Bankruptcy Preference Defense: Expert Witness v. Expert Witness
By Dorman Wood
"Just as purchasing a home is the average person's most common experience with the law, the average credit manager's most common brush with the bankruptcy process, aside from filing a proof of claim, is the Trustee's preference demand letter and ensuing litigation. Not only is the preference provision the most litigated of bankruptcy's avoiding powers, it can unwind a host of settled commercial transactions."[FN 1]
The return of preferential payments under 11 U.S.C. § 547 of the Bankruptcy Code is for the fair and equal treatment of all unsecured creditors. Reclamation of such payments is intended to redistribute the bankruptcy estate's assets equitably among all of the unsecured creditors.
It doesn't seem fair does it? As a practicing credit professional, you extended credit to a customer (debtor) on behalf of your employer. Your customer never disputed the account balance due your employer. Yet, after your customer files bankruptcy and you filed your proof of claim with the proper court, you are suddenly confronted by a demand letter from the Trustee, counsel for the Debtor In Possession (DIP) or counsel for an unsecured creditor's committee, seeking repayment of all monies received from your customer within the ninety (90) days [one year if payment was received from an insider] prior to the 'petition date.' This period is commonly known as the "preference period." The Bankruptcy Code presumes that a debtor is insolvent during the ninety-day period before the bankruptcy petition is filed. Therefore, all payments and transfers made to creditors by the debtor during that period are suspect.
"Preferential transfers under federal bankruptcy law are generally defined in 11 U.S.C. § 547(b), although a number of other sections provide definitions and other rules used to determine how the elements are applied. Section 547 provides that the trustee may avoid (set aside) transfers of the debtor's interest in property:
- to or for the benefit of a creditor;
- for or on account of an antecedent debt owed by the debtor before such transfer was made;
- made while the debtor was insolvent;
- made - (A) on or within 90 days before the date the petition was filed; or (B) if the creditor was an insider, on or within one year before the date the petition was filed; and
- that enabled the creditor to receive more than the creditor would have received if - (A) the case were a case under Chapter 7 of the Bankruptcy Code; (B) the transfer had not been made; and (C) the creditor received payment of such debt to the extent provided by the provisions of Chapter 7. [FN 2]
To recover a preference, the Trustee, DIP or Creditor's Committee must establish all five elements. In the event all five elements cannot be proven, a preference has not been established and no recovery can be made. However, if all five elements are established, creditors have a number of defenses that can be raised to eliminate any liability.
As maddening as it can be, §547 does not require proof of intent to receive a preference, notice of insolvency, fraud or other subjective elements.
Under the Bankruptcy Code, a Trustee, DIP or creditor's committee has two years from the date the bankruptcy petition was filed in which to commence a preference reclamation action. As many credit professionals have learned, their first notice of a preference action is receipt of a demand letter from a Trustee, DIP or creditor's committee. Such a demand generally includes the debtors name, your account number, totally dollar amount of payments made during the preference period or value of any goods returned, check numbers, check amounts and invoices being paid. The demand letter will also state the period to time in which the preference is to be repaid (grace period) before any litigation action is commenced.
At this point, the credit professional must make a decision: pay the amount of the demand; attempt to negotiate a settlement for a lesser amount, or hire outside counsel to mount a defense against the preference claim. Such a decision will most likely be driven by the dollar amount of the preference claim.
In the case of a preference claim for $100,000 (example amount only) or more, the credit professional, with proper management approval, will more than likely want to hire outside counsel for representation in a defense action. § 547(c) sets forth the following exceptions to a preference claim: 1) transfer was made in a contemporaneous exchange of new value to the debtor; 2) transfer was made in the ordinary course of business; 3) transfer was a security interest in property securing new value to the debtor; 4) transfer was made before the creditor provided new value; 5) transfer was a security interest in inventory or a receivable, such as a floating lien, that did not impair other creditors; 6) the transfer was the fixing of a statutory lien; 7) transfer was of an alimony or child support payment; or 8) transfer was of property with an aggregate value less than $600.00.
Although an "ordinary course of business" defense is the most expensive and difficult defense to establish, the number of such cases appears to be on the increase. "Three elements make up the ordinary course of business defense:
- First, the debt must be incurred in the ordinary course of business or financial affairs of the debtor and vendor.
