Looking back at the June article on bankruptcy preferences, recall the illogical nature of a preference recovery action from a business perspective. In a bankruptcy proceeding, all creditors are intended to be treated equally. Generally, if, in the 90 days before a bankruptcy filing, the soon-to-be-bankrupt debtor pays one creditor and not another, the bankruptcy code provides that the debtor or trustee can recover those monies and divvy the funds out equally among creditors. The policy of the preference law prevents over-aggressive collection practices and promotes equality among similarly situated creditors. While the policy appears sounds, illogical and harsh results often follow.

In June, we followed the unfortunate situation of the Ames supplier who suffered a triple blow from the Ames' bankruptcy. The supplier (1) wrote off a large balance upon the Ames filing; (2) lost its best and most steady customer and (3) nearly two years later, got sued by the bankruptcy estate seeking the return of any monies Ames paid to the supplier during the three months prior to the bankruptcy filing. And to make matters worse, the Ames case was administratively insolvent, meaning that the second phase of divvying out to unsecured creditors never occurred. These types of cases have too often been the norm rather than the exception.

Large scale suits are frequently filed against every creditor who received a check from the debtor within that three month period because the bankruptcy estate's initial burden of proof is that simple. It is then the defendant's job to prove a variety of defenses that may be available to the defendant-most often the “ordinary course of business” defense discussed last time. As noted, prior to the change in the law, the most litigated defense has been that the payments were made in the ordinary course of business and according to ordinary business terms. Litigation is quite expensive and often requires expert testimony as to what constitutes ordinary business terms on top of the detailed proof required with respect to the number of days past invoice that payments were received in the pre-preference period, as compared to the preference period.

Effective October 17, 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (the “Reform Act”) will effectuate large-scale bankruptcy reform-most notably as it applies to average consumer debt. Much media attention has been given to the Reform Act's disproportionate, negative impact upon the middle class and elderly without fixing the loopholes which continue to enable bankruptcy manipulation or fraud among the wealthy or the dishonest. Fortunately, because the Reform Act was drafted and passed at the behest of the credit card industry, there are countless minor and not so minor pro-creditor provisions, including those which will serve to protect the small business would-be preference defendant.

Under the current law, the large scale suits are filed in the district where the bankruptcy is pending-often New York or Delaware-which increases the costs exponentially for all defendants, even those who have an absolute defense to the preference suit. Under the Reform Act, an estate or trustee may only sue a preference defendant for non-consumer debt in the defendant's jurisdiction unless the suit is for more than $10,000.00. Further, under the Reform Act, no preference suits may be filed in business debtor cases where the claimed preference in the aggregate is less than $5,000.00. These changes will eliminate some of the 'extortion' element, where defendants settle zero liability suits because it is still cheaper than hiring out of state counsel or defense counsel.

Finally, the Reform Act eliminates the requirement that when using the “ordinary course” defense, the defendant must prove that the payments were made according to “ordinary business terms” or in other words, according to what is ordinary in the industry. This change will radically reduce the cost of defending preference actions, as the need for expert testimony as to the industry standard has virtually been eradicated. The defendant need only utilize what is readily available, being the defendant's own invoices and statements. Hopefully, the defendant will have heeded the advice from the June article and will have saved the necessary documentation for three years of business dealings with the debtor to firm up the proof.

The information provided in this article is offered for informational purposes only; it is not offered as and does not constitute legal advice. Every situation is unique— you are encouraged to seek legal consultation to address your individual circumstances.