Unsecured Trade Creditors Committee

ABI Committee News

Beyond New Value and Ordinary Course: An Outside-the-Box Preference Defense

A bankruptcy judge in Texas has issued one of the most compelling preference rulings in recent history. In the chapter 7 case of Brook Mays Music Co. pending in Dallas, the court ordered at the outset of a chapter 7 case that the chapter 7 trustee NOT pursue certain preference actions in an effort to reel in “preference litigation run amok.” In making this ruling the court stated:

… this court is troubled by a trend in large bankruptcy cases, in particular, of preference litigation run amok … trustees suing with reckless abandon, every recipient of a transfer of property of the debtor that occurred within 90 days of the bankruptcy filing, with no consideration of obvious defenses, or [added] what makes economic sense.

In our May 2004 LEGAL UPDATE: Enough is Enough: How to Reel In Abusive Preference Actions, we wrote:

If the company can successfully defend or settle the preference claim using the new value or ordinary course of business defenses, that should be done. However, those defenses don’t always work, leaving the company with potential preference liability.

At this point, a preference target should employ less common defenses, for example, that the preference recovery will not benefit the debtor’s estate. What if the debtor’s estate is not likely to distribute a dividend to the unsecured creditors (from whom the preference payments are recovered); rather, the only parties to benefit from the recovery are the secured lender or the professionals charging fees to the estate? In this case, a good argument exists that the claim for a preference recovery should be dismissed, as there will be no benefit to the debtor’s estate (which includes the unsecured creditors).

This theory is gaining traction in both case law and in commentary by bankruptcy professionals. Hopefully, this traction will evolve into more attorneys representing preference defendants raising this issue and more courts entering favorable rulings. Perhaps over time use of the “no benefit to the estate” defense can curb abusive preference filings. One strategy for preference defendants using this defense will be to force discovery to expose that there will in fact be little or no dividend to unsecured creditors, and that the bulk of the recovered funds will be used to pay a secured lender or professional fees. Making these facts well known to the court may create a disincentive for filing preference actions when creditors will receive no benefit.

The Brook Mays case is further evidence that this theory is gaining traction. The court converted the case from chapter 11 to chapter 7. In the conversion order, the court mandated the chapter 7 trustee to prepare a preliminary report for the court regarding:

- analysis of potential avoidance actions,

- list of insider payments,

- which potential preference defendants also had 20-day administrative claims, and

- likely defenses to preference actions

In ordering this report, the court expressed a “concern that there should be an expeditious and economical resolution of the case, and that the trustee should cautiously and properly exercise fiduciary duties in this regard.”

Obviously prompted by the court’s directive, the Brook Mays chapter 7 trustee issued a report that proposed to pare the list of preference actions from 1400 claims to 189 claims. On top of that, the court further ordered that the trustee not sue any vendor for any payment relating to goods shipped within 20 days prior to the filing which would give rise to a 20-day administrative claim under §503(b)(9) of the Bankruptcy Code. If a vendor is compelled to return a pre-petition payment for goods received by the debtor 20 days prior to bankruptcy filing, the 20-day invoices would now be unpaid, which in turn would result in a 20-day administrative claim.

In addition to its ruling, the judge took the opportunity to address the court’s “consternation about preference litigation being waged in a context, such as in this case, in which there is little chance that unsecured creditors are going to realize any benefit.” The court in this case correctly noted that the lender had a large deficiency claim, for which it obtained a “super-priority” administrative claim, pursuant to the original DIP financing order. The court observed that there was a “significant possibility” that, after payment of chapter 7 and 11 administrative expense claims, there will be no distribution to unsecured creditors, even if there are large preference recoveries in the preference litigation. The court expressed “grave concern whether it makes sense … to pursue preference litigation in such a context.”

Noting that the Bankruptcy Code requires only that preference recoveries “benefit the estate,” and not specifically the unsecured creditors, the court stopped short of ruling that preference actions would be barred if recoveries would produce nothing for unsecured creditors. Nevertheless, the court’s hostility to preference litigation in this context was apparent.

What are the “takeaway” points of the Brook Mays decision? As we stated in our May 2004 LEGAL UPDATE on abusive preference actions, if a vendor has a slam dunk new value defense or compelling ordinary course of business defense, the vendor should pursue those defenses. If, however, after applying the new value and ordinary course of business defenses, there remains material potential liability, it may be worth attacking the preference actions generally based on the Brook Mays ruling. We believe that the “benefit to the estate” test, at a bare minimum, should require at least two creditor constituents receive payment. If only administrative claims will be paid, preference litigation is not warranted. Moreover, a nominal distribution—to the point of being illusory—for unsecureds should not count as “benefit to the estate.”

Hopefully, creditors will begin using the Brook Mays reasoning to attack preference litigation and other courts will follow the lead of the Brook Mays court. The trick will be to get buy-in from bankruptcy courts in Delaware and New York, which are often debtor and lender-friendly forums.

In a related matter, on Nov. 27, 2007, Judge Burton Lifland in the Calpine Corp. case, pending in the Southern District of New York, approved Calpine’s request to abandon $80 million of preference claims. The reason is that Calpine anticipates unsecured creditors will receive almost a 97 percent recovery, thus, it makes no economic sense to pursue the preference claims. Any money paid in as a result of preference liability will give rise to an additional unsecured claim in the amount paid in, which in turn would be entitled to receive the 97 percetn distribution.

The common denominator in Brooks May and Calpine is that what made “economic sense” was the driver of the decisions to not pursue preference litigation. Hopefully, vendors will use this argument in appropriate cases to fend off preference litigation.