Chapter 11: Preferences/Fraudulent Transfers

Web posted and Copyright © 1/12/98, American Bankruptcy Institute.

The following abstract summarizes the text of submissions made to the National Bankruptcy Review Commission. The abstract is organized by NBRC working group and topic.

The Final Report of the NBRC can be viewed on-line. To obtain a copy of any document shown below, contact the Center for Legislative Archives, Room 205, National Archives Building, Washington, D.C. 20408. The telephone number is 202/501-5350. Mr. R. Michael McReynolds, Deputy Director, will be able to assist with specific inquiries. (The NBRC documents will be housed at this location until June, 1999. Thereafter, the records will be transferred to the Center's archives in College Park, MD.)

ID Name Group Other Code
Problem Referenced Proposed Solutions
NBRC-0010 Professor Morris G. Shanker Academia; Professor of Law, Case Western Reserve University
The preference avoidance statute has outlived its usefulness. Eliminate the provisions regarding preferences or significantly revised with an approach which permits the avoidance of "fraudulent preferences."
NBRC-0026 "United States Law Week"

Whether good faith standard under 548(c) is an objective standard or a subjective standard Section 548(c) is an objective standard. Jobin v. McKay. If the circumstances would place a reasonable person on inquiry of a debtor's fraudulent intent.
NBRC-0076 Tim Johnston President; Quality Welding & Fabricating, Inc. Forwarded on 8/28/96 by Steve Buyer; Congressman from 5th District of IN. 547
Small business did some work and was not paid for over 90 days after completion. 6 Mos. later, got a notice that U.S. Tech had filed for bankruptcy and small biz had to pay back $6,000. Atorney (hired in MI) was able to settle for $4,500 on preference, but was still too much for small business to pay. No logic or fairness to the fact that a small business that is put into financial jeopardy as a result of having to pay back potentially preferential amounts. The law needs to be changed. Small creditor had honored its end of the bargain, no reason why it should have to bail out bi debtor and risk serious financial problems itself as a result.
NBRC-0139 Ken Mease Congressman George W. Gekas
Preference law as applied to small businesses is tantamount to extortion Revise the Code to exempt small businesses from preference laws.
NBRC-0152 Kenneth L. Robinson President; National Ass'n of Federal Credit Unions
Recovery of preferences from creditors who had no reason to know of financial condition of debtor and act in the ordinary course of business Code should be amended to exclude from preferences transactions undertaken with creditors that lack the ability to know of the debtor's insolvency and act in the ordinary course of business.
NBRC-0175 Kenneth P. Childs, on behalf of the Bankruptcy Review Committee of the Oregon State Bar Debtor-Creditor Section Attorney
In interpreting the ordinary course defense to preference claims, courts have held that § 547(c)(2)(C), which specifies that tranfers must be made "according to ordinary business terms," requires that the transfers be made in a manner that is "ordinary in the industry in general." This standard is ambiguous, difficult to prove and unnecessary. Requirement under 11 USC § 547(c)(2)(C) that the transfer was "ordinary in the industry in general" is unnecessary. The requirements under subsections (A) (that the debt was incurred in the ordinary course of the debtor's business) and (B) (that the transfer was made in the ordinary course of affairs of the particular debtor and creditor) are sufficient for establishing that the subject of the claim was an ordinary course transfer and not a preference.
NBRC-0175 Kenneth P. Childs, on behalf of the Bankruptcy Review Committee of the Oregon State Bar Debtor-Creditor Section Attorney
547, 550
Recent amendment to 11 USC § 550 does not fulfill its intended purpose of overruling Levit v. Ingersoll Rand (DePrizio). In DePrizio, the court held that payment to a creditor on a debt guaranteed by an insider constitutes a transfer for the benefit of the insider, and thus the one-year extended preference period applies. Rather than precluding DePrizio type preference claims, the amendment simply places a limit on the trustee's ability to recover a voided preference (i.e., the trustee may not recover from a non-insider transferee a voided transfer that occured between 90 days and one year prior to the petition). The trustee's ability to void the transfer is still "left open." With some types of transfers, such as the granting of a security interest, avoidance will effectively result in defeating the non-insider transferee's interest and for all practical purposes result in recovery. 11 USC §§ 547 and 550 should be rewritten to provide that all transfers to a non-insider occuring between 90 days and one year prior to a bankruptcy petition may not be avoided by a trustee.
NBRC-0196 Chris F. Mohr Chairman and CEO of AmeriStaff, a temporary staffing company

