NACM Issue Brief With Suggested Changes to Section 547 - Preference Statute

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As mentioned in the first story in yesterday's edition of NACM's eNews, here is NACM's latest preference-specific issue brief.

NACM Issue Brief With Suggested Changes to Section 547 - Preference Statute

Under bankruptcy law, Section 547 of the Code requires that all payments made by a debtor to creditors within 90 days of a bankruptcy filing must be returned to the debtor's estate, unless the creditor can prove that the payment was made in the "ordinary course of business," that "new value" was given, or that the transaction was a contemporaneous exchange for new value. The fundamental premise of this section of the Code is to prevent any one creditor from receiving favorable treatment over other creditors.

Typically, the trustee for the debtor's estate or more recently the liquidating trust under a Chapter 11 plan will issue demands to all creditors who received a payment in this 90-day period without regard to any of the defenses. The NBRC wrote that there is an argument that "...Section 547 leads to abusive preference recovery suits by bankruptcy trustees who bring actions indiscriminately, without properly analyzing the creditor's available defenses, and to obtain settlements by creditors because of the litigation costs associated with defending these actions."

The Commission noted the common practice for the trustee to send out a blanket demand and complaint to every creditor who received payments within 90 days of the bankruptcy filing. The trustee would have done little or no prior investigation other than to review the debtor's check register and would have made no effort to determine whether the creditors have any valid defenses. It is rarely cost effective for the creditor to contest the action and most creditors enter into a negotiated settlement rather than incur the legal costs of defending the preference action. To make matters worse, there is no requirement that any funds returned to the debtor's estate through preference recoveries are ever dedicated to satisfying the needs of the unsecured class of creditors. In fact, the NBRC concluded that over 90% of preference recoveries do nothing more than fund the recovery activities.

The NBRC and Congress also recognized the significant problems that existed for small business creditors who had few resources with which to fight blanket preference challenges. For this reason, BAPCPA made three changes to the Code:

-It developed language to make it easier to prove the ordinary course of business defense by proving the transfer was either consistent with the "ordinary course of business" between the debtor and creditor or consistent with industry terms;

-It established a floor of $5,000 (since increased to $5,850 as a result of COLA changes) on preference claims; and,

-It required that any preference challenge made for payments of under $10,000 (since increased to $11,725 as a result of COLA changes) must be brought in the jurisdiction of the creditor.

Unfortunately, very little has actually changed in the real world in the years after the enactment of these new provisions. There are no disincentives or sanctions preventing debtors' trustees from continuing to issue blanket preference demands and complaints for all payments made within 90 days of the filing. For the most part, it remains the small credit grantors who are unable to afford legal counsel to fight these preference claims. It remains more cost effective for the creditor, especially small creditors, to negotiate a return of some portion of the payment (without regard to appropriateness of the claim) than it is to incur legal expenses to fight the challenge-even with the additional protections created in the 2005 law.

The trade creditor community believes that the abuse has not stopped and will not stop until the Code is modified. Specifically, we believe that if the onus to prove that a payment is indeed preferential is shifted, the blanket demands based on 90 day clock and the check register will stop. Under current law, the creditor is saddled with the onus to prove that the payment is not preferential. The Code offers nothing but encouragement to trustees to issue blanket challenges; there are no repercussions for trustees continuing to engage in this activity-even if the payments to the creditor are legitimate.

The reality is that trade creditors face a double jeopardy: they lose funds due to the bankruptcy and are also forced to repay funds already collected. This simple fact has put some small companies out of business. Other credit grantors have been forced to adopt more rigid credit policies and have become less likely to continue offering credit terms that would help customers who show signs of distress.

The trade credit community suggests adding two new provisions to Section 547(b) to require the debtor to prove that the payment is a preference. The first provision would require the trustee to prove that the transfer does not qualify as an ordinary course of business transaction. This change would allow for the deletion of the ordinary course of business defense, under Section 547(c)(2), which should be retained in its current form if the change is not adopted.

The trade credit community also suggests adding another subsection to Section 547(b) to require a trustee or debtor to limit the amount of preference claims to the difference between the aggregate amount of transfers made to or for the benefit of the creditor and all new value extended to or for the debtor's benefit during the 90 days before the bankruptcy filing. This change would allow for the deletion of the new value defense under Section 547(c)(4), which should be retained in its current form if the change is not adopted. This change is consistent with the "net result" rule that existed prior to the adoption of the Bankruptcy Code. It will also simplify the new value defense to avoid all the litigation that has been prompted by issues raised concerning this defense, and further prevent trustees from making illegitimate preference claims. The change would also settle a long-standing split among the courts on whether new value must remain unpaid to qualify for the defense. The Fourth, Fifth, Eighth and Ninth Circuit Courts of Appeal have allowed paid new value to be used as part of the new value defense if the payment is avoidable and not subject to any other preference defense. The Third, Seventh and Eleventh Circuits require that new value remain unpaid and the First, Second, Sixth, Tenth and D.C. Circuits have not ruled on this issue. Although there are lower court opinions that go both ways on this issue, the trend in court decisions is to allow paid new value. The change would allow all new value, paid and unpaid extended to or for the debtors' benefit within 90 days of bankruptcy, to limit the amount of preference claims.

Both changes will also encourage creditors to continue extending credit to a financially troubled company, replenish the debtor's bankruptcy estate with new goods and services provided on credit and promote equality of treatment among similarly situated creditors, all policies that Congress had intended to further when it created the preference statute.

Both changes to Section 547(b) are also consistent with a fundamental tenet in American jurisprudence that an individual is innocent until proven guilty. Under current preference treatment, this fundamental principle is completely reversed. We believe that such a shift in the onus of proof will arrest the unscrupulous activities of many trustees who recover fees that only fund their own recovery activity. At a minimum, it will require the trustee to carefully consider any payment made to a creditor before issuing a blanket preference recovery demand because the trustee will recognize that the onus remains with the debtor's estate to prove the claim. We believe this change will more thoughtfully restore the balance between debtor and creditor rights.


Section 547(b) is amended to add the following subsection 6, which replaces Section 547(c)(2), and to add the following subsection 7, which replaces Section 547(c)(4).

(6) that was not in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; was not made in the ordinary course of business or financial affairs of the debtor and the transferee and was not made according to ordinary business terms; and

(7) only to the extent that the aggregate amount of the transfers made to or for the benefit of the creditor exceeds the aggregate amount of new value that the creditor gave to or for the benefit of the debtor, which new value is not secured.

The "and" between subsections 4 and 5 of Section 547(b) should be deleted and an "and" should be inserted between subsections 6 and 7 as indicated.


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