A preference defense quartet: four recent court decisions to mull over.
Well folks, I missed reporting to you on bankruptcy developments as the focus has been on the recently passed and soon to be effective bankruptcy legislation. Meanwhile, there have been several court decisions of interest to trade credit grantors that deal with preference claims.
So, ladies and gentlemen, fasten your seat belts--you are in for a long but interesting ride! Here is a review of four recent court decisions on the contemporaneous exchange, new value and ordinary course of business defenses to preference claims.
The Elements Of A Preference Claim And Defenses
Section 547 of the Bankruptcy Code governs preferences. The preference statute is supposed to discourage a debtor from preferring one creditor over others by opting to pay the favored creditor during the debtor's plunge into insolvency. This is intended to promote the fair treatment of all of the debtor's creditors, and discourage creditor enforcement actions that might force a debtor into bankruptcy.
A bankruptcy trustee or other preference plaintiff can avoid and recover a preference by proving all of the following: (1) the debtor transferred its property to or for the benefit of a creditor; (2) the transfer was made on account of existing indebtedness owing by the debtor to that creditor; (3) the transfer was made within 90 days of the commencement of the bankruptcy case for non-insider trade creditors (and within one year of commencement for insider creditors, such as a debtor's officers, directors, controlling persons and certain affiliated companies); (4) the debtor was insolvent at the time of the transfer (i.e. liabilities exceeded assets, which is presumed within the 90 day preference period); and (5) the transfer enabled the creditor to receive more than it would have received had the transfer not been made and the debtor was liquidated under Chapter 7 of the Bankruptcy Code (there are insufficient assets for a 100 percent distribution to creditors).
Once a trustee or other preference plaintiff proves all of the elements of a preference claim, a creditor/preference defendant can reduce preference exposure through one or more of the preference defenses contained in Section 547(c). Section 547(c)(1) excuses any payment or other transfer that the debtor and creditor had intended as a contemporaneous exchange for new value and that was, in fact, a substantially contemporaneous exchange. This defense is frequently invoked for cash on delivery (COD) payments. This article addresses a recent case where the court refused to apply the contemporaneous exchange/COD defense to a debtor's payments of prior invoices, even in the face of a quid pro quo between the debtor and trade creditor that timed shipments to payments.
Another frequently invoked preference defense is the new value defense contained in Section 547(c)(4). A creditor can reduce preference exposure by its extensions of credit to or for the debtor's benefit subsequent to any alleged preferential transfer. The new value cannot be secured by an otherwise unavoidable security interest and cannot be paid by an otherwise unavoidable transfer. The Article addresses a recent United States Fourth Circuit Court of Appeals decision that allows "paid for new value" and another court decision that denies new value for a creditor's claim for specially manufactured goods not delivered to the debtor.
The ordinary course of business defense arising under Section 547(c)(2) is also a frequently invoked preference defense. A transfer is not a preference if it was (A) in payment of a debt incurred by a debtor in the ordinary course of business or financial affairs of the debtor and the creditor; (B) made in the ordinary course of business or financial affairs of the debtor and the creditor; and (C) made according to ordinary business terms. The first requirement, the incurrence of debt in the ordinary course, is straightforward and frequently satisfied by a creditor's extension of credit to the debtor. The second requirement, payment in the ordinary course of business of the debtor and creditor, requires some consistency between the alleged preference payment and the debtor's and creditor's payment history. The third requirement, payment according to ordinary business terms, requires proof that the alleged preference was consistent with the payment practices in the relevant (usually the creditor's) industry, and was not "idiosyncratic" or "unusual" when compared to payments to others in that industry. This Article also discusses a recent court decision that applied the ordinary course of business defense to multiple credit arrangements between the debtor and creditor and notwithstanding an inconsistency between the extended dating terms that characterized one of the arrangements and the terms contained in the creditor's invoices to the debtor.
Each of the Section 547(c) preference defenses are supposed to encourage creditors to continue doing business with, and extend credit to, financially troubled companies. The contemporaneous exchange/COD and new value defenses are based on a creditor's providing new goods or services that replenish the debtor, either after the transfer in the case of the new value defense, or substantially contemporaneously with the transfer, in the case of the contemporaneous exchange defense. The new value and ordinary course of business defenses are also designed to encourage creditors to continue doing business on normal credit terms with a troubled firm. In the absence of these defenses, creditors would not have any incentive to continue dealing with, providing goods or services to, and/or extending credit to troubled companies, thereby pushing them into bankruptcy.
