Preference Defense Checklist

Howard N. Madris and Michael Joncich

Business Credit Magazine
June, 2010
 
As the saying goes, “free advice is worth what you pay for it.”  That rings particularly true with respect to a plaintiff’s counsel’s pre-lawsuit letter demanding the return of an alleged preferential transfer (APT), in the context of a federal bankruptcy proceeding or state law assignment for the benefitof creditors (ABC).  In a typical demand letter, the plaintiff recites the elements of a preference as set forth in either Section 547(b) of Title 11 U.S.C. (the Bankruptcy Code), or the ABC statute.  Further, the letter often informs the potential defendant of select defenses to a generic preference claim, such as “ordinary course of business,” “contemporaneous exchange” and “new value” under Section 547(c). 
 
The prudent credit manager should not rely on the gratuitous legal advice emanating from the other side’s attorney in the demand letter; nor should the credit manager respond to the letter or ignore it.  Rather, the credit manager should retain experienced insolvency counsel to review the letter and to evaluate potential defenses.  If a lawsuit is filed, defendant’s lead counsel need not be licensed to practice in the state in which the action is commenced, as long as “local counsel” is also retained to sign court filings.
 
The following is a checklist of defenses that rely on legal provisions that are either wholly or partially outside the scope of Sections 547(b) and (c).  Defenses specific to a preference lawsuit arising in an ABC are also noted.  An ABC is a state law insolvency proceeding that is similar in many ways to a bankruptcy proceeding.  Although an ABC is recognized in most states as an alternative to bankruptcy liquidation, as assignee’s power to recover preferences varies among the states.  To a financially distressed company, an ABC may have the following advantages over a bankruptcy filing: (1) an asset sale can be arranged faster than through a bankruptcy trustee; (2) administration costs are typically less; and (3) the principals will not have the stigma of having to disclose that they put a company into bankruptcy. 
 
The preference defense checklist includes the following: 
 
Statute of limitations.    In bankruptcy court, a preferential transfer lawsuit must be filed within the later of two years after the petition date, or one year after the appointment of a trustee.  In an ABC the deadline may differ, depending on the state.  In California the deadline is one year after the assignment date.  It is quite rare for a preference action to be filed after the statute of limitations, but defendant’s counsel should consider the timing of the filing as part of his due diligence. 
 
Jurisdictional defect due to insufficient dollar amount.  In a bankruptcy proceeding, if a preference claim against a non-insider is for less than $10,950, the action must be brought in the district in which the defendant resides.  28 U.S.C. Section 1409(b).  However, a claim for less than $5,475 is completely barred under Section 547(c)(9).  
 
Defendant secured at time of transfer under non-bankruptcy law.  The preference laws are designed to prevent an unsecured creditor from receiving more favorable treatment than other unsecured creditors.   However, a secured creditor is entitled to such preferred status.  Thus, where the APT was made in satisfaction of a non-preferential lien that arose under state or federal law, the preference claim must fail, whether in a bankruptcy adversary proceeding or ABC.  By virtue of the defendant’s secured status, the plaintiff cannot establish that the APT enabled the defendant to receive more than it would have received in a liquidation proceeding absent the payment, as required by Sec. 547(b)(5) and ABC statutes as determined in In re Golfview Development Center, Inc., where payment in satisfaction of a state law mechanic’s lien is not a preference. In re Sims Construction Services Co., Inc. also found that payment received in consideration of an attorney’s lien is not preferential.
 
Therefore, defendant’s counsel should consider whether defendant was secured at the time of the APT, even where there is no UCC-filing or other obvious indicia of a secured position.  For instance, under California law, a lien is automatically granted to one who performs agreed upon improvements to the goods of another, as long as the improver is in lawful possession of the goods and has not been paid.    Thus if a preference defendant received an APT for repairing the debtor’s property in California, and the defendant was in possession of the repair item when it received the APT, the defendant may have a complete defense to the action.  
 
Transfer of trust property.  An essential element of a voidable preference under both the Bankruptcy Code and ABC statutes is that the transfer was of “an interest of the debtor in property.”  If, under non-bankruptcy law, the APT was paid with funds that the debtor was holding in trust for the defendant, the payment could not be preferential.   Statutes that create such a trust relationship, and thus defeat a preference claim, include without limitation the Packers and Stockyards Act of 1921 (PASA) (applicable to payment for livestock) and the Perishable Agricultural Commodities Act (PACA) (applicable to payment for certain fresh produce.) 
 
Transfer of “Earmarked” Funds. The earmarking defense is a judicially created doctrine. Where an APT is paid with funds that a third-party provided to the debtor for the payment of that specific debt, the transfer may be exempt from liability. Courts interpret the earmarking defense according to varying standards. Some courts require that the debtor lacked dominion or control over the funds. Other courts require that the APT did not diminish the assets of the estate (e.g., In re Marshall, which discusses the various tests).
 
Assumption of executory contract.  This defense, as well as the below-described “waiver pursuant to plan” and “waiver pursuant to critical vendor order” defenses, are unusual because they arise from post-petition bankruptcy events.   Section 365 allows a debtor or trustee to “assume” an executory contract post-petition.  An executory contract is typically construed as a contract in which both parties owe obligations.   If the bankruptcy estate assumed a defendant’s contract under Section 365, the estate’s representative cannot thereafter bring a preference action to recover an APT made under the contract.  However, two decisions, In re ABC-Naco, Inc. and In re Kiwi Int’l Air Lines, Inc., found the bankruptcy court must have expressly approved the assumption of the contract pursuant to a court order. 
 
