for dismissal of the avoidance action.

Some defendants have succeeded in raising res judicata principles to prevent avoidance of a transfer when the confirmed reorganization plan did not explicitly permit post confirmation prosecution of the action. Section 1123(b)(3)(B) states that a plan may provide "for the retention and enforcement by the debtor, by the trustee or by a representative of the estate appointed by such purpose of any claims or interest." Courts have struggled with a debtor's ability to prosecute an avoidance action where retention is not specifically provided for in a confirmed plan. The legal theory rests in concepts of res judicata. If a creditor's claim is not contested but is fully allowed in a plan, the court may bar the debtor under res judicata principles from pursuing the action because the plan resolved all issues between the debtor and creditor, including any potential avoidance actions. In re Mickey's Enter. Inc., 165 B.R. 188 (Bankr. W.D. Tex. 1994); In re Paramount Plastics Inc., 172 B.R. 331 (Bankr. W.D. Wash. 1994). A related res judicata issue involves claim-allowance proceedings. In re LaRoche Industries Inc., 284 B.R. 406 (Bankr. D. Del. 2002). Section 502(d) states that courts shall "disallow any claim of any entity...that is a transferee of a transfer avoidable under §...547 of the title, unless such entity or transferee has paid the amount, or turned over any such property for which such entity is liable." In LaRoche, a creditor filed a lease-rejection damage claim, and the debtor objected to the amount of the claim. The creditor did not respond to the objection, and the claim was allowed in the lesser amount. The creditor received stock under the plan based on its allowed claim. Subsequently, the debtor brought an avoidance action against the creditor. The creditor sought dismissal because the claim was previously litigated and allowed. In LaRoche, the court found that if a claim is allowed, there is no longer an avoidable transfer due from that claimant.

Make the Plaintiff Prove All of Its Elements

Often the best defense is to make sure that the plaintiff has the evidence necessary to cover all bases on the elements of its claim.

As a preference defendant, consider whether the property transferred was property of the debtor. The judicially created earmarking doctrine may provide necessary ammunition to defeat the plaintiff on this element of its case. Under the earmarking doctrine, if the debtor had no control over the funds in question, and rather the property transferred was property of a non-debtor third party, which merely passed through the debtor's hands on its way to the defendant, the plaintiff may fall on this element. See Norton Bankruptcy Law & Practice, 2d, §57:27.5; In re Heitkamp, 137 F.3d 1087 (8th Cir. 1998); In re Superior Stamp & Coin Co. Inc., 223 F.3d 1004 (9th Cir. 2000) (transferee dispersed funds pursuant to an agreement to use funds to pay a particular creditor and therefore, did not exercise "control" over money even though it was put in the debtor's bank account).

---

While some courts historically accepted analysis of the course of dealings between the parties as sufficient to meet the ordinary-course defense, the majority of courts confirm that a defendant must meet the independent, third prong of industry standards.

---

Similarly, although the debtor is presumed insolvent, the defendant can rebut the presumption. In re Lids Corp., 281 B.R. 535 (Bankr. D. Del. 2002) (transferee must present sufficient evidence that debtor was solvent to rebut the statutory presumption; if it does, the burden of persuasion shifts to the debtor to convince the court that it was insolvent on the relevant date). A cursory review of the debtor's bankruptcy schedules may show a situation where the debtor affirmed that its assets exceeded its liabilities. The debtor also may have taken the position that it was solvent in reclamation cases early in the bankruptcy. Although lengthy and costly litigation over insolvency can ensue based on determining the true value of assets listed on the bankruptcy schedules, the fact that the schedules display assets exceeding liabilities may be sufficient to rebut the presumption and gain leverage in settling your case.

Use Industry Standards in the Ordinary Course Defense

Section 547(c)(2)(C) requires that a defendant prove that the transfers at issue were made according to ordinary business terms. The third prong of the ordinary course defense requires that a defendant prove by a preponderance of evidence that the transfer was made in accordance with objective, industry standards. While some courts historically accepted analysis of the course of dealings between the parties as sufficient to meet the ordinary course defense, the majority of courts confirm that a defendant must meet the independent, third prong of industry standards.

