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The Art of Defending Preferential Transfers – Part Two: The Defenses

Learning how to defend a preferential transfer action is a particularly useful art for the credit professional.  In Part One, we discussed the Bankruptcy Code's specific requirements that must be established by the debtor or trustee in order for a transfer to be considered "preferential," and subject to avoidance (return to the debtor's bankruptcy estate)  The logical follow-up is a discussion of the most common defenses to a preferential transfer action.

The Bankruptcy Code describes a number of defenses to a preference action.  Each defense was designed to encourage parties to continue to do business with financially-distressed customers. The preference defenses are set forth in Bankruptcy Code section 547(c), and it is the creditor's burden to establish one or more of the defenses.  The most-used preference defenses include:

1)               the contemporaneous exchange for new value defense;

2)               the ordinary course of business defense;

3)               the ordinary business terms defense; and

4)               the new value defense.

Each of these defenses has its own considerations in terms of when and how the defense might be employed.  And the viability of each defense depends on the facts surrounding the transfers in question – more specifically the business relationship between creditor and debtor.  A brief discussion of these four defenses follows.

Contemporary Exchange for New Value Defense

To take advantage of the "contemporaneous exchange for new value" defense, the preference defendant must establish that (i) the transfer was intended by the debtor and the creditor to be a contemporaneous exchange for new value given to the debtor; and (ii) there was in fact a substantially contemporaneous exchange.  The key factual element here is the mutual intent of the parties.

Ordinary Course of Business Defense

The "ordinary course of business" defense is intended to protect ordinary trade transactions between a debtor and a creditor.  Key to proving the defense is a showing that the transfers during the preference period are consistent with how transfers were made prior to the preference period.  To establish an ordinary course of business defense (often called the "subjective" test), the creditor must show (i) that the transfer at issue was 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 (ii) that the transfer was made in the "ordinary course" of business or financial affairs of the debtor and the transferee.

In general, when determining whether a transfer was within the parties' ordinary course of business, a court will evaluate (i) the length of time the parties were engaged in the transactions at issue; (ii) whether the amount or form of tender differed from past practices; (iii) whether the debtor or the creditor engaged in any unusual collection or payment activity; and (iv) the circumstances under which the payment was made.    The most frequently analyzed term is the timing of the payments (i.e., invoice date to payment date).  The court will then compare the payments made during the preference period with those made throughout the parties' historical course of dealing.  Payments that took place outside the parties' normal course of dealing will be found to be "preferential" and subject to return to the debtor's estate.

Ordinary Business Terms Defense

Like the ordinary course of business defense, the "ordinary business terms" defense begins with a determination whether the transfer at issue was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee.  The court must then determine whether the transfer was made according to "ordinary business terms" (often called the "objective" test).  While the ordinary business terms standard has been defined in different ways by the various courts, courts generally examine credit arrangements between other similarly-situated debtors and creditors in the relevant industry to determine whether the payment practices at issue are consistent with what takes place in the industry generally.  Payments found to be "unusual" or "idiosyncratic" when compared to general industry standards are subject to return to the debtor's estate.

New Value Defense

The new value defense is the most quantitative of the preference defenses, and provides that a transfer may not be avoided to the extent the creditor provided new value (generally in the form of goods, services, or new credit) to or for the benefit of the debtor after the subject transfer was made.  In simplified terms, ten dollars in new goods shipped by a creditor after receipt of a ten dollar payment will completely protect that payment from being returnable.  Unfortunately, as we will see in future blog posts, the new value defense is not as easily applied as it might seem.

The preference defenses set forth in the Bankruptcy Code are presented in something of a "bare bones" fashion.  However, courts and bankruptcy practitioners have managed to put some meat on those bones, turning the defense of preferential transfers into nearly an art form.  We'll discuss preference defenses in more detail in future blog posts.