Preference Defense In the Wake Of The Pandemic: A Primer – JD Supra

Nothing is more frustrating to a trade creditor holding a large unpaid balance owed by a debtor in bankruptcy than the risk that payments the trade creditor received before the debtor filed bankruptcy may be clawed back by the debtors estate as preference payments. This frustration has been compounded since the onset of the COVID-19 pandemic early last year, during which time vendors have supported struggling customers by agreeing to defer or postpone payments under the terms of their goods or services contracts, even while the vendors themselves may have struggled to stay afloat. Pursuant to section 547(b) of the Bankruptcy Code, a debtor in possession or a trustee can seek to recover certain payments made within 90 days of the bankruptcy filing date, subject to various defenses.

The policy behind the preference statute is to treat creditors equitably and level the playing field by requiring preferred creditors to share their recovery with all other creditors. Paradoxically, however, when the estate recovers preference payments made to a particular creditor, that creditor often will not share in the recovery at all. Pursuant to the absolute priority rule, higher-priority claims, such as secured claims, unpaid chapter 11 administrative expense claims incurred by the debtor (such as professional fees), and other priority claims typically all must be paid in full before unsecured creditors receive any distribution. With increasing frequency, and particularly in retailer bankruptcies, preference recoveries are used to fund chapter 11 administrative expenses and to improve the recoveries of underwater secured lenders rather than to facilitate pro rata distributions to unsecured creditorsnot at all what Congress intended when it enacted the statute. While the preference statute is intended to promote fairness and equity among creditors, the creditor that finds itself defending a preference action is more likely to characterize the action as punishment for continuing to support a financially distressed customer.

So, what should a creditor do when it first receives a preference demand letter? What should it do when it is subsequently sued? What arguments and defenses can the creditor raise in opposition to a preference claim? How should the creditor go about putting this information to use when responding to, defending, and (hopefully) settling the preference claim? This article answers these questions, including by providing a list of action items that a creditor should be mindful of, beginning with the date that a customer files for bankruptcythe petition datethrough the resolution of a preference litigation. Creditors are nearly always far better off spending the time compiling and presenting proof of potential defenses to a preference demand than simply paying the amount demanded.

Some Necessary Background: Preference Claims and Defenses

The Elements of a Preference ClaimPursuant to section 547(b) of the Bankruptcy Code, a trustee, a debtor in possession, or a successor to the estate such as a liquidating trust can avoid and recover a transfer of property of the debtor as a preference by proving all the following required elements:

The Small Business Reorganization Act of 2019 (SBRA), which became effective on February 19, 2020, amended section 547(b) to require the plaintiff in a preference suit to allege, as part of its burden of proof, that the preference claim is based on reasonable due diligence in the circumstances of the case and takes into account a partys known or reasonably knowable affirmative defenses. This seemingly heightened burden of proof for preference claims has raised numerous questions that will need to be answered by the courts. How much of an additional burden will be placed on a plaintiff to prove a preference claim? What constitutes reasonable due diligence? What is a reasonably knowable affirmative defense? And can the plaintiff in a preference action rely on the debtors records to satisfy these requirements, or must the plaintiff engage in additional diligence? Given the relatively short time this change has been in place, few courts have had occasion to address these questions.

Defenses to a Preference ClaimSection 547(c) of the Bankruptcy Code provides several affirmative defenses that a creditor can assert to reduce or eliminate its preference exposure. These defenses are designed to encourage creditors to continue doing business with and extending credit to financially distressed companies. In the rare case that goes to trial, the creditor bears the burden of proving its defenses.

547(c)(1)Contemporaneous Exchange of Value: The contemporaneous exchange of value defense, set forth in section 547(c)(1), is one such defense. This defense excuses any payment or other transfer that the debtor and creditor had intended as a contemporaneous exchange for new value and that was a substantially contemporaneous exchange. A creditor that provides new goods or services to a debtor in exchange for a substantially contemporaneous payment, such as a cash-on-delivery transaction, replenishes the debtor and should not be subject to preference liability.

547(c)(4)Subsequent New Value: The subsequent new value defense, set forth in section 547(c)(4), is perhaps the most frequently invoked preference defense. The new value cannot be secured by a security interest in the debtors assets that is otherwise unavoidable, and it cannot be paid by an otherwise unavoidable transfer to or for the benefit of the creditor. The subsequent new value defense reduces a creditors preference liability dollar for dollar based on new value provided to the debtorsuch as sale and delivery of goods or provision of services to the debtor on credit termsafter the creditors receipt of an alleged preference payment. The defense is predicated on protecting a creditor from preference risk where the creditor replenished the debtor by continuing to extend credit after receiving a transfer otherwise alleged to be a preference.

The section 547(c)(4) new value defense clearly applies to new value that was unpaid as of the petition date. Several United States Circuit Courts of Appeals (the federal courts immediately below the United States Supreme Court) and other courts have reached conflicting results on the applicability of the new value defense to paid new valuevalue that the creditor provided to the debtor after receiving an alleged preference payment but that the debtor repaid before the petition date. The majority viewfollowed by the Fourth, Fifth, Eighth, Ninth, and, most recently, Eleventh circuits and many lower courtshas applied the new value defense to new value paid by an otherwise avoidable transfer (such as a subsequent preference payment) and unpaid new value. On the other hand, the Seventh Circuit and a minority of other courts have ruled that the new value defense applies only to unpaid new value. A creditors ability to assert paid new value, in addition to unpaid new value, could substantially reduce preference liability but depends on the jurisdiction in which the debtor filed bankruptcy.