Waiver pursuant to plan.  In a Chapter 11 proceeding, the provisions of a confirmed plan of reorganization or liquidation trump any rights that the plaintiff would otherwise have to file preference lawsuits.  Where the plan specifically waives such actions, suit is barred (e.g., In re Kmart Corp.).
 
Waiver pursuant to critical vendor order.  Operating Chapter 11 debtors sometimes obtain court approval to pay the pre-petition claims of “critical vendors” in order to continue to receive the vendors’ goods and services.  A plaintiff may be barred from asserting a preference claim against a defendant who was the subject of a “critical vendor order,” where the order so provides.  (The In re Fultonville Metal Prods. Co. decision found there is no waiver unless the critical vendor order expressly provides for it.)
 
Loss of  20 day administrative claim  and/or right of reclamation.  In a bankruptcy case, a vendor is entitled to an administrative claim under Section 503(b)(9) for the value of any goods that the debtor received from it within 20 days before the petition date.  Alternatively, where goods are sold to an insolvent debtor in the ordinary course of the seller’s business, and the debtor remains in possession of the goods, the vendor can seek to reclaim the goods by making a written demand.  In a bankruptcy case, the vendor must make the demand by the later of 45 days after the debtor received the goods, or 20 days after the petition date if the 45-day period had not expired as of the petition date.  Sec. 546(c)(1).  In an ABC, the vendor must make the reclamation demand within 10 days after the insolvent purchaser received the goods, in accordance with the state’s reclamation statute.  UCC Sec. 2-702.
 
In some instances, a defendant may be sued for recovery of an APT where had the payment not been made, the vendor could have asserted its rights to a twenty day administrative claim or for reclamation.  The defendant could argue that the plaintiff cannot satisfy Section 547(b)(5) (or the comparable ABC statutory provision), which requires the plaintiff to show that the APT enabled the defendant to receive more than it would otherwise have received in a liquidation proceeding absent the payment.   However, with respect to 20 day claims, it is not very common for a vendor to deliver goods to the debtor within 20 days of the petition date and then receive antecedent payment for those goods pre-petition.  Moreover, while bankruptcy reclamation claims may arise more frequently, they are often defeated.  For instance, if at the time of a reclamation demand, the debtor had already transferred the goods to a third-party, or the goods were subject to a third-party secured creditor’s pre-petition lien, the reclamation claim may fail (although recent case law on the latter point is unclear).   Thus it might be difficult for a defendant to establish that hypothetically, had it not received the APT, it would have successfully asserted a reclamation claim.
 
Protected transaction under Bankruptcy Code Section 546.  Defendant’s counsel should familiarize himself with Section 546.  The section protects certain types of businesses from preference liability in certain transactions.  For instance, grain sellers and fishermen are afforded certain protections, as are stockbrokers and other participants in certain types of finance-industry transactions. 
 
Out-of-state defendant in a California ABC.  This defense only applies in California ABCs.  In 2005, the federal Ninth Circuit Court of Appeals held that the Bankruptcy Code preempts, or precludes, the filing of preference claims under the California ABC statute in Sherwood Partners, Inc. v. Lycos, Inc.  That ruling is binding on all California federal courts.  On the other hand, California state courts have rejected the Sherwood ruling as in Credit Managers Assoc. of Cal. v. Countrywide Home Loans, Inc.  A Delaware superior court also held that preference claims under the California ABC statute are not preempted by the Bankruptcy Code (Spector v. Melee Entertainment, LLC).
 
Under 28 USC Section 1332, federal courts have exclusive “diversity jurisdiction” over lawsuits where the plaintiff and defendant are from different states and the amount in controversy exceeds $75,000.  Therefore, where a non-California defendant is sued in a California ABC for preferences exceeding $75,000, the defendant should have the action removed to a California federal court, which would then dismiss the action based on Sherwood.  Thus post-Sherwood, a California ABC plaintiff suing a non-California defendant for preferences exceeding $75,000 will typically file the lawsuit in state court in the defendant’s home state. 
 
Poverty defense.  This defense is not found in any case law.  Rather, based on practical realities, a plaintiff may agree to settle a preference action on reduced terms if it receives verifiable evidence that the defendant would be unable to satisfy a judgment.  In some instance, providing a balance sheet or profit and loss statement may suffice.   
 
In sum, in defending a preference action, defendant’s counsel needs to think “outside the box.”  Defenses mail be available that are not set forth explicitly in Sections 547(b) and (c), or in plaintiff’s counsel’s pre-lawsuit demand letter.  By fully exploring these defenses, counsel may obtain the best result available to the client. 
 
Howard N. Madris, Esq. is principal attorney at the Beverly Hills, California based Law Office of Howard N. Madris, A P.C.  The firm has a nationwide preference defense practice.  It is AV-rated by Martindale-Hubbell Peer Review, and specializes in bankruptcy and insolvency matters.  Mr. Madris can be reached via email at hmadris@madrislaw.com.
 
Michael L. Joncich manages theAdjustment Bureau of NACM affiliate Credit Management Association, headquartered in Los Angeles.  He has extensive experience with the administration of general assignments for the benefit of creditors and preference recovery.  He can be reached via email at mjoncich@emailcma.org