Author is responding to an article by Commissioner Butler that was published in the Insight Newsletter. The author raises concerns about how temporary staffing companies could be victims of "unscrupulous" debtors who use large numbers of temporary staff, and then file for bankruptcy without compensating the staffing company. In such a case, the staffing company would itself be obligated to pay the staff, which could total several hundred thousand dollars in wages and taxes. Due to their unsecured status, these staffing companies would have no recourse against the debtors. Temporary staffing companies should receive protection from "unscrupulous" creditors who declare bankruptcy without first paying temporary staff. Staffing companies should at least be able to recover direct wages and taxes on a preferred basis.
NBRC-0197 J. Stanley Payne Attorney; Corporate Vice President & General Counsel/Secretary of Bassett Furniture
Author is responding to an article by Commissioner Butler that was published in the Insight Newsletter. The author comments on the judicial interpretation of "ordinary course of business." The author of the attached letter notes that trustees categorize every payment within the 90-day pre-petition period as preferential, thereby shifting the burden of defense. The author's furntiure company, however, has a national chain of distribution and faces different standards for the "ordinary course of business" defense across jurisdictions. Of the various standards they encountered, the "best" was one based on the payment history between the two parties, and not on the industry as a whole. In other words, if the retailer has a history of late payments, then a late payment made within the preference period should be considered in the "ordinary course of business." Bankruptcy Code should be amended so that "ordinary course of business" is based on each individual creditor-debtor relationship, and not on the industry as a whole.
NBRC-0229 Tim Johnston President, Quality Welding & Fabricating, Inc. Cover letter from Representative Steve Buyer 547
Author is a small business owner who complains that the preference provisions are unfair and have resulted in hardship for his company. Bankruptcy system should be revised with regard to preferences.
NBRC-0318 Paul Mignini, Jr., Mary E. Wysocki and Charles M. Tatelbaum President-National Association of Credit Management ("NACM"), Chair-NACM Government Affairs Committee, and NACM Legislative and Bankruptcy Counsel, respectively
NACM sought the input of all NACM members with respect to proposed changes to the bankruptcy laws. The NACM Government Affairs Committee, without discussing the rationales for their suggestions, prepared the proposals below. NACM's Government Affairs Committee concludes that § 547 should be amended to provide: (1) in the event of a recovery of an avoidable preferential transfer by a debtor-in-possession under chapter 11, the proceeds shall initially be placed into a separate interest-bearing escrow account which may be used only to satisfy the claims of creditors in the same class from which the proceeds were received; (2) when dealing with the avoidance of a preferential transfer, and the transfer in question is made by check in payment of an antecedent debt, the transfer shall be deemed to have been made and effected on the date the transferee deposits the check; (3) the term "made according to ordinary business terms" shall include a course of dealing between the debtor and the creditor for a period not to exceed one year prior to the transfer in question, and the bankruptcy court may use practices that are consistent and relevant as a basis for defining this term; contractual terms shall be used only in the absence of a pattern of practice.
NBRC-0330 Richard G. Ephgrave Director of Credit and Product Service, Bassett Furniture Industries, Inc.

The 90 day presumption for voidable preferences is unfair to the debtor and creditor alike, and may actually force the debtor into bankruptcy by forcing the debtor into "cash before delivery" agreements. Often, trustees severely compromise the integrity of the preference statutes by routinely making settlements on preference claims to avoid litigation or abandoning the claim entirely, leaving the creditor in the uncomfortable position of having to haggle with the trustee to negotiate a settlement. The 90-day insolvency presumption, the author concludes, is "invalid" and should be lowered to seven days for non-insiders. Also, the ability of the trustee to make settlements to avoid litigation should be eliminated. The trustee should be allowed to cancel a preference claim if a valid defense has been proven to his satisfaction.
NBRC-0557 Paul Mignini & Gary White President and Chair, Government Affairs Cmte, respectively, of the National Association of Credit Management

Authors write on behalf of National Association of Credit Managers. They feel that, while the preference provisions work well in large cases, their application in small businsess bankruptcy cases or with respect to small amounts of preference is not always fair. Any preference recoveries should substantially benefit the debtor's estate, and not be used to meet administrative claims. A dollar threshold should be created for qualification of preference challenges. A dollar ceiling should be created for preference challenges, and all preference actions between the threshold and the ceiling would have to be brought in the jurisdiction of the creditor. All preference recoveries should be retained by the debtor's estate to satisfy the demands of other dreditors within the same creditor class.
NBRC-0558 Lowell W. Belk, CCE Vice President - Credit, Dan River, Inc.

