The worst feeling in the world is getting paid on a past due debt, and thinking you are in the clear, because the business who paid you filed bankruptcy after they paid you; only to get a knock on your door from the Trustee of the bankruptcy estate, wanting to get the payment back from you. If you’re getting that knock on the door from the Trustee, or you want to prevent the Trustee from reaching back into your pockets, this blog post is for you.
When a business entity is contemplating the initiation of bankruptcy proceedings, good public policy dictates that the business continue its operations to the best of its ability. That means, in part, the ordinary payment of debts.
The rub comes, however, when some of the creditors, post-bankruptcy, think that one or more of the creditors were getting preferential treatment in the payment of their debts prior to filing bankruptcy. The net effect of this alleged “nefarious” preferential payment is that there is less money in the kitty for all the other creditors.
If push comes to shove, the Trustee, aka Plaintiff, will challenge the alleged preferential payment in an Adversarial Proceeding. 11 USC 547(b) authorizes the Trustee to avoid (meaning put the pre-bankruptcy payment back into the kitty for all the creditors to get their fair share) any transfer of an interest of the debtor in property if five conditions are met. The Trustee must show that the transfer was:
To the creditor;
On account of antecedent debt;
Made while the debtor was insolvent (547(f) presumes debtor’s insolvency on and during 90 days preceding filing);
Made within 90 days prior to the filing of bankruptcy (1 year for insiders);
Effective in allowing the creditor to receive more than it would under Chapter 7 liquidation.
It’s important to keep in mind that 547(b) dictates that the Trustee has the burden of proof. In order to prevail, the the Trustee must present evidence to show P’s history of payments throughout its business relationship with Defendant/Creditor (“D/C”). After he Trustee establishes prima facia case of 1-5, the burden shifts to D/C to show that the transfers are non-avoidable (meaning the pre-bankruptcy debt payment can stay in the original payee’s bank account). The standard of proof for the D/C/ is preponderance of evidence and the D/C must prove that payments qualify for a 547(c) exception.
A pedagogically helpful case on the topic is MP-Tech America v. Best Rental Corp., Adv. Proc. 12-03095 (Mid. D. AL. Bk.) (August 29, 2013). At issue in MP-Tech America v. Best Rental Corp was the application of 547(c)(2). MP-Tech America (“MP-Tech”) sought to avoid two preferential transfers, “comprising the payment of twenty individual invoices” to Best Rental Corp (“Best”).
The D/C in the case, Best, asserted that the transfers were made in the ordinary course of business (“OCoB”). The Trustee, via MP-Tech responded that the payments were outside OCoB because they were (a) tendered late; and (b) in response to unusual collection activity.
The Court explained that the purpose of 547(b) is to discourage a race immediately before bankruptcy to get al of one’s own debt paid. The Court also explained that the purpose of 547(c) exceptions is to pinpoint cases where there is little risk that the pre-bankruptcy payments will give rise to the race and little risk of costly self-protection of other creditors.
The Court explained that to show that the transfers are nonavoidable under the “ordinary course defense”, the D/C must prove by a preponderance of the evidence that the transfers at issue were: (a) made in the ordinary course of financial affairs between the debtor and the transferee (subjective); and (b) made according to ordinary business terms (objective based on industry standards).
In MP-Tech America v. Best Rental Corp, D/C failed to put forward evidence of the second factor, (b) – industry custom; and thus failed to prove that all the transfers were nonavoidable.
As explained by judge Dwight Williams, the court will look for specific evidence to determine if a D/C qualifies for the “ordinary course defense”, including:
prior course of dealings between the parties;
the amount of the payments (a sudden payment in full of all debts in anticipation of bankruptcy is the epitome of a preference);
the timing of the payments; and
the circumstances surrounding the payments.
The first step of the test is to look at the parties’ pay history before the pre-preference period; then contrast that with transactions which occurred during the preference period. The D/C will want to demonstrate that these were all made on similar terms.
There is a general presumption that late payments are outside OCoB, but the D/C can overcome this presumption by providing evidence that it was the parties’ ordinary course to make payments late. This is typically done by providing a spreadsheet showing the pre-preference invoices and making an average of the date range of payments.
On the other hand, the Trustee may assert that there was “unusual collection activity” (UCA). Again, evidence must be produced showing pre-preference activity, in order to contrast with preference period activity. An attempted repossession would probably be construed as UCA, but there must be evidence of date and whether it had any effect on the Trustee tending payment.
In conclusion, it’s helpful to remember the purpose of avoiding preferential payments, i.e., to discourage (by eliminating fruits of) a race immediately before bankruptcy to get al of one’s own debt paid. It’s also helpful to remember the purpose of 547(c) exceptions – to pinpoint cases where there is little risk that the pre-bankruptcy payments will give rise to the race and little risk of costly self-protection of other creditors.