"Chapter 11: A Primer on Preference Claims, " published in the Spring Edition of Eurofenix (INSOL Europe)

1. USA
Chapter 11:
A primer on Preference Claims
A
consequence of the global Under Section 547 of the the criteria set forth above for
recession is the increase of Bankruptcy Code, a preference is a determining whether a payment is
Chapter 11 filings by transfer of property of a recoverable as a preference, to
United States based companies. bankruptcy debtor that (1) was to avoid liability, the vendor must
For non-US vendors of such or for the benefit of a vendor; (2) establish one or more of the
Chapter 11 debtors, it is important was on account of an antecedent Bankruptcy Code defences. There
to understand the key provisions of debt; (3) was made while the are three defences that apply most
Chapter 11 to mitigate risks and debtor was insolvent; (4) was made often, “subsequent new value”,
potential losses. A prominent within 90 days of the filing of the “ordinary course of business” and
feature of Chapter 11 cases in the bankruptcy petition; and (5) “contemporaneous exchange for
United States is the debtor’s ability allowed the vendor to receive more new value”, all set forth in Section
to recover “preference payments,” than the vendor would receive in a 547 of the Bankruptcy Code.
essentially payments made to hypothetical liquidation of the Subsequent new value occurs
DAVID H. CONAWAY debtor. when a vendor provides additional
vendors 90 days prior to the
Shumaker, Loop & Kendrick,
LLP (USA) Chapter 11 filing. For vendors, this A debtor normally issues a goods or services (or the release of
is a particularly unpopular aspect written demand for payment on a security interest or lien) after the
of Chapter 11 cases, since the the preference claim prior to alleged preferential payment to the
vendor has likely already sustained commencement of an adversary vendor. This defence acts as a
a write-off of accounts receivable proceeding. Often debtors offer to dollar for dollar credit against
existing at the time of the Chapter discount the claim to receive potential preference exposure.
11 filing. After imposing that loss immediate payment without the Since subsequent shipments are
on a vendor, the debtor has two need for litigation. If the parties readily identifiable, this defence is
years after the Chapter 11 filing to cannot resolve the claim in this objective and easy to prove.
sue the vendor to recover manner, the debtor may file an The ordinary course of
payments that were made by the adversary proceeding against the business applies if payments were
debtor in the 90-day period prior vendor. Vendors are well advised ordinary compared to prior
to the Chapter 11 filing. As a result to not pay a preference demand transactions between the vendor
of this, vendors must evaluate without first performing an and the debtor (paid roughly the
potential preference exposure to analysis of the defences, for claims same number of days after invoice
understand the full potential loss can often be resolved for a fraction date and paid in the same manner,
arising from a US customer’s of the demand amount. such as by check) or if the
Chapter 11 filing. If a debtor is able to establish payment was made according to
40 Spring 2011

2. USA
“Companies doing
ordinary business terms in the commonly used by financially preference claim, vendors often
industry. Changing invoice terms, troubled debtors to gain more time choose to waive the potential
either formally or informally, may to pay the obligations owed. claim dividend as credit to
preclude the ordinary course of Courts have routinely found that reduce the potential preference business with US-
business defence. Moreover, where workouts are common in a exposure.
payments made sooner than usual particular industry, payments • Payments made by a debtor to a based companies
or before their due date are often made to vendors pursuant to a vendor pursuant to an assumed need to be aware
considered to not qualify for the workout plan are not preferable. executory contract are not
ordinary course of business “Contemporaneous exchange preferential. Section 365 of the of the laws relating
defence. Debtors will generally for new value” is a defence that Bankruptcy Code defines an to preferences
”
argue that a payment was not in arises when the debtor and the executory contract as any
the “ordinary course of business” vendor intended to exchange contract where both parties
if it is more than a few days payment for new value in the form have performance obligations to
beyond the due dates of the of goods or services, and the the other, and would include
invoices being paid. However, if exchange was in fact substantially leases and sales contracts.
the payment history shows that the contemporaneous. The classic • Payment of a vendor’s pre-
debtor historically paid the vendor example of this defence arises petition claim as a critical
much later than stated invoice when a customer requests goods or vendor is a “remedy” that allows
terms, then late payments during services from the debtor, but the debtors in Chapter 11 cases to
the preference period would be in vendor refuses to provide them voluntarily pay a vendor’s pre-
the ordinary course of business unless there is first a payment. As petition claim since the vendor’s
between the parties. The standard this defence hinges on the parties’ ongoing goods or services are
for “ordinary business terms” in intent, there must be evidence that “critical” to the debtor’s
the industry has been broadened there was an agreement that the survival. As part of a critical
by court rulings in recent years, so payment and the shipment were vendor agreement, vendors may
terms are generally considered dependent on one another. negotiate a waiver of any
ordinary if they are not so preference claims.
idiosyncratic as to fall outside the Other considerations If a Chapter 11 debtor pursues a
broad range of business practices. preference claim against a non-US
• Pre-payments are not
Payments made in response to vendor, one possible outcome is
preferences since they are not
a vendor’s enforcement of a credit the Chapter 11 debtor would
on account of an antecedent
limit can also be considered obtain a judgment against the
debt.
ordinary course of business. If a “foreign” vendor. If such vendor
• Payments to a secured creditor
customer is operating near its has no assets in the US, the debtor
are not preferences since the
credit limit and wishes to increase must then proceed with an extra-
vendor would have been paid in
its level of orders, but the vendor is territorial enforcement of the
a liquidation in any event.
not willing to increase the credit judgment, usually through an
• Payments to a vendor pursuant
line, then by necessity the debtor applicable treaty such as the
to a letter of credit are not
must pay open invoices sooner Hague Convention on the
preferential since they are not a
than normal. An actual reduction Recognition of an Enforcement of
transfer of the debtor’s property.
of the credit line is generally fatal Foreign Judgments. Whether or
• A payment of an account by an
to the ordinary course of business not a Chapter 11 debtor would
entity affiliated to the debtor
defence, but it has been allowed in actually pursue the judgment in
would similarly not be a transfer
some cases where the credit line this manner may influence the
of the debtor’s property.
fluctuated frequently in the past. foreign vendor’s decision on how
However, if the paying entity
Another factor that courts vigorously to defend the preference
itself later files bankruptcy, the
have considered in applying the claim in the US. For non-US-
payments might be recovered as
ordinary course of business based vendors with assets in the
a fraudulent transfer because
defence is whether there was any US, it is likely prudent to defend
the entity making the payment
unusual action by the vendor to material preference claims since it
may well have received no value
collect the debt or whether the is easy for Chapter 11 debtors to
in exchange for the payment.
vendor did anything to gain an transfer judgments with the US’s
• Vendors facing preference
advantage in light of the debtor’s Federal Judicial System.
claims usually also hold an
deteriorating financial condition. Companies that do business with
unsecured claim against the
For example, threats of legal US-based companies need to be
debtor. The Bankruptcy Code
action or cutting off sales can be aware of the laws relating to
allows a debtor to withhold any
considered undue pressure for preferences, because they can
dividend on such claim pending
payment, although enforcing a result in a material increase in the
payment of the preference. This
consistent credit line is generally potential loss associated with a
provides the debtor leverage to
not considered undue pressure. customer’s Chapter 11 filing.
negotiate the resolution of the
“Ordinary business terms”
preference claim. In connection
can sometimes include workout or
with the settlement of a
alternative payment arrangements,
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