Form letter from National Association of Credit Managers. Same as NBRC-0557.
NBRC-0604 Richard H. Walker General Counsel, Securities and Exchange Commission Document entitled "Issues Identified by Division of Enforcement and Office of General Counsel of Securities and Exchange Commission for Consideration by Bankruptcy Review Commission.

In securities fraud cases, the SEC often obtains a judgment requiring the defendant to pay money to a disgorgement fund, which may be distributed to defrauded investors or paid to the United States Treasury. Numerous courts have found disgorgement to be a necessary remedy for deterring violations of the federal securities laws by depriving a violator of the fruits of his wrongdoing and for achieving equity by preventing unjust enrichment. If the funds are considered to be property of the estate, subject to turnover and avoidance powers, or to a preference, important securities law enforcement policy would be subverted. Exclude disgorgement/restitution funds from property of the estate, turnover provisions, and preference provisions.
NBRC-0688 David T. Young Vice President, Corporate Credit, Russell Corporation
Author's company is "forced to spend a lot of man hours in just about every bankruptcy case to defend against preference actions in which the trustee or debtor's attorney has simply sent a demand letter to every vendor who received a check within 90 days of the filing." "Additionally, ther are very few cases where any of the proceeds from preference actions ever are recovered by creditors. It simply goes to pay fees for attornies [sic] and accountants, whose fees would have been less without the preference actions." "There should be a penalty to a debtor's attorney who is found to have blatantly abused filing a preference action without first investigating the circumstances of the alleged preference payment."
NBRC-0710 Franklin Feldman Attorney Exhibit A - a collection of letters from and to author concerning the enforcement of a Guarantee and legal representation of the company; and, Exhibit B - exchage of letters between author and Michael L. Cook concerning a request for legal fees and a threat of sanctions.

Author invested in company which had filed chapter 11 but which got a new president and CEO whom author thought could turn the company around. Author later became convinced that the CEO had acted in his own best interests, and not those of the company, when the company had to file chapter 11 two more times. Author petitioned for the appointment of a trustee or examiner and was denied, and has been actively involved in the legal procedings of the bankruptcy. Author writes with suggestions for changes in the bankruptcy code based on his experience. Employment agreements of all Board members and senior executives should automatically be rejected, and the salaries of each during the Chapter 11 prodeeding should be examined on an individual basis either by the Bankruptcy Judge or an examiner appointed by him.
NBRC-0818 Timothy M. Lupinacci Attorney, Burr & Forman LLP Letter refers to an enclosure of an article written by author in 1995 entitled Analyzing Industry Standards and Defending Preference Actions: Equitable Purpose in Search of Statutory Clarity, which was published in the Journal of Bankruptcy Law and Practice in January/February 1996, but it is not included with the database copy. 11
Author writes with regard to Proposal Number Three of the proposals for 11 U.S.C. § 547 concerning the ordinary course of business defense. "...I recommend that § 547(c)(2)(B) should be amended to provide that a transfer is protected to the extent it was 'made in the ordinary course of business or financial affairs of the debtor and the transferee, or if no such course of affairs exist, such transfer is made according to ordinary business terms....Therefore, I strongly support Preference Proposal Number Three which includes a disjunctive test under the subsection."
NBRC-0819 Neal R. Allen Attorney

Author writes in response to Elizabeth Holland's memorandum dated 6/1/97. With respect to Proposal #1, the minimum threshold requirement, author asserts that the effect is to prevent a preference recovery of less than $5,000.00 from any one creditor. Author poses examples in which debtor has paid equal amounts, but in one case it is a lump sum to one creditor, while in another it is in equal amounts, below the threshold, to a number of small creditors. "Both types of preference are basically 'unfair'. The trustee (or Chapter 11 debtor in possession) should have discretion to decide which ones to go after." The point is that there will be great variences in the result in these two types of case where the total preference is identical, and this is not a good result. None
NBRC-0819 Neal R. Allen Attorney

