Legal Update: Important Preference Decision
by: David Conaway
Shumaker, Loop and Kendrick, LLP; Charlotte, N.C.
When a vendor gets hit with a preference claim, most often such claims are settled without significant court proceedings. In fact, in many cases, prior to filing a preference complaint, a debtor or trustee will make an informal demand for repayment of the alleged preference. The usual procedure is that the parties exchange documentation that supports the allegations of a preferential payment and the assertion of the defenses of new value, ordinary course of business or contemporaneous exchange for value. Normally, based on such documentation, the parties are able to settle the preference claim out of court.
Sometimes, however, the parties simply cannot agree on a settlement, and ultimately the debtor or trustee files a complaint against the vendor seeking recovery of the amount of the alleged preferential payment. Even in cases where litigation is commenced, the overwhelming majority of cases are settled well before trial. The litigation costs and risks of an uncertain outcome are simply too much for the parties to swallow.
In a small number of cases, the parties are so entrenched in their positions that the preference litigation proceeds to trial. If so, the vendor must fully understand and be prepared to prove each and every element of its defenses. As one vendor recently learned, failure to prove all of the elements of its defense can be fatal.
In Bridge Information Systems Inc. v. Gulfcoast Workstation Corp. (8th Cir. Ct. App., Mo., June 2006), the debtor, Bridge Information Systems Inc., filed for chapter 11 relief. The debtor and Gulfcoast Workstation Corp. (the preference defendant) were both computer resellers who bought and sold products with one another prior to the chapter 11 filing. Within the 2-year statute of limitations of the date of the chapter 11 filing, the debtor sued the preference defendant seeking to recover $2.1 million in alleged preferential payments made by the debtor to the preference defendant within 90 days prior to bankruptcy. The parties were not able to reach a settlement, so the case proceeded to trial.
At trial, the debtor was able to prove the basic elements of a preferential payment.1 Once the debtor satisfied its burden of proof of the essential elements of a preference, the burden of proof shifted to the preference defendant to prove that the defenses of new value and ordinary course of business shielded it from preference exposure. In this context, the appeals court noted, “establishing the ordinary-course defense by a preponderance of the evidence is the transferee’s burden.”
The case came down to the preference defendant’s ordinary-course-of-business defense. Under §547(c) of the Bankruptcy Code, a preference defendant can avail itself of the ordinary-course-of-business defense when the transfer is (1) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; (2) made in the ordinary course of business or financial affairs of the debtor and the transferee; and (3) made according to ordinary business terms.
The key issue here was the third prong of the ordinary-course-of-business defense – whether the payment was made according to ordinary business terms in the computer resale industry. Apparently, the checks issued by the debtor to the preference defendant contained remittance advices specifying to which invoices the payments applied, thus allowing the debtor to direct the application of each payment to specific invoices.
During the trial in bankruptcy court, the preference defendant produced as a witness its general manager, who testified about the industry practice concerning the length of time between invoice and payment. The preference defendant also produced as a witness its vice president, who testified that the 30-day net payment terms were common in the computer resale industry. However, neither the general manager nor the vice president testified about the industry practice concerning which party directs application of payment or generally the method by which suppliers apply customer payments to outstanding invoices. The preference defendant was able to establish that its own general policy was to allow customers making payments to specify which invoices are paid. Despite this, the court ruled that Gulfcoast (the preference defendant) was required to produce evidence of industry practice concerning how suppliers apply a customer’s payment to outstanding invoices to establish the general terms prevailing in the industry.
The court concluded that the preference defendant had failed to meet its burden of proof. Accordingly, without its ordinary-course-of-business defense, the preference defendant was liable for the preference.
What are the lessons from this decision? We believe this is an unfair result. It is well settled law that a payor is the master of its payments, and if it chooses to specify what obligations are being paid, the payee is obligated to honor those directions. In absence of directions, however, the payee is free to apply payments at its discretion. This is common commercial practice that cuts across all industries, and to “trip up” the preference defendant on the use of remittance advices in the computer resale industry is unfair, and suggests the court was looking for a “hook” to find liability. On the other hand, technically, a preference defendant is required to prove each and every element of its defense. Doing so in this case would not have been difficult, but it just needed to be done. The court even indicated that it would have accepted testimony from the preference defendant’s employees and not require an expert witness. If the preference defendant’s witnesses had simply testified about practices regarding remittance advices on customer payments in the computer resale industry, it would have met its burden.
It is important to note that the Bridge case is a pre-BAPCPA2 case. Here’s how BAPCPA’s changes to the ordinary-course-of-business defense work: – In addition to proving that the debt was incurred in the ordinary course of business of the debtor and the transferee, the preference defendant must prove that the payment was:
PRE-BAPCPA |
BAPCPA |
-in the ordinary course of business of the debtor and the transferee AND |
-in the ordinary course of business of the debtors and the transferee OR |
-according to ordinary business terms. |
-according to ordinary business terms. |
Under the prior law (still applicable to cases filed pre-Oct. 17, 2005) the preference defendant is required to prove both prongs of the ordinary-course-of-business defense set forth above. After BAPCPA, a preference defendant need only prove either one of the prongs.
The Bridge case provides a striking example of the benefit to vendors of the preference amendments. If this had been a post-BAPCPA case, the preference defendant would have prevailed. For bankruptcy cases filed before Oct. 17, 2005, the old rules will apply, and Bridge remains “good” law. For cases filed under BAPCPA, where a vendor cannot prove the payments were made in the ordinary course of business presumably between itself and the debtor, the vendor will have to rely on proving what is ordinary in the industry. In such cases, the Bridge case will also apply. Perhaps the Bridge case also illustrates the vagaries of court proceedings, and thus why most cases settle before trial.
1 The essential elements that a debtor or trustee must prove to establish that a payment is preferential are that the payment: (1) is to or for the benefit of a creditor; (2) is for or on account of an antecedent debt; (3) is made while the debtor was insolvent; (4) is made on or within 90 days before the date of the filing of the petition; and (5) enables the creditor to receive more than the creditor would receive in a chapter 7.
2 BAPCPA is the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which with some exceptions is effective for cases filed on or after Oct. 17, 2005.