Preference Defense: New Challenges Facing Creditors

At its inception, the Bankruptcy Abuse Prevention and Consumer Protection act of 2005 (BAPCPA) was hailed as the most sweeping revision of the bankruptcy law in more than two decades.

While the majority of the revisions under BPACPA were aimed at individual bankruptcy reform, several touched on commercial bankruptcy reform.

One such revision was to §547(c)(2), which is commonly referred to as a creditor’s ‘ordinary course of business defense’ to a preference suit brought by a trustee, unsecured trade creditors committee or in some cases, a plan administrator. A creditor’s ordinary course of business defense’ pre-BAPCPA was required to meet a three-prong test to show that a payment received within the 90 day period prior to (and including) the bankruptcy petition date, was: 1) made upon a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and transferee, 2) made in the ordinary course of business or financial affairs of the parties, and 3) made according to ordinary business terms. Prongs 1 and 2 were referred to as the “subjective test” of the parties’ dealings. Prong 3 was referred to as the “objective test” of the standards observed in the relevant industry.

BAPCPA revision of §547(c)(2) was initially believed to lessen the creditor’s burden, as it replaces the conjunctive “and” after prong 2 with “or.” This revision is interpreted as giving the creditor the option of meeting the “subjective test” of the dealings between the parties, or the “objective test” of the standards observed within the relevant industry in their defense of a preference action. The matter is not as clear-cut as one may initially think after reading the revisions.

As seen in In re National Gas Distributors, LLC, 2006 WL 2135557 (Bankr. E.D.N.C.), the bankruptcy court (Eastern District of North Carolina) ruled that while the creditor only needed to establish one prong of the ordinary business defense under the revised statute, it required the court to consider the ordinary business terms of both debtor’s industry and creditor’s industry.

The National Gas decision is but one of a limited number that have handed down in post-BAPCPA preference suits. Based on a nonscientific survey of bankruptcy attorneys, it appears too early to determine how the courts will view creditor’s ordinary course defenses in cases yet to be tried.

It does appear however, that plaintiff’s (debtor’s) attorneys are becoming more creative in their efforts to counter creditor’s ordinary course defenses. In a recent 5th Circuit (Western District of Texas) preference suit1, plaintiff’s attorney claimed that defendant (creditor) had not met the burden of the two prongs of ordinary course between the parties, or within their industry. A few of the reasons stated in plaintiff’s motion to exclude various reports, testimony and evidence were as follows: 1) creditor did not follow its own written credit policy and procedures; 2) the manner in which debt was incurred was not proven; 3) the manner in which debt was incurred by plaintiff’s competitors was not proven; 4) creditor did not prove the manner in which its competitors dealt with plaintiff; 6) creditor did not prove that its collection practices were according to industry standards, and, 7) creditor did have a written policy for document retention or destruction or follow any apparent routine for document retention or destruction.

A settlement of this case negated the scheduled trial, therefore, we will never know who might have prevailed at trial. However, the points listed above could be used by creditors in general for the purpose of reviewing and improving their internal policies and procedures; becoming more aware of the business practices of their competitors and, if not already in place, to develop and implement a written policy and procedure for the retention or destruction of documents.

If polled, the majority of credit executives will likely state that they have credit policies and procedures in place at their respective companies. However, if asked whether their policies and procedures are applied equally and fairly to all customers, the same credit executives may not answer yes in the majority. Further, if the same credit executives are asked when the last time their policies and procedures were reviewed and updated, they may not be able to give a definitive answer. The primary purpose of credit policies and procedures is to provide a basis for the manner in which the daily functions of the credit department are carried out, as well as the application of the policies and procedures to customers. The policy and procedures must be reviewed on a regular basis and updated if needed in order to keep pace with any changes in the business environment in which the creditor operates. In an ordinary course of business defense in a preference suit, the creditor must provide evidence that its credit policies and procedures are similar to those of its competitors and/or like companies within their industry and, that the policies and procedures are applied equally and fairly to all of its customers.

“On December 1, 2006, the Federal Rules of Civil Procedures were amended to address court procedures for disclosing electronic information during the discovery phase of litigation. The new court rules begin to apply to a company when litigation is “reasonably anticipated.” At that point, a company must put a “litigation hold” on its electronic and other records that may be discoverable in litigation. Companies that take this step will be protected against court sanctions, so long as they take reasonable steps to protect and preserve information.”2

The Federal Rules of Civil Procedures are considered to apply to bankruptcy proceedings and therefore, apply to discovery (also referred to as production) of documents in a preference suit. Motions for discovery or production filed by counsel for both plaintiff and defendant are generally far-reaching and include, but are not limited to all documents or records pertaining to the business relationship between the parties. Such documents or records can include emails – internal and external; accounts receivable records – aging reports, cash application and check copies; lock box records; invoice copies; collection notes – hard copy or electronic; contracts or distribution or purchase agreements; purchase orders; shipping records; notes from telephone calls; other forms of correspondence, and policies and procedures to name a few. Documents or records described may have been stored electronically – on servers, disc drives – internal or external, laptops, PDA, or in hard copy form.

Creditors who may not have a written policy or procedure in place governing the retention and or destruction of corporate documents are encouraged to develop and implement one. Those who have already have such a policy and procedure in place should review it and revise as needed to conform to recent court decisions. Remember, preference suits may be filed any time within two years following the bankruptcy petition date. The time to start gathering documents to aid in a preference defense is not when a notice of such preference action is received.

Other examples of such creativity were apparent in a preference suit filed in the 8th Circuit (Eastern District of Missouri)3, in which plaintiff’s attorney listed the following reasons had not met the burden of proof for an ordinary course defense: 1) defendant’s use of a lock box for collection of customer payments was not ordinary; 2) defendant’s observance of customers’ instructions for payment application [remittance advice] was not ordinary; 3) accuracy and validity of documents reprinted from defendant’s ERP system were unreliable due to a system conversion; 4) due to system conversion, defendant could reprint documents that were identical to the originals sent to plaintiff prior to the conversion, and 5) weekly phone calls by defendant to plaintiff to follow up on payment schedules was not ordinary.

While credit executives, and perhaps some bankruptcy professionals may be left scratching their heads over some of the above listed points, they are a few examples of what creditors may be required to prepare for in defending a preference suit. Creditors may also use them as reminders of areas of their business and credit department operations that should be reviewed and revised if necessary with an eye toward preference defense.

While the intent in revising §547(c)(2) may have been to ease the ordinary course of business defense burden of proof for creditors, many bankruptcy professionals believe it still too early to how the courts will rule in the current cases in progress, as well as those filed in the future. In re National Gas Distributors, LLC, 2006 WL 2135557 (Bankr. E.D.N.C.), not withstanding, it still appears too early to label the “ordinary course” revisions as “creditor friendly.”

Note: The opinions expressed in this article are solely those of the author. The author is not an attorney and the opinions expressed or information stated herein should not be construed as any form of legal advice and is presented for informational purposes only.

Copyright © 2007 Dorman Wood, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Sep 10, 2014.