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Reforms to Preference Recovery under 11 U.S.C. § 547

Procedural preference reforms start with the premise that although the theory and substance of the preference power are sound, the practice of preference recovery is somewhat flawed. The argument is 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.

There is a dearth of authority or statistics on preference abuses. For example, the perception of certain preference actions is that a trustee (or in rare instances, a debtor in possession) sends out a blanket complaint to virtually every creditor, particularly trade creditors, who received any payment within ninety days of the petition date. The trustee would have done little to 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. Given the small amount of money at stake, it is rarely cost-effective for the creditor to contest the action, especially if the creditor is located in another state. As a result, those creditors are led to settle the action regardless of its merits.

The tension, therefore, is to develop efficient procedures to restrain abusive litigation techniques by the trustee without interfering with the policy goals of the preference power itself, which can be summed up as equality of treatment of creditors.

Proposals to the Commission on preference reforms have centered on the limited area involving smaller trade creditors from whom recovery of prepetition payments were sought by debtors in possession or trustees as avoidable preferences. In these instances there is, at times, a disincentive for such creditors to defend rather than settle the actions because (i) the amount sought is relatively small (cost of defending could be greater) and (ii) the bankruptcy court is in a distant location making it more costly to defend. It has also been noted that in chapter 7 cases converted from chapter 11, a fair amount of time had elapsed from the payment and chapter 11 petition date to the date recovery was sought by the chapter 7 trustee. In such instances, the demand could come as a surprise as well as long after the transaction was considered closed.

Possible solutions to these problems include (1) placing a dollar amount below which a payment to a business creditor (trade creditor, supplier) would not be voidable; and (2) placing a dollar amount below which any action to recover a preference would have to be brought in the district where the creditor is located. The American Bankruptcy Institute provided the Commission with the results of a survey it took of attorneys as well as credit managers canvassing a variety of preference experiences. The survey results provided support for these solutions to address the problems faced by smaller trade creditors.

Preference Proposal #3: Amending the Ordinary Course of Business Exception Under 11 U.S.C. § 547(c)(2)(B)

Proposal

Section 547(c)(2)(B) should be amended to provide a disjunctive test for whether a payment is made in the ordinary course of the debtor’s business if it is made according to ordinary business terms. The ordinary course of business defense to a preference recovery action under Section 547(c)(2) should provide as follows:

(2) to the extent that such transfer was --

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(C) made according to ordinary business terms

Reasons for the Change

The purpose of the ordinary course of business exception to preference recoveries is "to protect recurring, customary credit transactions that are incurred and paid in the ordinary course of the debtor and the debtor’s transferee." [ FN: 4 Collier on Bankruptcy ¶ 547.10 at 547-52 (Lawrence P. King et al. eds. 15th ed. 1996).] Some confusion exists, however, as to whether a payment is made in the ordinary course of business if it deviates from industry standards but is otherwise ordinary between the parties. [ FN: Compare Lovett Jr. v. St. Johnsbury Trucking , 931 F.2d 494, 498 (8th Cir. 1991) ( "Late payments may be held to be made in the ordinary course of business, when such payment practices were well- established between the parties. ") with Lawson v. Ford Motor Co. (In re Roblin Indus. Inc.), 78 F.3d 30, 38-40 (2d Cir. 1996) (citations omitted) ( "the thrust of §547(c)(2)(C) . . . is clear . . . . [O]nly when a payment is ordinary from the perspective of the industry will the ordinary course of business defense be available for an otherwise voidable preference. ")] In fact, the trend has gone from requiring proof of ordinary course between the parties to requiring ordinary course between the parties and within the industry. [ FN: See In re Excello Press Inc. , 967 F.2d 1109 (7th Cir. 1992) (court noted that prior to 1987, the test under section 547(c)(2)(B) & (C) required the same showing of course of dealing between the parties and that after 1987, the majority view is that satisfaction of both prongs is required).] Some courts have blurred the distinction between course of conduct between the parties and industry standards; finding that only extremely aberrant transfers fall outside the exception. [ FN: See, e.g., In re Tolona Pizza Prod. Corp. , 3 F.3d 1029 (7th Cir. 1993) ( " ‘ordinary business terms ’ refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealing so idiosyncratic as to fall outside that broad range should be deemed extraordinary and therefore fall outside the scope of [section 547(c)(2)(C)] ").]

The Proposal adopts the view that the conduct between the parties should prevail to the extent that there was enough prepetition conduct to establish a course of dealing. [ FN: This view has already been adopted by some courts. See, e.g. , Fiberlite Corp. v. Molded Acoustical Products (In re Molded Acoustical Products Inc.), 18 F.3d 217 (3d Cir. 1994) ( "section 547(c)(2)(C) countenances a greater departure from that range of terms the longer the pre-insolvency relationship between the debtor and creditor was solidified ").] A disjunctive test telescopes the ordinary course inquiry on the course of conduct between the parties. In the event there is not enough prepetition conduct to establish a course of dealing, then industry standards should supply the ordinary course benchmark. The Proposal accomplishes thisresult without effecting a significant statutory change.

Competing Considerations

It may be argued that debtors and creditors should not be encouraged to (i) diverge from standard industry payment terms; and (ii) manipulate their course of conduct prepetition. The current conjunctive requirements reinforce this policy goal. The Proposal does not dissuade debtors and creditors from complying with industry standards, but rather focuses on the course of dealing to determine whether a transfer was made in the ordinary course of business. If the parties have sufficient prepetition conduct to establish a course of dealing, the Proposal eliminates any argument that the course of dealing did not comply with industry standards, and therefore, that the transfer was not in the ordinary course of business. Preference litigation in this area should be simplified as a result of the Proposal.

 

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