Defenses to a Preference Action
November 15, 2022
In this Surety Today Blog post we will continue exploring the dreaded preference action in bankruptcy. In the first Blog post, we discussed preference actions in general, the elements, purpose and procedural aspects. In this post we will focus on defenses against preference actions.
Defenses Based Upon the Elements
A surety’s potential defenses to a preference action can initially be found in the elements of a preference action itself. In order to prevail on a preference action, the trustee or DIP must establish each and every element of a voidable preference under the Bankruptcy Code. In re Ralar Distributors, Inc., 4 F.3d 62 (1st Cir. 1993). While any of the elements could potentially be challenged as a defense, one element bears mentioning in the surety context i.e.: the requirement that the transfer be of property of the Debtor. An essential element of proof for a preference action includes establishing that the Debtor had an “interest in the property transferred” under Section 541 of the Bankruptcy Code. Thus, an initial defense can be raised challenging whether property of the estate was involved in the transfer. For example, if a payment was made by the Debtor within 90 days of the bankruptcy and all of the other elements were present, if the funds paid were held in trust by the Debtor, a preference action could not be maintained. Trust funds are common in the construction industry by statute, contract or in the GAI. When a trust exists, the Debtor holds the trust funds as a mere trustee and such interest is not property of the bankruptcy estate under section 541 of the Code. In In re IT Group, Inc., 326 B.R. 270 (Bkrtcy. D. Del. 2005), the Chapter 11 Debtor, in its capacity as prime contractor on construction projects, held funds in trust for the benefit of unpaid subcontractors pursuant to provisions of New York lien law. Under the lien law the funds did not constitute an “interest of the debtor in property;” accordingly, the Debtor’s prepetition transfers of such funds to subcontractors were not avoidable as preferences.
Defenses may also be found in the other elements of a preference action such as whether the debtor was insolvent, whether the amount received was more than what would have been received in a Chapter 7 distribution, and limitations. When a preference action comes in, the surety needs to walk through each of the elements and examine if they have been established.
Statutory Defenses to a Preference Avoidance Action – Section 547(c).
Even when the trustee satisfies all of the elements of a preference action, the transfer may be avoided as a preference if the creditor can prove that it is entitled to rely on one of the exceptions listed in section 547(c). As noted earlier, the creditor has the burden of establishing the elements of such exceptions or defenses. Section 547(c) lists 7 exceptions that may be used as defenses, however, the exceptions that are the most common and valuable to a surety are the following:
Section 547(c)(1) – A Contemporaneous Exchange for New Value.
Section 547(c)(1) provides the so-called “new value” defense and states that a trustee may not avoid a transfer to the extent the transfer was intended by the Debtor and creditor to be a contemporaneous exchange for new value given to the Debtor, and there was in fact a contemporaneous exchange. A good example of this defense would be where the Debtor pays COD in exchange for a shipment of materials for a project. In that scenario you essentially have a simultaneous exchange of goods for payment. The new value defense “is grounded in the principle that the transfer of new value to the debtor will offset the payments, and the debtor’s estate will not be depleted to the detriment of other creditors.” Lubman v. C.A. Guard Masonry Contractor, Inc. (In re Gem Constr. Corp. of Virginia), 262 B.R. 638, 645 (Bankr. E.D. Va. 2000) (citations omitted). Thus, for this defense to apply, the value given for the transfer must actually enhance the worth of the Debtor’s estate so as to offset the reduction in the estate caused by the payment/transfer of funds. Id.; In re JWJ Contracting Co., Inc., 287 B.R. 501, 506 (B.A.P. 9th Cir. 2002), aff’d, 371 F.3d 1079 (9th Cir. 2004). The purpose of this defense is to encourage creditors to continue to deal with troubled entities without fear of having to disgorge payments that were received in exchange for value given.
In order to establish the defense, it must first be demonstrated that new value was provided. “New value” is defined in the Bankruptcy Code as:
money or money’s worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee under any applicable law, including proceeds of such property, but does not include an obligation substituted for an existing obligation.
New value is measured at the time of the transfer. A promise to provide future goods and services in exchange for payment cannot constitute new value at the time of the transfer. In re Modtech Holdings, Inc., 503 B.R. 737, 747 (Bankr. C.D. Cal. 2013). The Tenth Circuit in Elec. Metal Prod., Inc. v. Bittman (In re Elec. Metal Products, Inc.), 916 F.2d 1502, 1506 (10th Cir.1990) noted that the fact that a creditor may have promised to continue to do business with the debtor if the Debtor paid its bills is not new credit or new value to the estate. Furthermore, forbearance from exercising pre-existing rights may not constitute new value under §547(a)(2) of the Code. In re Maxwell Newspapers, Inc., 192 B.R. 633, 637 (Bankr. S.D.N.Y. 1996).
In considering new value, a court must measure “the value given to the debtor in determining the extent to which the trustee may void a contemporaneous exchange.” Sulmeyer v. Suzuki (In re Grand Chevrolet, Inc.), 25 F.3d 728, 733 (9th Cir.1994). Thus, if the Debtor received $30,000 in materials, but paid $50,000, $30,000 for the goods and another $20,000 on prior shipments, there would still be a $20,000 preference, because the extent of the new value to the estate was only $30,000, not the entire $50,000 paid. The Court in O’Rourke v. Coral Constr., Inc. (In re E.R. Fegert, Inc.), 88 B.R. 258, 259 (9th Cir. BAP 1988), aff’d, 887 F.2d 955 (9th Cir. 1989) held that the release of a fully secured lien in exchange for payment from the Debtor would constitute new value.
