PREFERENTIAL PAYMENTS AND THE DE

PREFERENTIAL PAYMENTS AND THE DEFENSE OF PAYMENT IN THE

“ ORDINARY COURSE OF BUSINESS”

Presented to Transportation Intermediaries Association National Industrial Transportation League Intermodal Association of North America Anahein, California November 11-15 2005 by Ronald H. Usem, Transportation Attorney, Huffman, Usem, Saboe, Crawford & Greenberg, PA, 5101 Olson Memorial Highway, 1000 Water Park Place, Minneapolis, MN 55422; telephone, 763-545-2720; fax, 763-545-2350.

Many of our members have received either a demand letter or a complaint from a trustee in bankruptcy demanding repayment of a debtor’s payment made within 90 days of filing a bankruptcy. The trustee is empowered to collect “preferential transfers” made within 90 days of filing of the Bankruptcy Petition. The theory behind the bankruptcy code section allowing this to happen is that debtors tend to favor their friends as the filing date draws near so that the friends would receive a disproportionate share of payments at the expense of those creditors who are not friends. Thus, the purpose behind recovering the preferential payments is to level the playing field for all creditors.

One of the most commonly claimed defenses for preferential transfers, are payments made “in the ordinary course of business”. The Bankruptcy Code lays out the requirements for this defense in 11 USC §547(c)(2) which requires the creditor to show by preponderance of the evidence that the transfers were “(a) made in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the creditor; and ( b ) made according to ordinary business terms.” The burden of proof is on the creditor seeking relief. Generally, a trustee and/or bankruptcy court will take into consideration the entire course of dealing of the parties.

The initial reaction to preferential payment claims is usually one of exasperation and anger. However after you are done being angry careful analysis of the payment history of the parties, which is essential to your defense must be prepared. A careful analysis of the history of the payments billed and received needs to be made in order to determine whether in fact, the payments were “preferential” or whether you have a valid affirmative defense, that the payments were received “in the ordinary course of business”.

Upon receipt of a preference claim, this is what you need to do:

1. Contact the trustee, or the attorney for the trustee, and let him/her know that you are in receipt of the claim, and that you will review your accounting information regarding the claim and contact him as soon as possible with a response.

2. Ask for copies of the documents supporting the trustee’s claim so that you have an accurate listing of the allegedly preferential payments, their dates, and amounts. Confirm in writing that the trustee or his attorney will do this when you can expect to receive them.

3. If the notice you received is in the form of a complaint, ask for an extension of time in which to research and gather your information as soon as possible. Almost always you will be granted additional time. Get the approval/confirmation in writing of the extension from the trustee or his attorney. Do not discuss the merits of the case! Discussion of the merits before you know your payment history can be very damaging to your case.

4. Upon receipt of the information from the trustee, outlining the allegedly preferential payments, dates and amounts, verify that the information is correct. Be careful to analyze whether the allegedly preferential payments in fact fall within the 90-day period, following the filing of the Bankruptcy Petition. Do not discuss the merits of the case! Discussion of the merits before you know your payment history can be very damaging to your case. Verify the filing date of the petition.

5. Calculate the number of days between the date of billing and the date of receipt of payment for each payment made within the preference period, then calculate the average. It is helpful to place this information on a spread sheet.

6. Next, calculate the average number of days from the date of billing to the receipt of payment outside the preferential period, for all payments made within one year of the date of filing of bankruptcy. This calculation will not include the allegedly preferential payments. If your payment history does not go back a year, calculate for the number of months that business was conducted outside of the preference period.

7. Next, perform the same calculation for all payments made (both inside and outside the preference period) going back one year from the date of filing bankruptcy.

8. You may want to go back 18 or 24 months, depending upon your history with the debtor. If going back further helps your average then do it.

9. Place all calculations on a spread sheet.

10. The closer the number of days average within the preference period to the number of days average outside the preference period, the more likely it is that the payments were received “within the ordinary course of business”. Once your calculations are made, you will need to contact bankruptcy counsel in order to research preference cases in the Federal District/Circuit in which the Bankruptcy Court is located in order to determine how close you have to be in order to be successful.

11. Example: In a currently pending case, here are the calculations: A preference claim asserts that $35,745 was received within 90 days of filing of the Bankruptcy Petition.

12. Calculations reveal the following: The average number of days from billing to receipt of payment during the preference period was 67.2 days.

13. The average number of days from billing to receipt of payment for all payments, including the preference period, was 64.6 days. The average number of days for receipt of payments outside the preference period was 63.5 days. Thus, the allegedly preferential payments were received an average of 2.6 days later than the average for all payments for the entire year. The numbers are very close which is an excellent result.

14. The average number of days inside(90 days) the preference period is 67.2 days. Thus, compared to the preferential payments outside the preference period, the allegedly preferential payments were received an average of 3.7 days late. This is a good result.

15. Note, a case law indicates that late payments may be considered preferential as well as early payments.

16. Thus, the question in the current example case is whether the preferential payments received an average of 3.7 days late were either “preferential” or were received in the “ordinary course of business”, and thus are not recoverable by the trustee. The courts look at the established practices of the parties, compare actual practices with agreed upon credit terms, look to see if any unusual collection pressures were placed on the debtor, and take the position that substantial deviations outside normal practices will be considered “preferential”. Thus, while a final answer to the question in this currently pending case cannot yet be made, case law within the applicable district indicates that payments which are only 3.7 days late are well within the “ordinary course of business between the parties”. In this case, there were well over 100 shipments involved. I have attached a case from the 6^th US Circuit Court of Appeals ( Tennessee Chemicals v Shell Canada 112 F.3rd, 234, 1997) to give you an idea of how that court analyzed preference issues. As you will see, payments that were 16 and 17 days late were not held to be preferential payments.

As you may well imagine, the shorter the payment history, the more difficult it is to establish a course of dealing, and thus prove the ordinary course of business defense. Even if there are just a few payments involved, have your attorney check the cases in your district/circuit to see if there is any precedent that may help you.

Significant Change in the Bankruptcy Law Which Became Effective October 2005:

Under prior bankruptcy law, in order to be successful in asserting the ordinary course of business defense, you also had to prove that the ordinary course of business was within some broader industry practice. This was very difficult and costly to prove. Under the revised bankruptcy law (Title 11 USA §547(c)(2)), as long as the defendant creditor can show either that the transfer was made in the ordinary course of business, or the financial affairs of the debtor and the transferee, or that the transfer was made according to ordinary business terms, then the Defendant creditor will have a valid affirmative defense to an otherwise voidable preference action. The amendment to the code should reduce the cost of defending a preference action because the defendant will no longer be required to produce expert testimony regarding industry standards.

There are two other important changes in the bankruptcy code: Preference claims under $5000.00 are no longer allowed; Preference claims that do not exceed $10,000.00 must be brought in the district in which your business is located. This makes the cost of recovery more expensive to the trustee and thus lees likely to start litigation.