Chapter 2 Background: The Bankruptcy Code and the Ordinary Course of Business Defense

• Jurisdiction: United States

Chapter 2 Background: The Bankruptcy Code and the Ordinary Course of Business Defense

"Approached from the perspective of the common pool, preference law exists to prevent creditors from trying to change their position vis-a-vis other creditors in anticipation of bankruptcy's collective proceeding...."¹⁰ In other words, bankruptcy preference law is meant to encourage fair dealing and ordinary behavior between the parties by limiting aggressive collections practices prior to the debtor's bankruptcy. Section 547 of the Bankruptcy Code outlines certain criteria for determining whether a payment made by the debtor prior to its bankruptcy filing can be considered preferential in nature.

Section 547 of the Bankruptcy Code states:

b. Except as provided in subsections (c) and (i) of [§ 547], the trustee may avoid any transfer of an interest of the debtor in property

(1) to or for the benefit of the 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;
(4) made —

(A) on or within 90 days before the date of filing of the petition; or
(B) between 90 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 under Chapter 7 of the 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 the title.¹¹

What Is a "Transfer"?

The literal definition of a transfer is "to convey or hand over."¹² Under the Bankruptcy Code, the definition of a "transfer" is broad. "Transfer" is defined in the Code to include "each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with — (i) property; or (ii) an interest in property."¹³ While payments by cash, check and wire transfer are the most typical form of a transfer, "transfers" can encompass a wide range of exchanges of value beyond these items, including a conveyance of real or personal property, the grant of a lien, or the perfection of an unperfected lien.

The full extent of analysis regarding what a transfer is and what a transfer is not is beyond the scope of this book. However, determining whether a certain economic transaction is a "transfer" under the Bankruptcy Code is an important initial step in understanding the possible preference defenses.

When Does a Transfer Occur?

Businesses are increasingly making payments via electronic methods in which payment is transmitted and received nearly instantaneously. However, in many instances there is a delay between when a payment is processed by the creditor and when it is received by the debtor. Further, there can be ambiguity associated with these dates due to the internal processes utilized by either the debtor or the creditor. For example, there may be a difference between the date a check is received at a business, the date that the accounting personnel processes the receipt of the payment, and the date on which the payment actually clears the bank or financial institution on which it is drawn.

The U.S. Supreme Court has held that, in the context of a bankruptcy preference action, when payment is made by check, the transfer is recognized to have occurred when the check is honored by the bank.¹⁴ However, where the transfer involves a conveyance of property other than cash, the timing of the occurrence of a transfer can be a significant point of contention. Some additional guidance on the issue of when a transfer occurs is provided in § 547(e) of the Bankruptcy Code, which states:

(1) For the purposes of [§ 547]—

(A) a transfer of real property . is perfected when a bona fide purchaser of such property from the debtor against whom applicable law permits such transfer to be perfected cannot acquire an interest that is superior to the interest of the transferee; and

(B) a transfer of . property other than real property is perfected when a creditor on a simple contract cannot acquire a judicial lien that is superior to the interest of the transferee.

(2) For the purposes of [§ 547], except as provided in paragraph (3) of this subsection, a transfer is made —

(A) at the time such transfer takes effect between the transferor and the transferee, if such transfer is perfected at, or within 30 days after, such time, except as provided in subsection (c)(3)(B);
(B) at the time such transfer is perfected, if such transfer is perfected after such 30 days; or
(C) immediately before the date of the filing of the petition, if such transfer is not perfected at the later of —

(i) the commencement of the case; or
(ii) 30 days after such transfer takes effect between the transferor and the transferee.

(3) For the purposes of this section, a transfer is not made until the debtor has acquired rights in the property transferred.

The time period over which the transfers are evaluated is also an important consideration. For most preference actions, the relevant time period is the 90 days prior to the bankruptcy filing pursuant to § 547(b)(4)(A) of the Bankruptcy Code (the "preference period"). Courts have generally ruled that the preference period excludes the date of the bankruptcy filing itself, and begins with the date immediately preceding the filing and counting backwards 90 days, although there is disagreement in the case law on this point. That is, the preference period extends from the date before the filing to the 90th date preceding the filing. Weekends and holidays are not excluded from the 90-day period because, as one commentator noted, "a transfer can take place on any day of the week, including a weekend or holiday, and therefore does not require the bankruptcy court to be open for business for the purpose of determining the preference period."¹⁵ This period is extended to one year before the petition date for individuals or entities considered insiders of the debtor under § 547(b)(4)(B).¹⁶

In some cases, trustees have been successful in avoiding payments that occurred during the preference period, but that represented reimbursement for payments that had been returned for insufficient funds prior to the preference period. "The date of an original bad check does not have the effect of taking a transaction beyond the 90-day preference period to permit a creditor to preserve the funds from the transaction in question."¹⁷ Similar to the definition of a transfer, the full analysis and consideration of preferential transfer timing is beyond the scope of this book. However, this too is an important consideration in evaluating the nature of an economic transaction being alleged as a preference.

Defenses to Preference Claims Under § 547(c)

Even if a trustee or debtor-in-possession establishes the elements of a preference contained in § 547(b) of the Bankruptcy Code, there are a number of affirmative defenses contained in § 547(c) that may be available to the preference defendant. Among the most common defenses are:

• Contemporaneous Exchange for New Value: The debtor cannot avoid transfers to the extent the transfers were "(A) intended by the debtor and the creditor ... to be a contemporaneous exchange for new value given to the debtor and (B) in fact a substantially contemporaneous exchange."¹⁸
• Ordinary Course of Business Defense: The debtor cannot avoid the alleged preferential transfers to the extent the transfers were in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the defendant, 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.¹⁹
• Subsequent New Value Defense: The debtor cannot avoid the alleged preferential transfer "to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor..." that was "(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...."²⁰

The trustee bears the burden of establishing that a preference exists. However, if the trustee puts forth sufficient evidence to make a prima facie case on § 547(b), the burden shifts to the transferee to present sufficient evidence that one of the statutory defenses is applicable.²¹

Once a transfer is avoided under § 547 of the Bankruptcy Code, § 550 provides the mechanism for allowing the trustee to recover the avoided transfers. In pertinent part, that § provides:

(a) Except as other provided in this section, to the extent that a transfer is avoided under . this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from —

(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or
(2) any immediate or mediate transferee of such initial transferee.

(b) The trustee may not recover under subsection (a)(2) of this section from —

(1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or
(2) any immediate or mediate good faith transferee of such transferee.²²

Simply put, § 550 of the Code allows a trustee to recover an avoidable transfer from its initial transferee or, subject to certain defenses, subsequent (i.e. immediate or mediate) transferees of the transfer. The trustee is, of course, limited to a single satisfaction of the amount of the avoided transfer.²³

The term "transferee" is not defined in the Bankruptcy Code, and "there is no legislative history to elucidate its meaning."²⁴ Nevertheless, whether the recipient of a transfer is deemed a transferee in the first place and, thereafter...