Step 1: Can the Trustee Recover a Preference?
To assert a preference claim, the trustee must plead the following elements under section 547(b) of the Bankruptcy Code:
(b) Except as provided in subsections (c) and (i) of this section, the trustee may, based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses under subsection (c), avoid any transfer of an interest of the debtor in property—
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such creditor to receive more than such creditor would receive if—
(A) the case were a case under chapter 7 of this title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title.
In its defense, the creditor has an opportunity to show that the trustee has not met his or her burden of proof. In other words, the trustee has failed to prove all five elements and cannot establish a preference. For example:
- A creditor can make arguments that the trustee failed to comply with the due diligence requirement (this is relatively new and may need to be litigated), or it can make arguments regarding whether the debtor had any interest in the transferred property. For example, if the debtor was holding the funds in trust for the creditor, the transfer of those funds cannot be a preference because the money never belonged to the debtor, in which case a preference action fails.
- A creditor whose contract or lease has been assumed while the bankruptcy case was pending can argue that the trustee is unable to meet section 547(b)(5) because that creditor, based on the law on the assumption of leases and contracts, would be paid in full. See, e.g., Kimmelman v. Port Auth. of N.Y. & N.J. (In re Kiwi Int’l Air Lines, Inc.), 344 F.3d 311 (3d Cir. 2003).
- A secured creditor whose collateral has sufficient equity can also argue that the trustee is unable to meet its burden under section 547(b)(5) because the creditor would have been paid in full under a Chapter 7.
In addition, a creditor can challenge the timing of the payments. For instance, the U.S. Supreme Court held that, under section 547, a transfer occurs on the date a check is honored for preference purposes. Barnhill v. Johnson, 503 U.S. 393, 394, 112 S. Ct. 1386, 1387 (1992).
Step 2: Do Any Defenses, Safe Harbors, or Counterclaims Shield the Creditor from Liability?
After an analysis of the core elements of the preference cause of action, the creditor should next look to the statutory defenses set forth in section 547(c) of the Bankruptcy Code, which provides:
(c) The trustee may not avoid under this section a transfer—
(1) to the extent that such transfer was—
(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and
(B) in fact a substantially contemporaneous exchange;
(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—
(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or
(B) made according to ordinary business terms;
(3) that creates a security interest in property acquired by the debtor—
(A) to the extent such security interest secures new value that was—
(i) given at or after the signing of a security agreement that contains a description of such property as collateral;
(ii) given by or on behalf of the secured party under such agreement;
(iii) given to enable the debtor to acquire such property; and
(iv) in fact used by the debtor to acquire such property; and
(B) that is perfected on or before 30 days after the debtor receives possession of such property;
(4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor—
(A) not secured by an otherwise unavoidable security interest; and
(B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor;
(5) that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent that the aggregate of all such transfers to the transferee caused a reduction, as of the date of the filing of the petition and to the prejudice of other creditors holding unsecured claims, of any amount by which the debt secured by such security interest exceeded the value of all security interests for such debt on the later of—
(i) with respect to a transfer to which subsection (b)(4)(A) of this section applies, 90 days before the date of the filing of the petition; or
(ii) with respect to a transfer to which subsection (b)(4)(B) of this section applies, one year before the date of the filing of the petition; or
(B) the date on which new value was first given under the security agreement creating such security interest;
(6) that is the fixing of a statutory lien that is not avoidable under section 545 of this title;
(7) to the extent such transfer was a bona fide payment of a debt for a domestic support obligation;
(8) if, in a case filed by an individual debtor whose debts are primarily consumer debts, the aggregate value of all property that constitutes or is affected by such transfer is less than $600; or
(9) if, in a case filed by a debtor whose debts are not primarily consumer debts, the aggregate value of all property that constitutes or is affected by such transfer is less than $6,425 [this figure is indexed to increase every three years].
Each of these defenses needs to be carefully evaluated for applicability to any specific circumstance. One or another may appear to clearly apply, and others may require intense litigation. Irrespective, the creditor defendant will have the burden of proof when asserting these defenses, as well as any defenses developed under case law. (An example of a defense under case law is the earmarking doctrine.” This article is limited to the more common statutory defenses.) The creditor should also consider challenging venue in light of jurisdictional limits as to where the adversary proceeding may be brought. For example, if the claim against a non-insider is for under $25,000 on a business debt, the claim must be brought in the defendant’s “home” court. 28 U.S.C. § 1409(b). There may also be some room for litigation over whether a preference claim arises “in” or “under” the Bankruptcy Code for other jurisdictional arguments.
Furthermore, the creditor should evaluate whether it falls within the safe harbor of section 546 or whether it can assert a counterclaim, such as pleading any post-petition delivery of goods as an administrative expense and offset.
Once the creditor has completed its analysis, the creditor will have to weigh the cost of defending the preference action. If the costs outweigh a successful defense, it may make sense to settle.