Legal Spotlight

Brian T Harvey explains the intricacies of the Bankruptcy Code and offers some strategies that could help creditors defend themselves against preference liability

Whether you are a party to litigation entering into a settlement agreement, a trade creditor contemplating a compromise of a delinquent account, a lender negotiating a workout, or simply conducting business as usual, all dealings with financially troubled parties should be approached with an eye on avoiding preference risk. Creditors who do business with entities they suspect are on the verge of seeking bankruptcy protection may be required to return the payments received from that entity within the 90 days preceding the commencement of a bankruptcy case.

Most creditors would probably consider it unreasonable that they be required to return a payment received on a valid debt, but the US Bankruptcy Code's preference provisions are intended to ensure all creditors receive an equitable pro rata share of the debtor's assets. Despite this, there is nothing improper about accepting a potentially avoidable preferential payment. For that reason, all creditors should be aware of the following defences and practical strategies for reducing potential liability to preference claims.

Elements of a preference action

Section 547 of the Bankruptcy Code sets forth the elements that a trustee, or debtor in possession, must establish to recover a preferential payment. The trustee bears the burden of proof in establishing that the payment was (i) a transfer of an interest of the debtor in property, (ii) made to or for the benefit of a creditor, (iii) for or on account of an antecedent debt, (iv) made while the debtor was insolvent, (v) made within 90 days before the date of filing the bankruptcy petition (or within one year if the creditor is an insider of the debtor) and (vi) that resulted in the creditor receiving a greater distribution than it otherwise would have in a chapter 7 distribution.

Preference liability is predicated upon a creditor's betterment of position during the 90 days preceding the commencement of a bankruptcy case. As a result, fully secured creditors typically do not need to be concerned about preference risk because pre-petition payments do not provide secured creditors with a greater distribution than they would receive upon liquidation of the collateral. However, under-secured and unsecured creditors do need to be aware of preference risks because pre-petition payments within the preference period will improve those parties' distribution upon liquidation. Likewise, the grant or perfection of a new security interest within the preference period, such as the acquisition of additional security through a workout, is also subject to potential avoidance.

Statutory defences

The Bankruptcy Code provides several defences to preference liability in order to encourage creditors to continue conducting business with a financially troubled debtor in the hope of avoiding a bankruptcy filing. The three most common defences are (i) the contemporaneous exchange for new value, (ii) the subsequent new value and (iii) the ordinary course of business defences.

The first of these three defences prevents recovery of a payment when the transfer was intended by the debtor and creditor to be a contemporaneous exchange for new value given to the debtor and when such exchange was in fact substantially contemporaneous. New value is defined by the Bankruptcy Code as money or money's worth in goods, services or new credit, or a release by a transferee of property previously transferred; but does not include an obligation substituted for an existing obligation.

A common mistake of creditors conducting business with a financially distressed entity is to apply incoming payments to the oldest outstanding invoices. Creditors who suspect a debtor is in financial trouble and wish to protect incoming payments from a preference action should apply those new payments to the goods or services provided at the time of payment. Doing so will allow a creditor to avail itself of the contemporaneous exchange for new value defence.

Slightly different is the subsequent new-value defence, which - as the name suggests - prohibits a trustee from avoiding a transfer where the creditor subsequently provided new value to the debtor. Once a creditor receives notice that a bankruptcy case has commenced, the creditor should account for all payments received from the debtor within the 90 days preceding the filing of the bankruptcy petition and match those payments to goods shipped or services provided after the date of the oldest payment received within the preference period. This will allow the creditor to analyse the extent of its new-value defence and potential liability to a preference attack, aiding a cost-effective resolution of any preference demand.

The third of the common defences applies when the payment is received in the ordinary course of business between the creditor and debtor. The 2005 revisions to the Bankruptcy Code greatly eased the requirements for application of this defence in that a creditor now must prove either that the payment was received in the ordinary course of business between the parties, or on terms ordinary for their particular industry. Prior to the amendments, a creditor was required to prove both.

To employ this defence successfully it is vital a creditor keeps detailed records of the dates payments are received in relation to the payment-due dates, or dates invoices are generated, to show the pattern of payments received within the 90-day preference period is comparable to either industry statistics or the prior payment history between the parties. This defence highlights another common mistake of creditors, which is to restrict credit terms upon discovering a debtor is in financial difficulties. Payments received after a creditor begins restricting credit terms may be viewed by a bankruptcy court as outside the ordinary course of business between the creditor and debtor. Rather than tighten or more strictly enforce credit terms, creditors should require prepayment in order to avail themselves of the new-value defences discussed above.

Settlements and workouts

Settlement payments received within the preference period may be subject to avoidance since the settling parties are compromising an antecedent debt and no new value is being provided to the debtor. However, a minority of courts have agreed with the argument that a settlement agreement constitutes a contemporaneous exchange for new value when the settlement releases the debtor from risk of a contingent claim, thus providing the debtor with new value. Therefore, when entering a settlement agreement, the agreement should be drafted to recite explicitly the new value being exchanged, such as a full release of all causes of action, and the parties' intentions that the exchange be substantially contemporaneous.

Another possibility for drafting a transaction that minimises risk of avoidance is to make use of the earmarking doctrine. One of the elements necessary for a trustee to avoid a pre-petition transfer is the requirement that the transfer consist of an interest of the debtor in property. This requirement presents an opportunity for structuring a transaction in a way that limits the risk of a preference attack. The earmarking doctrine protects transfers that are supplied by and earmarked for the creditor by a non-debtor third party, such as a new lender, an insider or an affiliate. If a creditor can establish that all of the elements of the earmarking doctrine have been met, it may be able to protect successfully a settlement payment received within the 90 days preceding the commencement of the debtor's bankruptcy case.

For a transaction employing the earmarking doctrine to be protected from avoidance, the transacting parties should adhere to the following guidelines: (i) there should be an agreement between the debtor and the non-debtor third party that the new funds will be used specifically to pay the existing creditor's antecedent debt, (ii) the agreement should evidence that the debtor does not have control over the disposition of the funds, (iii) the existing creditor should retain evidence that the agreement has been performed according to its terms and (iv) the transaction should not diminish the debtor's estate, for example, by replacing an unsecured obligation with a secured obligation.

Conclusion

Although it may be impossible to eliminate preference risk completely when dealing with a distressed entity, especially when drafting a settlement or workout agreement, the strategies discussed above can help reduce such risk. Further, given the available statutory defences, if a payment received within the preference period is attacked as a preference, a compromise can probably be reached with the trustee that would prove more favourable to the creditor than the recovery that could be expected through the bankruptcy claims process.

Brian T Harvey is an associate in Buchalter Nemer's Financial Solutions Practice Group. He can be reached at [phone] or [e-mail].