Paid For New Value Can Count--The Fourth Circuit Court Of Appeals Weighs In: The JKJ Case
Chrysler Credit had entered into a floor plan financing arrangement with JKJ Chrysler-Plymouth ("JKJ"). JKJ had paid Chrysler Credit $2,109,274 within 90 days of JKJ's bankruptcy filing, which JKJ claimed was a recoverable preference. Chrysler Credit was an unsecured creditor of JKJ since Chrysler Credit had failed to perfect its security interest, and was, therefore, subject to preference exposure on this claim.
Chrysler Credit argued that it was entitled to deduct its subsequent extensions of credit to JKJ, that were thereafter repaid, as new value under Section 547(c)(4) of the Bankruptcy Code. The United States Court of Appeals for the Fourth Circuit had to decide whether new value that was subsequently paid can ever be a defense to a preference claim.
The Fourth Circuit held that the new value defense applied to a creditor's extensions of credit to the debtor that were subsequently repaid, as long as the new value was paid by a transfer that is not otherwise subject to any other preference defense. And it does not matter whether the trustee sought to recover the payment for the claimed new value as a preference. As long as the payment for the new value was recoverable as a preference and was not subject to any other preference defense, the paid for new value counts as an offset to the preference.
So there are now four United States Courts of Appeals that count paid for new value: the Fourth Circuit in its recent decision in the JKJ case; the Fifth Circuit in its 1994 decision in Matter of Toyota of Jefferson Inc.; the Eighth Circuit in its 1998 decision in In re Jones Truck Lines Inc. and the Ninth Circuit in its 1995 decision in In re IRFM Inc. However, there are three United States Courts of Appeals that do not count paid for new value: the Third Circuit in its 1989 decision in In re New York City Shoes Inc.; the Seventh Circuit in its 1986 decision in Matter of Prescott; and the Eleventh Circuit in its 1988 decision in In re Jet Florida System Inc. Sounds like a division of opinion the United States Supreme Court must resolve!
Are you ready for some more preference chatter? Well here goes!
A Trade Creditor's Manufacture Of Unshipped Specialty Goods For A Debtor Does Not Count As New Value: The Moltech Power Systems Decision
Truelove & Maclean, Inc. ("T&M") was a supplier to Moltech Power Systems Inc. ("Moltech"). T&M supplied nickel-plated steel rechargeable battery cans and stampings to Moltech for use in Moltech's rechargeable battery systems. T&M manufactured the parts to conform to Moltech's designs and specifications. As a result, the parts were specially made goods that could not be sold to anyone but Moltech.
Moltech filed Chapter 11. During the 90-day period preceding Moltech's bankruptcy filing, T&M continued to manufacture and complete production of parts that Moltech had ordered. However, T&M never shipped these goods to Moltech.
During the 90-day preference period, Moltech made payments totaling $358,418 to T&M. T&M faced preference exposure of $280,631 after deducting payments subject to undisputed preference defenses.
T&M asserted a full new value defense to Moltech's preference claim. T&M claimed it had provided new value to Moltech after the alleged preferences by incurring expense in manufacturing specialty goods for Moltech, even though the goods were never shipped to Moltech.
The United States Bankruptcy Court for the Northern District of Florida, in In re Moltech Power Systems, Inc., sided with the debtor, Moltech, and found T&M's manufacture of specialty goods for Moltech did not constitute deductible new value because Moltech had never received the goods. New value must provide the debtor with a material benefit that repays the earlier preference and negates the prejudicial effect of the preference on Moltech's other creditors. T&M's manufacture of specialty goods for Moltech did not benefit or replenish Moltech, or its bankruptcy estate, and, therefore, cannot constitute deductible new value, because Moltech never got the goods. The fact that the goods were produced and potentially available to Moltech did not change the fact that they were not delivered to Moltech, and Moltech did not receive anything of value from T&M. The specialty nature of the goods, and their nonsaleability to third parties, impacts only the amount of T&M's unsecured damage claim against Moltech and should not be considered deductible new value.
Had enough? Well here is some more preference news.
