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A Look at Preference Actions in a Recession

This article was originally published as a chapter in Bankruptcy Litigation Trends in California, June 2010.

The key trend in current bankruptcy litigation is the proliferation of preference actions being brought by bankruptcy trustees. This is not a surprise, as such actions follow from an increase in bankruptcies across the board. These preference actions are filed by Chapter 7 trustees in an attempt to seek the return of payments made by the debtor to a creditor within 90 days of the filing of a bankruptcy. From the creditor’s perspective, these actions are truly seen as a double whammy (not a legal term).

Specifically, many of these creditors, in fact probably 99 percent of them are already taking losses as a result of their vendor filing a bankruptcy. They feel lucky to have received something, only to have a Chapter 7 trustee seek the return of even more money.

These actions are generally successful; that is, even where a creditor can show a complete defense, much like any other piece of litigation, there is a cost to prepare a defense and to defend an action brought by a trustee.   The majority of these actions are prosecuted by counsel on a contingency basis; that is, the trustee is not required to pay counsel for counsel’s time in prosecuting the action.  Thus, the trustee has little downside in attempting to recover monies in a preference action.  This is another reason why creditors, who have to pay for their counsel to defend these actions, are at an economic disadvantage when faced with a preference action.

Preference actions are most often seen in Chapter 7’s.   The reason for that is the actions are generally brought by Chapter 7 trustees.   Having said that, Chapter 11 trustees, when appointed by a court, can also bring preference actions.  They are technically available in all chapter proceedings.

The legal issues are not unique to California. The number of filings is relatively unique in that we simply have more businesses, and thus more filings than probably any other state. As a result, there are that many more preference actions filed.

Causes

While certainly this is a trend in the sense that there were not as many preference actions filed in the previous couple of years, this is no surprise. Trustee have two years from the filing of the bankruptcy to file such actions, and bankruptcy filings have increased dramatically in 2009 and continue to be high in 2010. In simple terms, trustees are now getting around to filing preference actions based upon commercial bankruptcies filed over the last couple of years.

The increase in bankruptcy filings is tied most generally to the failing economy and to market losses.   As one might imagine, as business slows, individuals and businesses feel the brunt of making payroll and other obligations.   With a 30-40% loss in business, and no way to offset such losses with corresponding expense reductions, businesses start to operate in the red, not the black.  For individuals, drops in personal income may cause an inability to meet credit card or loan obligations.  As real estate values drop, individuals don’t have the ability to re-finance leaving them without good options to meet their obligations.  As a result, individuals turn to Chapter 7 to discharge their obligations.

The current economic climate is the primary reason for the explosion of these preference claims. This connection is akin to the cold and flu season coinciding with winter. When the commercial bankruptcies rise, preference actions follow.

There has not been any legislation that has promoted an increase in preference actions. There was legislation attached to the October, 2005 Bankruptcy Abuse Prevention and Consumer Act of 2005 that did help creditors better fight preference actions. Specifically, the Act modified the “ordinary course of business” defense under 11 U.S.C. Section 547(c)(2). There is a now a less rigorous standard to defend a preference action. Namely, a preference may not be recovered if it was made either in the ordinary course of business between the debtor and the creditor or made according to ordinary business terms.  Now, a creditor can use either defense as a means to defeat a preference action.

The Practice

Our practice has seen a growing number of preference actions for which we are defending companies. One particular preference action sought the return of over $1.1 million. We were able to present a compelling preference defense and ultimately settled the matter for $65,000.  Generally speaking, a preference defense depends upon a review of the actual transactions between the parties.  The scope of the review depends often upon whether a more lengthy review of the transactions is helpful to the defense.  For example, we may first review the last 9 months to one year of transactions between the parties.   However, a particular trustee may want to see a much broader view – over several years.   Assuming that business terms have not changed over the course of several years, then a broader view can be helpful to the creditor.

As an example, a trustee will want to show that the preference payment at issue was not in the ordinary course.   Perhaps the payment in question was made 60 days after the services were rendered or goods provided.  However, if over the course of several years of transactions, the debtor generally paid in around 60 days, then this information would confirm that the payment at issue was made according to the ordinary course of business between the parties.

In the case noted above, we reviewed thousands of transactions between the parties to show that the payments about which the trustee was claiming a preference were made in the ordinary course of business. While the payment of $65,000  was still a big number for the creditor to swallow, it was a far cry from the possible exposure it had.

The kind of business involved in a preference action will not affect the viability of a preference defense.  Regardless of the business, a preference defense will depend upon a review of the transactions.

From an economic perspective, the increase of these actions does not, in our view, help the economy. Bankruptcy trustees can file literally hundreds of preference actions in a particular case. Usually, these actions are filed in a kind of “file first, ask questions later” approach. The trustee files an action against any creditor who receives a payment within 90 days of the bankruptcy. The trustee then waits for the creditors to provide a defense to the action. In some instances, once the dust settles, the trustee has collected enough to pay trustee’s fees, attorney’s fees and a perhaps a minimal or even non-existent payout to creditors. This is not to say that trustees do not intend to do the right thing for all creditors. However, the end result does not always justify the costs incurred by the very creditors who often time have to defend themselves, only to get virtually nothing for the payments that they were owed and never paid by the debtor. Of course, the law also requires a trustee to file these actions as a means to get a greater recovery for all creditors, not just those who happened to be lucky enough to have received payments within 90 days of the bankruptcy filing.