Author is responding to Proposal #3 of Elizabeth Holland's memorandum of 6/1/97. "The effect of this proposal is to allow the exception (and resulting no preference recovery) upon a showing that the paytment is in the ordinary course of this debtor's and creditor's business, without requiring a further showing that the payment is within customary industry standards. Assume that the industry standard is payment within thirty days of invoice date. However, debtor has a supplier who is more lenient than most, and requires payment within ninety days of invoice date. Debtor, being strapped for cash, of course takes advantage of this. Under existing law, all payments within the preference period which were over thirty days from invoice date would be recoverable, but under the proposal, only payments to this creditor which were more than ninety days from invoice date could be recovered. This emasculates the concept of recovery of preferences. Debtors and creditors should not be allowed to design their own unusual terms of payment if these vary radically from industry standards, at least for preference purposes." Nothing specific.
NBRC-0820 Eric P. Israel Attorney, Danning, Gill, Diamond & Kollitz, LLP
Author is a member of the Avoiding Powers Subcommittee and is responding to the commission's position on three proposals dated June 1, 1997 to amend section 547. "I do not agree that abuse of section 547 is occurring, at least not in the district where I practice (the Central Disstrict of California). In any event, adequate remedies already exist to deal with the conduct over which concern is expressed....I also note that hte first two proposals completely ignore existing section 547(c)(8), which already provides a floor for preference recoveries." "The three proposals should not be recommended for adoption, at least not without further consideration, and I urge the commission to reject them at this time."
NBRC-0826 Craig A. Weinberg Attorney, Stevens, Littman & Biddison, L.L.C.
547, 548 10 Author raises the problem of investors who lost money a Ponzi scheme and were then sued by the Trustee to recover money paid to them under the scheme when the scheme filed bankruptcy on the basis that the payments were preferences or fraudulent transfers, and not payments made in the ordinary course of business. This perpetuates the Ponzi scheme because the only moneys the trustee will be able to recover are payments made to later investors who received payments within the last ninety days. "As a result, the bankruptcy trustee wil end up distributing the funds recovered from later investors (those who typically lose the most money in a Ponzi scheme) to pay earlier investors - those outside the reach of the trustee's avoidance powers - while at the same time taking a fee for her services. By definition, that is a Ponzi scheme." "Because Ponzi schemes will unfortunately endure, Congress should clarify the broader issue which was expressly left unanswered by Union Bank, to wit, whether payments made by a Ponzi scheme can be within the 'ordinary course of business or financial affairs.'" "I therefore request that the Commission consider making recommendations to Congress to amend §101 to include a definition of "good faith" that is consistent with the former Bankruptcy Act and applicable fraudulent conveyance state law requiring only subjective honesty, rahter than non-negligence The Commission should also consider a proposal to change the ordinary course of business exception to account for the situation where the debtor turns out to be a fraudulent business."
NBRC-0854 Robert L. Baer Attorney
547 10 Author has raises objections to a number of proposals in the memorandum of June 1, 1997 for reform of preference recovery under 11 U.S.C. § 547. Author agrees that instances exist in which preference actions are initiated either without proper investigation or consideration of affirmative defenses, or in spite of information which makes it apparent that the action is not well founded; however, author feels that there have been various protective and remedial reforms, and denying a remedy for all based upon perceived abuses of a few is not an appropriate approach." "With respect to preference proposal #1, the threshold amount is too high." "Preference proposal #2 is unsound. To the extent it is more expensive to litigate in a distant form it is unwise policy to shift that expense in every instance, without regard to any other factor from the transferee to the estate...Requiring actions for less than $10,000 t be brought in the district where the creditor has his principal place of businessmay indeed protect parties...from actions...brought by trustees. However, it also has the effect of diminishing the net recovery for the estate to the dtriment of creditors." With regard to proposal #3, author disagrees with the memorandum's interpretation of the language, and feels that the language should be clarified to avoid misinterpretation. Author notes that the proposed changes are in response to concerns about abusive or frivolous §547 claims. Author feels there are adequate safeguards in place, but if the Commission feels that additional safeguards are needed, he proposes ADR. Lower the threshold amounts in Preference proposal #1. Author suggests an ADR procedure and a relaxed standard for award of fees to curb abusive or frivolous §547 claims.
NBRC-0858 Ed Goldwasser, et al. Small World Toys

Authors write to express changes they would like to see in the Bankruptcy Code. "Elimination of the 90-day preference period prior to the filing during which payments received by creditors must be subsequently reimbursed to the debtor."
NBRC-0995 Daniel C. Cohn Attorney
"I was susrprised to read in Bankruptcy Court Decisions (July 29, 1997, page A-11) that the commission has voted to change the ordinary course of business exception so that Section 547(c)(2)(A), (B), and (C) are in the disjunctive rather than the conjunctive. If so, the commission has effectively voted to repeal the preference statute, since almost every preference meets the criterion set forth in (A), namely, that the debt was incurred in the ordinary course of business." "The best solution would be to simply repeal the ordinary course defense. This would leave us with a 'no-fault' preference law designed to simply and efficiently redistribute all transfers that were made on the eve of bankruptcy without regard to any fault by the recipient."
NBRC-0998 Bruce Sledd Vendor. Letter contains no return address. Was apparently faxed.