The Section 547(C)(1) Contemporaneous Exchange/COD Defense Does Not Apply To Payments Of Prior Invoices: The Hechinger Case
Hechinger is a liquidating chapter 11, having filed bankruptcy on June 11, 1999. Just prior to the beginning of the 90-day preference period (before February 4, 1999), Hechinger had an unlimited open line of credit with Universal Forest Products Inc. ("Universal"). Universal, the leading manufacturer of treated lumber products, was also extending credit terms based on 1 percent 10 days, net 30.
Then, starting February 4, 1999, Universal imposed a $1 million credit limit on sales to Hechinger and reduced its credit terms to 1 percent 7 days, net 8. These two changes required Hechinger to make larger and more frequent payments to Universal. Hechinger switched its mode of payment from checks in the exact amount of the invoices being paid, accompanied by remittance advices identifying all invoices paid by the check, and delivered by mail, to more frequent large lump sum payments by wire transfer, without any accompanying remittance advices, which were sent to Universal 2-4 weeks after the payment. All of Hechinger's payments to Universal during the preference period were by wire transfer in amounts of either $500,000 or $1 million.
Hechinger asserted a preference claim exceeding $6,576,603 against Universal. Universal invoked the Section 547(c)(1) contemporaneous exchange defense, claiming a full defense to the claim. Universal argued many of the transfers during the preference period were made virtually simultaneously with Universal's shipments to Hechinger and Universal did business with Hechinger on a "I ship, you pay" basis, notwithstanding the credit terms contained in Universal's invoices. Hechinger disputed this, arguing that it did business with Universal on credit terms. Hechinger's payments to Universal were made simultaneously with shipments to Hechinger because of Universal's newly imposed credit limit and Hechinger's large volume of orders with Universal. Finally, Hechinger's remittance advices directed Universal's application of all payments to prior invoices and Universal honored this requirement and applied the payments as requested.
The United States Bankruptcy Court in Delaware, in In re Hechinger, entered judgment in the amount of $1,004,216 in favor of Hechinger and held the Section 547(c)(1) defense was not applicable because the payments were for credit, not "COD", sales and the Section 547(c)(1) defense does not apply to a credit transaction. (1) Hechinger's payments to Universal were not intended to be contemporaneous exchanges for new value, and were, therefore, not subject to the Section 547(c)(1) contemporaneous exchange defense, even though the payments roughly coincided with the value of Universal's shipments to Hechinger.
The court also refused to apply the ordinary course of business defense. The court rejected Universal's argument that all of Hechinger's payments to Universal within credit terms (8 days after invoice date) were presumptively ordinary and, therefore, satisfied Section 547(c)(2)(B)'s requirement that the payments were in the ordinary course of business of Hechinger and Universal. The court found that the $1 million credit limit and restricted 1 percent 7 days, net 8 credit terms that Universal had imposed shortly before the preference period disqualified Universal from relying on the ordinary course of business defense. Newly imposed, very restrictive, credit terms of 1 percent 7 days net 8, and the new $1 million credit limit were in sharp contrast with the open and unlimited line of credit and 1 percent 10 days, net 30 terms throughout Universal's 15-year relationship with Hechinger. (2)
OK, you made it through three interesting preference cases. Let's do a fourth and call it an article.
The HomePlace Case: Multiple Payment Histories May Be Considered In Applying Ordinary Course Of Business Defense
The debtor, HomePlace, operated super-stores for the home decor, housewares and furnishings marketplace. HomePlace ordered products from Salton, a vendor and manufacturer of small appliances, starting in July 1999 and continuing through January 16, 2001 when HomePlace filed Chapter 11. In 1999 and 2000, Salton sold products to HomePlace on conventional "Net 30" day terms. In 2000, Salton and HomePlace also agreed to "Extended Dating" or "Big Buy" terms for certain sale transactions. This "Extended Dating" and "Big Buy" arrangement was normal in Salton's industry--the small appliance industry--and typically involved large purchases with payments to be made on an agreed specified date towards the end of the year. Salton's "Big Buy" sales to HomePlace called for "split dating", with 50 percent payable on November 10, 2000 and the remaining 50 percent due on December 10, 2000. However, Salton's invoices on these "Big Buy" sales stated terms of "Net 30", rather than the extended dating terms, because Salton's computer-based system that generated the invoices could not accommodate the dating terms that were part of the "Big Buy" arrangement.