Generally, trustees will send letters to creditors well before any preference actions are filed. These letters outline the alleged preference and seek any information as to a purported defense. While this approach would seem to be practical and would seem to eliminate the need for the filing of so many actions, our experience has been that even though we provide, in letter form, evidence positing a defense to the claim, many trustee’s counsel do not review these letters until the time comes for them to file the preference actions. In simple terms, they move our letters (with sometimes pages and pages of supporting documentation) to the bottom of the pile, and thus end up filing the preference case anyway, even where we timely provided evidence in response to the early letter. Again, we understand the reasons why this sometimes occurs. Trustees and counsel have so many actions to file that they simply do not have the manpower to review these letters. Thus, cases are filed because of statute of limitations issues, even where defenses have been suggested well in advance.

In terms of our strategies in this area, and new and changing/emerging issues, we have directed more resources toward preference defense and now have several pending matters in the office. We have also represented trustees and have filed the hundred-plus case preference actions, so we know the tricks and strategies on both sides. The defense requires an analysis of the transactions of the parties well prior to the filing of the bankruptcy. Sometimes, we can demonstrate a complete defense with only six months of transactions. Other times, we need more information and transactions going back up to a couple of years. The goal is to show that the payments about which the trustee is seeking the return were part of an ordinary business relationship between the parties.

Responses

Certainly, preference actions are very difficult for non-lawyers, and even non-bankruptcy lawyers, to understand. It seems fundamentally unfair for a creditor who is usually still owed money to be required to pay back some of the money that it was paid even though it was owed the money. The “bigger” picture, of course, is to level the playing field for all creditors so that all of them get the benefit of the payments made by the debtor.

It has been suggested that there should be new legislation to deal with this proliferation of preference actions, and the attendant problems. Other than the change noted above to 11 U.S.C. Section 547(c)(2), we are not aware of any legislation put in place regarding these trends. While it would certainly be nice for trustees to be required to write pre-lawsuit preference letters and be further required to respond to defense letters prior to filing litigation, this is probably an area where Congress should not step, and let the litigants simply act according to their own devices.

Ultimately, trustees have good reason to review pre-lawsuit defense letters, as the trustee recovers nothing from filing a case where there is little or no chance of recovery. From the defense side, while it is unfortunate for a creditor to provide a preference defense letter and not receive a response prior to the filing of an action, the work done to prepare the defense letter is virtually identical to the work needed to respond to the action. Thus, the letter is not a wasted effort.

The Future

Given the depth of our recession, it is likely that there will be more, and not less, preference actions over the near future. Where five years ago there was little preference activity, there are now thousands of cases “clogging” the bankruptcy courts. Again, this is not to say that these cases should not be filed. However, the addition of all of these cases will make it that much tougher for bankruptcy court judges, already taxed with so many Chapter 7 and Chapter 13 filings, to find time to hear and consider these matters. Parties will likely see trial dates extended and more difficulty making deals as trustees deal with a large multitude of cases.

Most bankruptcy judges will ask the parties to mediate these types of disputes as a means of resolving them prior to trial.   Mediation is an excellent method to lessen the cost of litigation and settle many matters.  Creditors have good reason to participate in mediations.  For that matter, trustees also see the benefit of mediation as a means to settle cases quickly and obtain money for the estate.

Like most cyclical events, bankruptcy practitioners need to recognize where we are in the cycle and adjust accordingly. From the creditor side, creditors should be reminded to keep detailed records showing that payments from the debtor were made in the ordinary course of business.    As noted above, preference litigation will keep practitioners busy for some time. There are a much larger number of Chapter 11 filings compared to only a few years ago. This does not necessarily mean that these filings will end with confirmable plans, but certainly the number of Chapter 11 filings has increased.

Bankruptcy practitioners need to be ready to advise their clients that Chapter 11 may be an option, with creditors perhaps more likely to agree to take discounts as a means to confirm plans. Having said that, practitioners still have to be concerned that Chapter 11s are fraught with uncertainty and difficulty. There are significant reporting requirements with which a Chapter 11 debtor must comply.  A Chapter 11 debtor must remain current in lease payments and other vendor payments.  A Chapter 11 plan must provide for payment of administrative claims to debtor’s counsel and possibly creditor’s committee counsel.   Can the Chapter 11 debtor make it? Will counsel be able to confirm a plan and pay itself before a large receivable makes confirmation an issue?

Issues concerning Chapter 11 confirmation are really no different than they have ever been.  However, with money and credit tightening, the possibility of bringing in an investor to fund a plan is that much more difficult.

In terms of the future of bankruptcy litigation in California, it will increase as the number of bankruptcies increase. Moreover, as people look for ways to recover against debtors, the number of non-dischargeability claims is also likely to increase. Creditors will file actions seeking to permit their particular debt to remain, notwithstanding the filing of the bankruptcy.   When dollars become sparser, litigation will increase as a means to seek some method to uncover those hidden assets and force debtors to come up with more dollars. What we see now is nothing new. Economies cycle, litigation cycles, and what is hot now will not be hot in 10 years. There is nothing remarkable about what is occurring now. We have seen this before and will see it again.