If new value can be established, in order to prove the defense, the exchange of the new value must in fact be substantially “contemporaneous.” Some courts have adopted a bright line 10-day rule for determining if the exchange was contemporaneous. Under this rule, if the transaction was not completed within 10 days, it was not contemporaneous. Other courts employ a case by case approach and look to the facts and circumstances to determine if the exchange was contemporaneous – things such as: length of delay, reason for the delay, complexity of the transaction, intent of the parties, risk of fraud, etc. are considered. Under this approach, a two to three week delay in an exchange has been held to be contemporaneous.
Finally, to establish the new value defense, the parties must have intended the transaction to be contemporaneous. Even if the transaction on its face appears to be contemporaneous, if the parties did not intend for the exchange of new value to be contemporaneous, the defense will fail.
Section 547(c)(2) – Transfers in the Ordinary Course
Section 547(c)(2) provides that the trustee may not avoid a transaction as preferential if the transfer was made 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 made in the ordinary course of the business or financial affairs of the debtor and transferee or was made according to ordinary business terms. The ordinary course defense is intended to protect recurring, customary credit transactions that are made and paid in the ordinary course of business. It is designed to induce creditors to continue to deal with a distressed entity.
To establish the ordinary course defense, the creditor must first prove that the underlying debt on which payment was made was incurred by the Debtor in the ordinary course of business or financial affairs of BOTH the Debtor and the creditor. This analysis requires the court to examine the “normality” of incurring the debt at issue in each party’s business operations generally. If the transaction from which the debt arose was not ordinary for both parties, then the defense will fail. The question will be was the debt incurred in a typical, arms-length commercial transaction that occurred in the marketplace as part of routine operations.
Once it is established that the debt was incurred in the ordinary course, then it must be proven that either the transfer: (1) was made in the ordinary course of business of both parties or (2) it was made according to ordinary business terms. In analyzing this aspect of the defense, the court will engage in a subjective, factual analysis. The controlling issue is whether the transactions both before and during the 90 day period were consistent. Even if the payments were irregular, they may still be considered ordinary if they were consistent with the course of dealing between the particular parties. Thus, it becomes important to establish a baseline of dealing between the parties during a time period when the debtor’s day to day operations were ordinary, preferably before the debtor became financially distressed. The court will then compare those dealings with the dealings in the 90 day preference period. Factors the court will examine include: (1) length of time the parties were engaged in the type of dealing at issue; (2) whether the amount or form of payment differed; (3) whether any unusual collection or payment activities occurred; and (4) the circumstances under which payment was made.
With respect to the alternative prong of the defense, it may be proven that the transfer was made according to ordinary business terms in general. This prong creates an objective standard according to norms in the specific industry and will typically require some expert testimony.
Section 547 (c)(4) – Transfer for Subsequent Advances.
Section 547(c)(4) provides that a transfer may not be avoided as a preference if the transfer was made to or for the benefit of a creditor to the extent that after such transfer the creditor gave new value to or for the benefit of the debtor that is not secured by an otherwise unavoidable security interest and on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor. Thus, from the Code the elements of this defense are: (1) a creditor extends new value, (2) the new value provided is unsecured and (3) the new value is not repaid to the debtor after the preferential transfer. In re Saco Local Development Corp., 30 B.R. 859 (Bankr. D. Me. 1983); In re Formed Tubes, Inc.,46 B.R. 645, 646 (Bankr. E.D. Mich. 1985); In re Bishop, 17 B.R. 180, 183 (Bankr. N.D. Ga. 1982). The subsequent new value exception was devised as a solution for the unsecured creditor with a running account who would otherwise find the last 90 days of payments avoided by the trustee in bankruptcy. 4 Lawrence P. King et al., Collier on Bankruptcy ¶ 547.12 (15th ed.1994). The defense is based on two policy considerations. First, a creditor who implicitly relies on prior payments in extending additional credit would otherwise increase its bankruptcy loss. Second, such creditors should be encouraged to continue their credit arrangements with financially distressed debtors, potentially helping them avoid bankruptcy. In re Liberty Livestock Co., 198 B.R. 365, 376 (Bankr. D. Kan. 1996).
This defense is premised on the theory that to the extent unsecured new value is given to the debtor after a preferential transfer is made, the preference is repaid to the bankruptcy estate. In re Prescott, 805 F.2d 719 (7th Cir. 1986). The Debtor’s assets have not been depleted to the disadvantage of other creditors, when a creditor advances new value. Jones Truck Lines, Inc. v. Full Serv. Leasing Corp., 83 F.3d 253, 257 (8th Cir. 1996). This defense is intended to remove the unfairness of voiding transfers without giving corresponding credit for subsequent advances of new value.
No one wants to receive a preference action, but as discussed above there are defenses available and the surety must scrutinize and analyze all aspects of the transfer in question to determine in any of the defenses can be raised. Getting access to the Debtor’s records can be critical in the analysis. In addition, keep in mind that typically preference actions can be negotiated and resolved, often for pennies on the dollar, which might make sense when compared to the costs of litigation in fighting the claim.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 or email@example.com) or George J. Bachrach, Esq. (410-659-1308 or firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
Upcoming EventsPhiladelphia Surety Claims Association Holiday Party, Philadelphia, PA
December 7, 2022, 4-7 PMMore Upcoming Events
Full list of 2022 Surety Events
AccoladesAbout the WCS Surety Today Team
Surety Today: The Blog is brought to you by your friends and counsel at the Surety and Fidelity Law Group at Wright, Constable & Skeen, LLP.Accolades
The WCS Surety Law Group’s drive for excellence has secured our firm and surety team a variety of awards and recognitions on the media.Where We Are
The WCS Surety Group is very active in the surety industry. In this section you can see where we are, where we’ve been and where we’re going.Recent Successes
It might be a judgment won, case won, motion won, favorable settlement, or something else the Surety Law Group is proud of. Be sure to check back frequently to see how we are doing.