During the 90-day preference period, HomePlace made payments totaling $3,522,561 to Salton. The payments included two large payments, one in November 2000, in the amount of $1,250,025 that was picked up by Salton's independent sales representative; and a second payment in December 2000 in the amount of $2,091,594 that was picked up by Salton's credit manager. The November and December 2000 payments included payments of both "Net 30" and "Big Buy" invoices.
The issue considered by the Delaware Bankruptcy Court in the HomePlace case was whether the November and December 2000 payments were subject to the Section 547(c)(2) ordinary course of business defense and, therefore, not subject to preference risk. The court had to determine the applicability of the ordinary course of business defense to two separate payment arrangements: invoices subject to "Net 30 Terms" and other invoices subject to the extended dating "Big Buy Terms." The court held that it could review the payments of Net 30 and Big Buy/extended terms invoices separately in determining the applicability of the Section 547(c)(2) ordinary course of business defense. Thus, Salton could separate the invoices that were paid by the November and December 2000 payments into two groups: the invoices subject to the "Big Buy" program ("Big Buy Invoices") and the other invoices subject to the standard "Net 30" terms ("Net 30 Invoices") and do a separate analysis in determining whether they satisfied the twin requirements of Section 547(c)(2) that the payments were in the ordinary course of business between HomePlace and Salton, and were made according to ordinary business terms.
The Big Buy Payments
The court held that HomePlace's payment of "Big Buy" Invoices totaling $1,598,310 were subject to the ordinary course of business defense, and not recoverable as preferences. The court determined there was a "Big Buy" program between the parties that was ordinary both between the parties and in the small appliance industry.
The lack of a history of "Big Buy" terms between HomePlace and Salton did not alter this result. Various predecessors of HomePlace had entered into similar "Big Buy"/extended dating programs with Salton. Also, Salton proved that "extended terms", "dating terms" and "split billing" were ordinary in the small appliance industry. In fact, the court found that extended dating terms, with payments due later in the year, made sense; because retailers like HomePlace did about 30 percent of their business in that time period. That prompted many retailers such as HomePlace, and manufacturers like Salton, to utilize "Big Buy"/extended dating programs in order to stock merchandise in those seasons to bolster sales.
The court also determined that Salton's behavior in picking up the checks for the November and December 2000 payments did not disqualify these payments from the ordinary course of business defense. Salton presented evidence that its sales representatives had previously picked up checks from HomePlace on behalf of Salton and other vendors. It was also ordinary in the small appliance industry for both independent sales representatives and credit managers to pick up checks from retailers. In view of the long period of time in which the "Big Buy" Invoices were outstanding and the size of the payables, it was appropriate for Salton's sales representative and credit manager to pick up the November and December 2000 payments on the specified dates the parties had agreed upon months before.
The Net 30 Invoices
The court held that $1,743,309 of the November and December 2000 payments that paid Net 30 Invoices were not subject to the ordinary course of business defense, and were, therefore, recoverable as preferences. During the one-year period preceding the 90-day preference period, HomePlace had paid Net 30 Invoices on average 55.9 days after invoice date. HomePlace's payments of Net 30 Invoices during the preference period were, on average, 77.3 days after invoice date. The court found this deterioration in timing of payment during the preference period to be inconsistent with the parties' pre-preference payment history and outside the range of terms in the small appliance industry.
A split decision for the trade creditor!
In a nutshell, paid for new value can count as a preference defense; unshipped goods do not count as new value; the contemporaneous exchange defense applies to payments for goods shipped around the same time; and the ordinary course of business defense can be applied where the debtor has multiple credit terms with its vendor.
Lots to digest--and we have a new bankruptcy statute to deal with in October!
(1) Interestingly, the court allowed paid for new value even though the United States Court of Appeals for the Third Circuit holds to the contrary.
(2) The court also found that Universal's credit limit and restricted credit terms were not consistent with the range of terms in Universal's industry and, therefore, did not satisfy Section 547(c)(2)(C)'s ordinary business terms requirement.
Bruce S. Nathan, Esq. is a Partner in the law firm of Lowenstein Sandler PC in New York, NY. He is also a member of NACM and is a Co-Chair of the American Bankruptcy Institute Unsecured Trade Creditor Committee. He can be reached via e-mail at firstname.lastname@example.org.
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|Title Annotation:||CREDIT COLUMN|
|Author:||Nathan, Bruce S.|
|Date:||Sep 1, 2005|
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