In analyzing industry standards, courts are looking to the "range" of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage and that only dealings so idiosyncratic as to fall outside that "broad range should be deemed extraordinary and outside the scope of ‘547(c)(2)(C)." In re Tolona Pizza Prods. Corp., 3 F.3d 1029, 1033 (7th Cir. 1993). The issue then becomes what evidence is sufficient for a defendant to meet the objective standard of the ordinary course defense. Early cases indicated that testimony from informed representatives of the defendant was sufficient for the defendant to carry its burden. Tolona Pizza; Lovett v. St. Johnsbury Trucking, 931 F.2d 494 (8th Cir. 1991). Recently, a majority of courts require independent expert testimony to prove industry standards. See Lupinacci & Meek, "Objective Ordinariness Under §547(c) (2)(C): Is It Merely a Battle of Experts?," Norton Bankruptcy Law Adviser (January 2003) (cataloging independent evidence required to prove industry standards); Official Comm. of Unsecured Creditors v. Liberty Savs. Bank (In re Toy King Distribs. Inc.), 256 B.R. 1 (Bankr. M.D. Fla. 2000). In Toy King, the court indicated the defendant must adduce evidence of a prevailing practice among similarly situated members of the industry facing the same or similar problems. The court stated that testimony from the defendant's own representative as to the specific practices of the defendant in the industry was insufficient to prove industry standards. The court noted that testimony of a defendant's officers is inherently suspect, even if it includes evidence of industry practices. As a result, the court found that the defendant failed to prove that industry standards and their ordinary-course defense failed.

Courts are generally all over the map on the type of evidence required to prove industry standards. See In re DeMert & Dougherty Inc., 232 B.R. 103 (Bankr. N.D. Ill. 1999) (defendant's credit manager with no personal knowledge of competitors' credit practices was insufficient to prove industry standards); Arrow Elecs. Inc. v. Justus (In re Kaypro), 218 F.3d 1070 (9th Cir. 2000) (testimony of industry knowledge of credit manager with five years of experience is sufficient despite "self-serving" nature of declaration); Grigsby v. Purolator Prods. Air Filtration Co. Inc. (In re Apex Auto. Warehouse L.P.), 245 B.R. 543 (Bankr. N.D. Ill. 2000) (affidavits from vice president and general manager of an industry trade group sufficient to show credit relationship of creditors in the industry). It is important early on in your defense to focus on industry standards and identify any experts you intend to use at trial. Make sure to timely identify the expert and produce any expert report.

Do Not Overlook Local Trade Groups and Competitors When Hiring Experts

When you determine that the specific facts of your case and the dollar amount involved warrant hiring an expert, check with local chapters of national or regional trade groups. For example, the National Association of Credit Management (NACM) has active local chapters of credit managers and other credit personnel who meet regularly to discuss a variety of issues. At the regional and national meetings of these groups, many trade groups provide advance training in testifying as experts as to industry standards. If there is a local chapter active in your jurisdiction, this is an excellent source to locate individuals to serve as an expert witness in a particular industry. Also check if there are any trade group standards governing the applicable industry, such as the Southern Mill Rules for the Buying and Selling of American Cotton.

Another key source of expert testimony is credit personnel from competitors in the industry. While this provides an interesting dynamic of relying on testimony from a competitor, the realities of the global economy dictate that the competitor may need your client to return the favor in a subsequent case. Using testimony from a competitor in the same geographic region will help cut down on the expense of such testimony, and it is the type of testimony that courts find persuasive in framing the applicable industry standards.

Make a Jury Demand

If the defendant has not previously filed a proof of claim in the bankruptcy case, consider including a jury demand in the answer. It is well-settled that a creditor filing a proof of claim submits to the summary jurisdiction of the bankruptcy court and waives its rights to a jury trial. If, however, no claim has been filed, the creditor maintains the right to a jury trial. In re Just for Feet Inc., 2002 WL 550035 (Bankr. D. Del. 2002); In re Silver Mill Frozen Foods, 80 B.R. 848 (Bankr. W.D. Mich. 1987). The overlay of a jury trial complicates matters for the plaintiff and may be in the defendant's best interest.

Secure All Necessary Evidence

If you get to trial, make sure you have the evidence necessary to prove each element of your defense. Reported avoidance action decisions are littered with courts finding that a defendant proved some, but not all, of the elements necessary to prevail and avoid liability. When preparing the defense, consider whether enough evidence exists to argue the case on appeal. If you cannot introduce at least that level of evidence into the record at trial, you will have significant problems convincing the trial judge. Do not assume the judge will agree that one or more of your elements are clearly proven; rather, give the judge enough evidence so that she has no choice but to rule in your favor. If you have concerns about your ability to prove one or more of your elements as you prepare for trial, that is an excellent reason to revisit settlement with the plaintiff.

It is important to provide a preference defendant accurate, concise and cost-effective analysis of its exposure before spending significant time in litigation. Using some or all of these practical tips should assist in the resolution of avoidance actions.