Author is sending warning that vendors of bankrupt companies may be sued to force a refund of all monies received for goods and services provided. This apparently happened to author, as he cites case no. 97-20093 Sledd vs. Smith, before the 5th Circuit Court of Appeals. Author warns that "If this case is not over-turned, no vendor would risk future litigation by conducting ordinary and customary business transactions with any entity under Chapter 11 bankruptcy protection." See above.
NBRC-1028 Jim Gulechyn National Credit Manager, General Mills, Inc.
Author gives examples of situations in which §547 harms trade creditors with no concomitant benefit for debtors or their estates. "To solve these problems, the ordinary course exception of §547(c)(2) could be revised. (author suggests changes)" "Next, subsection (C), which has been interpreted to mean that the payments must have been within the ordinary terms of both the debtor's and creditor's respective industries, could be deleted." If subsection (C) is not deleted, the 90-day period should be reduced to 60 days.
NBRC-1034 Harry W. Greenfield and Alan Gordon Chair, Bankruptcy & Insolvency Section, and Chair, Chapter 11 Subcommittee, respectively, Commercial Law League of America (CLLA) Comments and suggestions regarding reforms to preference recovery; Comments and suggestions regarding Employee Participation in Bankruptcy Cases; Proposal on Section 547(c)(2) Ordinary Course of Business 547
Author makes observations with regard to three proposals issued in a memorandum dated June 1, 1997 by Professor Lawrence P. King and Elizabeth I. Holland: Minimum threshold requirement; Venue; and, Amending the Ordinary Course of Business Exception. CLLA supports the minimum threshold requirement for recovery of preferences; does not support the shifting of venue in such actions to the district where the creditor has its principal place of business; and, generally supports the disjunctive test to determine whether a payment is made in the ordinary course of the debtor's business, although it believes that an error was made in that the disjunctive appears to be intended to connect subdivisions (B) and (C), not (A).
NBRC-1034 Harry W. Greenfield and Alan Gordon Chair, Bankruptcy & Insolvency Section, and Chair, Chapter 11 Subcommittee, respectively, Commercial Law League of America (CLLA) Comments and suggestions regarding reforms to preference recovery; Comments and suggestions regarding Employee Participation in Bankruptcy Cases; Proposal on Section 547(c)(2) Ordinary Course of Business

"Despite the noble intentions of Congress, the ordinary course exception, in its present form, has woefully failed to achieve its legislative objectives. Section 547(c)(2) has not left normal financial relations undistrubed but, rather, has produced a tremendous amount of legal uncertainty." Section 547(c)(2) of the Bankruptcy Code should be amended with the language given in this recommendation.
NBRC-1069 T.C. Walthour Director, Corporate Credit, Dean Foods
The requirements of the ordinary course of business exception of §547(c)(2) lead to results that are contrary to the overreaching purpose of §547. "The law can harm trade creditors with no concomitant benefit for debtors or their estates." "To solve these problems, the ordianry course exception of §547(c)(2) could be revised. First, the requirement that the purchase by the debtor be in the ordinary course of its business is unnecessary if the purchase was proper and in the ordinary course of the vendor's business. this requirement could, therefore, be deleted. Second, absent coercion or overreaching, there is no reason why vendors who allow a debtor extra time to pay, therby helping the debtor and its other creditors, should have a preference problem. Subsection (b) could be rewritten to include in the exception any payments within the ordinary course of the vendor's and debtor's business or later than such terms provide. Next,subsection (C)...could be deleted."
NBRC-1147 Carolyn O'Connor Credit Manager, Beeswax Designs

Author feels that the preference rule is not fair because "the creditor must return the payment for goods that were shipped in good faith and have probably been sold by the debtor." Further, the creditor also incurs the expense of an attorney to defend the action. "We would suggest that if a creditor receives money priior to the filing of a bankruptcy that he get to keep [sic] as in most cases it is in exchange for new product."