- Second, the transfer must have been made in the ordinary course of business or financial affairs of the debtor and vendor. This element is often referenced as the "subjective" test to the ordinary course of business defense.
- Third, the transfer must have been made according to ordinary course of business terms within the respective industry. This element is often referenced as the "objective" test of the ordinary course of business defense."[FN 3]
This is where the important role of a Certified Expert Witness (CEW) comes into play. The National Association of Credit Management (NACM), through its qualification and testing program, has certified ninety-two (92) credit professionals as Certified Expert Witnesses. Individual credit professionals who meet all qualification and testing requirements are "certified" by NACM as experts in bankruptcy matters, including preference defense cases (see www.nacm.org for more details).
A CEW who is retained by counsel for the defense (creditor) will be challenged to meet the burden of proof of the three elements outlined above. The CEW's activities may include, but not be limited to the following: 1) reviewing the business transaction history between creditor and debtor; 2) reviewing payment history between creditor and debtor for the preference period as well as the ninety days prior to the preference period - including a review of payment terms, invoices and copies of checks received from the debtor, usually through a lockbox system [payments are deemed "received" when honored, not by check date or deposit date]; 3) creditor's credit policy and procedures - consistency in both theory and practice are important factors in establishing "ordinary course of business;" 4) all correspondence between creditor and debtor relating to business transactions - internal and external; 5) reports on the debtor generated by credit reporting agencies; 6) industry group statistics on payment history (DSO - Days Sales Outstanding) or other available industry statistics such as the National Summary of Domestic Trade Receivables compiled and reported by the Credit Research Foundation; 7) interview relevant creditor personnel who had frequent, ongoing contact with debtor, such as credit manager, collectors and sales personnel.
Following his or her review of the previously described documents and personnel interviews, the CEW will be required to render a report to engaging counsel. Such report may include, but not be limited to the following: 1) Statement of engagement; 2) Explanation of the scope of engagement; 3) CEW's CV outlining his or her business, professional and educational experience; 4) details of activities in carrying out the engagement; 5) copies of all pertinent documents (exhibits) supporting the report; 6) summary and opinion in support of ordinary course of business defense.
While fulfilling the terms of their engagement, the CEW should keep in mind that the Trustee, DIP or Creditor's Committee counsels will more than likely be engaging their own "expert witnesses" to counter their works. Expert witnesses hired by the plaintiff may well be other CEWs. However, it has been this writer's experience that most such witnesses are public or certified public accountants. This is not to infer that an expert witness who is not "certified" is less competent to perform their examination. It has been this writer's experience however, that expert witnesses who are not professional credit practitioners may not be familiar with the nuances of the creditor-debtor relationship or industry in which they do business. The assignment of the plaintiff's (debtor) expert witness is similar to that of the defendant (creditor); develop support for their preference claim.
In anticipation of the preference claim proceeding to trial, both expert witnesses will be subject to deposition conducted by opposing counsel. The primary purpose of the deposition is to question the expert witness regarding his or her professional and educational background; scope of the engagement and fees to be paid; experience in bankruptcy matters; experience with specific types of customers and industries; methodology used in developing their report and opinion; documents reviewed, and individuals interviewed. Answers to questions posed by counsel conducting the deposition also give them insight into the viability of the opposition's defense. During the deposition, counsel accompanies the witness being deposed. However, while opposing counsel may object to questions "as to form," the witness is required to answer all questions to the best of his or her ability. At the end of the deposition, counsel representing the expert witness has the opportunity to ask questions to correct or clarify answers previously given by the witness. Although depositions are generally conducted in a 'non-adversarial' atmosphere, the expert witness being deposed must maintain his or her professional composure at all times, despite opposing counsel's attempts to upset or confuse them. Remember, it is opposing counsel's job to attempt to discredit you as an "expert witness" and while difficult at times, you should not take their efforts personally.
In the event the preference claim cannot be settled through negotiations between counsels it will be necessary for the opposing expert witnesses to appear in court to give sworn testimony. This is an oppor-tunity for opposing counsels to expand on questions posed during the deposition, to review documents and other information contained in your report, and possibly to introduce additional evidence.
Creditors should never ignore a preference demand. Nor, should a preference demand be feared. Rather, it should be considered as an opportunity for the creditor to fully utilize the defenses available to them under the Bankruptcy Code. Include a Certified Expert Witness on your defense team. It is just good strategy.
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