In certain instances, new value provided before the petition date might be paid after the petition date pursuant to an order authorizing the debtor to pay critical vendor claims or administrative claims arising under section 503(b)(9) of the Bankruptcy Code. As discussed later in this article, a creditor may have some or all of its prepetition claim paid after the petition date by being deemed a critical vendor during the bankruptcy case. Also, a creditor may be granted an allowed administrative expense claim under section 503(b)(9) of the Bankruptcy Code for the value of goods received by the debtor within 20 days before the petition date (a 503(b)(9) claim). Courts are divided on whether new value that is paid after the petition date pursuant to a critical vendor order or as an allowed 503(b)(9) claim nevertheless can be used to reduce preference liability as subsequent new value. Some courts, including the Third Circuit (whose rulings are binding on the lower federal courts in Delaware, New Jersey, Pennsylvania, and the United States Virgin Islands), have held that such new value may still count toward the new value defense, because new value is determined based on a snapshot as of the petition date. Other courts have denied the application of such new value toward the new value defense, largely under the premise that permitting such new value would permit the creditor to double-dip by reducing its preference exposure based on credit extended before the petition date where such credit was fully paid after the petition. This issue, specifically as it relates to 503(b)(9) claims, is presently on appeal in the Eleventh Circuit.

547(c)(2)Ordinary Course of Business: Another frequently invoked defense is the ordinary course of business defense set forth in section 547(c)(2) of the Bankruptcy Code. The creditor must first prove the alleged preference payment satisfied a debt that the debtor incurred in the ordinary course of business or financial affairs of the debtor and the creditor. A trade creditor that extended credit to the debtor should have little difficulty satisfying this requirement. The creditor must then prove the preference payment was either (A) made in the ordinary course of business or financial affairs of the debtor and the creditor (the subjective test), or (B) made according to ordinary business terms (the objective test). The subjective test requires proof that the alleged preference payments were consistent with the debtors payments to the creditor prior to the preference period. A creditor can prove the objective part of the defense by showing that the alleged preference payments were consistent with the terms and payment practices in the creditors industry, the debtors industry, or some subset of either or both. Needless to say, this defense is fact-intensive, and courts and parties have approached it in a wide variety of ways.

During the COVID-19 pandemic, vendors and customers frequently negotiated extended terms for the payment of invoices. If a customer subsequently filed for bankruptcy protection and sought to recover payments made to the vendor as alleged preferences, the vendorby giving the customer more time to payrisked losing the ordinary course of business defense. To address this seemingly unfair result, Congress, through the Consolidated Appropriations Act of 2020 (CAA), which became effective on December 27, 2020, amended section 547 to create a new, temporary preference exception in new subsection (j), under which covered payment[s] of supplier arrearages[1] may not be avoided as preferences. According to section 547(j)(1)(B), a covered payment of supplier arrearages means a payment of arrearages that is made in connection with an agreement or arrangement made or entered into on and after March 13, 2020 (the generally recognized onset of the COVID-19 pandemic in the United States), between a debtor and a supplier of goods or services to delay or postpone payment of amounts due under an executory contract. The payment of arrearages cannot exceed the amount due under the contract before March 13, 2020, and does not include fees, penalties, or interest in an amount greater than that scheduled to be paid under the contract or which the debtor would owe if the debtor had made all payments on time and in full before March 13, 2020. As with the SBRAs amendment to section 547, this statutory language leaves much unanswered about the scope and application of this new exception that the courts will need to decide. Absent further congressional action, this temporary provision expires on December 27, 2022, but will continue to apply to bankruptcy cases filed before that date.

Critical Vendors: Another defense creditors have asserted with mixed success is the critical vendor defense. Chapter 11 debtors frequently seek and obtain authority to pay the prepetition claims of critical vendors based on the premise that the debtors businesses would be irreparably disrupted and their efforts to maximize value for their estates and creditors would be severely impaired if such vendors refuse to continue extending credit. When defending preference actions, creditors that have been granted critical vendor status have argued that a preference claim against them must fail in light of the fact that the court granted authority for the debtor to pay the creditors prepetition claim, because the plaintiff cannot prove one of the necessary elements of the claimthat the alleged preferential transfer enabled the creditor to receive more than the creditor would have received in a hypothetical chapter 7 bankruptcy liquidation. This argument has had mixed success, largely depending on whether the estate was required to pay the creditors prepetition claim or merely had discretionary authority to do so. Under the latter circumstance, courts tend to uniformly reject the critical vendor defense. Therefore, creditors considering extending credit to a debtor after the petition date in exchange for the payment of prepetition claims pursuant to a critical vendor order in the bankruptcy case should carefully review how the debtors critical vendor program is structured and should consider entering into a trade agreement that requires payment of the prepetition claim if the creditor wishes to minimize the risk of preference liability.

Preference Action ItemsUnsecured trade creditors seeking to analyze and prepare their defenses and respond to a potential or asserted preference claim should be mindful of the action items listed below, beginning even before receiving a preference demand:

ConclusionNotwithstanding Congress recognition of the realities of doing business during the COVID-19 pandemic, and indeed in light of the recent amendments to the Bankruptcy Code concerning preferences, it is absolutely critical for trade creditors to be prepared to address and respond to potential preference claims following a customers bankruptcy filing. The information and action items provided above are a great start for doing so. However, upon receipt of a demand letter or a preference complaint, a trade creditor should consult an attorney to assist in the defense of the claim and to help navigate the choppy and unclear waters underlying preference risk.

[1] The CAA also added new section 547(j)(2)(A), which provides that a trustee or debtor-in-possession may not avoid a covered payment of rental arrearages. This additional covered payment exception is substantially similar to the covered payment of supplier arrearages exception discussed in this article.[2] It could be argued that the SBRAs new venue threshold applies more narrowly to bankruptcy cases (as opposed to lawsuits) filed on or after February 19, 2020.

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Preference Defense In the Wake Of The Pandemic: A Primer - JD Supra