New Bankruptcy Law Changes Preference Rules

The Bankruptcy Prevention and Consumer Protection Act of 2005 (the “Act”) contains many changes in the bankruptcy laws that impact business credit. The Act was passed by Congress and signed into law on April 20, 2005. Most provisions of the Act become effective on October 17, 2005.

The main impact for business creditors is in three areas:

• Preference Defense
• Reclamation in Bankruptcy
• Changes in Chapter 11 Bankruptcy Rules

This article discusses the changes to Preference Defense law. Future articles will address the Act’s impact on Bankruptcy Reclamation Claims and Chapter 11 case administration.

PREFERENCE DEFENSE
The Act makes three major changes to preference defense law:

• Ordinary Course Defense in broadened
• Suits for preferences under $5,000 are barred
• Actions for preferences under $10,000 must be filed in the creditor’s (defendant’s) home district

Each of these changes helps business creditors.

ORDINARY COURSE DEFENSE
The ordinary course defense is codified in section 547(c) of the Bankruptcy Code. It provides an absolute defense against a preference claim if the transfer (usually payment of money to the creditor) was made in the “ordinary course”. Under current law, to quality for the ordinary course defense the transfer may not be avoided:

“(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was-

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; and
(B) made according to ordinary business terms”

This means that a creditor must satisfy the standards of both 547 (c) 2 (A) and (B) under current law. This entails meeting the “Subjective test” concerning the ordinary course between the debtor and creditor and the “Objective test” concerning the ordinary course terms in that type of business. The current law often has been criticized on four basic grounds:

1. It requires creditors to find and present evidence about “ordinary business terms” in their industry. The scope of the industry is not defined and may be difficult to identify for many. For example, if a manufacturer sells unique children’s accessories to a large retailer which sells the items in its apparel department, is the relevant industry gift items, children’s wear, general apparel, or a unique category?

2. The ambiguity about how the objective ordinary course standard should be defined makes it expensive to litigate preference defense cases as most cases require extensive discovery and expert witness testimony including an expert hired by the creditor.

3. Antitrust laws make inquiries into competitor’s terms a dangerous practice, even if the purpose is to assemble evidence for a preference defense. The Antitrust and Bankruptcy Laws appear contradictory in this area because the Robinson Patman Act and other antitrust laws create potential liability for competitors who work together to fix and determine sales terms to customers, while the existing bankruptcy preference laws effectively require competitors to check continually with other about sales terms and programs and to extend the same terms as are standard in the industry.

4. The imposition of the “objective” portion of the test puts a creditor in preference danger if it establishes terms different from the standard terms in its industry. For instance, under current law, if a company launches a sales campaign for a new product by giving extended terms for payment (e.g. 60 days instead of industry standard 30 day terms) it leaves itself extremely vulnerable to a preference claim attack if any buyers of its new product go bankrupt. This discourages a company from introducing new terms or sales programs by providing a strong disincentive to give terms or incentives different from the industry standard.

The new Act addresses these criticisms by changing the conjunctive “and” to the disjunctive “or” so that a creditor must only satisfy either the subjective or objective tests rather than both tests. Therefore, a creditor may utilize the ordinary course defense if it receives payment in either its ordinary business with the debtor or under the ordinary business in that industry. This less rigorous standard should expand the application of the ordinary course defense and often reduce the costs to present on ordinary course defense.

PREFERENCE CLAIMS UNDER $10,000
Congressional hearings established that small business creditors were almost helpless when faced with defending small preference claims. The legal cost to defend a small preference claim is often more than the claim itself. The defense cost increased because the creditor has to defend in the district where the bankruptcy case is filed. Additionally, it was determined that the net recovery to the bankruptcy debtor from small preference claims was typically small anyway.

The new bankruptcy law addresses this problem with two changes:

• Preference claims for an amount under $5,000 are barred.
• Preference claims for non-insider business debts less than $10,000 can only be filed in the district where the creditor has its principal place of business.

These changes should help protect creditors from small “nuisance” preference claims.

CONCLUSION
The new bankruptcy Act helps creditors by expanding the availability of the ordinary course defense to preference claims, barring preference claim suits for amounts under $5,000 and changing venue for preference cases under $10,000 to the creditor’s district. These changes become effective for bankruptcy cases filed on or after October 17, 2005. Future articles in this series will address changes to the Bankruptcy Reclamation provisions and Chapter 11 case administration and rules.

William Creim is a partner with the law firm Creim Macias Koenig & Frey LLP. He can be reached at (213) 614-1944 ext. 4572 or via email at WCreim@CMKLLP.com