Defending Preference Actions Optimal Strategies for Comprehensive Mathematical Analyses

<p>Too
often, when a bankrupt debtor or a trustee (collectively referred to herein
as "the debtor") demands or sues for the return of preference payments,
the defendant company relies solely on its outside counsel to handle the entire
preference case. The company's failure to understand how to defend preference
actions can lead to a less-than-optimal settlement by its own counsel.
</p><p>Given the relative ease in which the proper method of defending preference
actions can be learned and the big dollars often involved, it is well worth
a company learning the ins and outs of defending preference actions. This article
describes preferential transfer law under the Bankruptcy Code¹ and how a defendant
(or its counsel) should combine the available defenses to effectively analyze
its potential liability and prepare the best defense.
</p><p><b>Preferential Transfers and Defenses </b>
</p><p>A preferential transfer is any transfer of property (typically a payment, and
often referred to as a "preference payment") made by a debtor within
the 90-day or one-year (for transfers to insiders) period prior to the date
the debtor filed for bankruptcy protection (the "preference period").
Because under the Code it is presumed that the debtor could not pay all of its
creditors during the preference period, the debtor "preferred" those
creditors it paid over those creditors it did not pay. The Code allows a debtor
to sue its vendors and service providers to recover preference payments so that
the debtor can redistribute those payments to all unsecured creditors as provided
for in the Code. That a debtor can sue to recover preference payments up to
two years after the debtor made the preference payments (and probably two years
after this money was spent) makes this law especially galling to defendants.
</p><p>The potential saving grace for a preference payment recipient (PPR) is that
it can keep any preference payment protected by a Code "defense."
For purposes of this article, there are two types of defenses. One type is the
subsequent new value defense (SNV defense). The other type includes all other
defenses (primary defenses), all of which must be applied prior to the SNV defense.²
Unlike the SNV defense, the primary defenses typically require subjective assumptions
to be made prior to their application.
</p><p><b>Primary Defenses and Related Assumptions </b>

</p><p>In calculating a PPR's liability, a PPR will make assumptions as to which defenses
protect which preference payments. (A detailed discussion of the assumptions
that must be made is described later in this article.) Naturally, a PPR will
seek to minimize its liability by asserting that the defenses protect as many
preference payments as possible. However, if a PPR's assumptions are not reasonable
and legally supportable, the debtor will disagree with the PPR's analysis. Contrary
to the PPR's goal, the debtor will try to maximize the number of preference
payments it can recover from the PPR by trying to support those assumptions
most favorable to the debtor. Obviously, resolving preference disputes involves
convincing the other side which assumptions are reasonable and legally valid.
To demonstrate how assumptions impact a PPR's liability and negotiations, two
primary defenses, the "contemporaneous exchange of new value" defense
and the "ordinary course of business" (OCB) defense, are examined
here.
</p><p>The "contemporaneous exchange for new value" defense provides that
a PPR may retain a preference payment if the PPR provided new value (that is,
new goods or services) to the debtor contemporaneously with the debtor's preference
payment. 11 U.S.C. §547 (c)(1). Cash-on-delivery payments are clearly contemporaneous
exchanges of new value. Based on the facts of a case, however, a court may also
consider certain payments made shortly after the PPR provided new value to be
contemporaneous. Accordingly, which preference payments are protected by this
defense depends on two things: (1) the assumptions as to which payments were
made contemporaneously with the new value, and (2) the validity of those assumptions.³
</p><p>The OCB defense provides that a PPR may retain a preference payment if that
payment was made within the ordinary course of the business relationship between
the PPR and the debtor.⁴ An OCB analysis, whether prepared by the
debtor or the PPR, typically entails (1) reviewing the payment history between
the debtor and PPR, (2) calculating the average number of days from the PPR's
invoice date to the preference payment date (the "payment time"),
and (3) determining a range of payment times (the "OCB protected range,"
described in more detail below), using the historical average payment time as
the midpoint of that range, such that if a preference payment was made within
that range, it is protected by the OCB defense.⁵ Importantly, because
one check can pay multiple invoices, the payment of each invoice is analyzed
as a separate preference payment and not on a check-by-check basis.
</p><p>The assumptions underlying the application of the OCB defense dictate which
preference payments are protected by the OCB protected range. Obviously, a PPR
would like to be able to support those assumptions that provide the widest and
most beneficial OCB protected range, while a debtor seeks the opposite. To illustrate,
assume a PPR's historical average payment time for the one-year period prior
to the preference period was 49 days. The PPR could assume that the one year
of data supported that those preference payments made within five days of the
historical average are protected by the OCB defense (that is, the OCB protected
range protects those preference payments made with payment times from 44 to
54 days). Using the same or a different historical data period, the PPR could
also assume that those preference payments made within 10 days of the historical
average are protected by the OCB defense (that is, the OCB protected range protects
those preference payments made with payment times from 39 to 59 days).
</p><p>In this example, it is presumed that (1) the 21-day OCB protected range protects
more preference payments than the 11-day OCB protected range, and (2) it is
harder to demonstrate that the larger OCB protected range is reasonable and
legally supportable. Accordingly, the PPR must decide which assumptions to assert.
This necessarily involves analyzing the PPR's liability under, and the supportability
of, both sets of assumptions. Chart 1 (p. 64) demonstrates a PPR's liabilities
using only the OCB defense based on 11 different sets of ordinary-course assumptions
including the two described above. The difference in liability under the 11-day
range ($408,652.43) and the 21-day range ($144,023.99) is $264,628.44. Knowing
this (and the results of other assumed OCB protected ranges) will help in developing
the optimal settlement strategy.
</p><p>The many reasonable combinations of assumptions regarding which preference
payments are protected by the primary defenses are subjective and subject to
debate. Typically, the more beneficial the assumptions are to the PPR, the harder
it is to support those assumptions and the greater the chance the debtor will
oppose those assumptions.
</p><p><b>SNV Defense⁶ </b>

</p><p>As noted above, after application of the primary defenses, the SNV defense
may be applicable. Tha defense provides that if a PPR provides new value (in
goods or services) to a debtor <i>after</i> receiving a preference payment,
the PPR can offset the preference payment with the subsequently-provided new
value to the extent there may be a preference. A creditor cannot carry over
any unused SNV to future payments it receives. As noted in Footnote 2, §547(c)(4)
of the Code provides that the debtor or trustee in bankruptcy may not avoid
(that is, it may <i>not</i> recover from a PPR) a payment "to the extent
that, after such transfer, such creditor [(the PPR)] gave new value to or for
the benefit of the debtor...on account of which new value the debtor did not
make an otherwise unavoidable transfer [(payment)] to or for the benefit of
such creditor..."). 11 U.S.C. §547(c)(4). Accordingly, if a PPR provided
new value, and the debtor either (a) never paid for the new value or (b) paid
for the new value with an otherwise avoidable transfer, the SNV defense can
be used, and the new value provided can offset a prior preference payment. Accordingly,
after the primary defenses are applied, the SNV defense is applied mechanically,
and there is only one correct way to do that. Chart 2 illustrates an example
of the SNV defense without any primary defenses being applied. Because it is
a mechanical calculation that requires no assumptions to be made, there is only
one possible result.
</p><p><b>Optimal Defense Analyses</b>
</p><p> The most effective analysis must combine the primary defenses and the SNV
defense in a way that allows a PPR to easily and efficiently determine its liability
under any number of reasonable sets of primary defense assumptions. Such flexibility
is necessary because a debtor will likely disagree with the PPR's original assumptions
(which are favorable to the PPR, of course), forcing the PPR to either re-calculate
its liability based on different assumptions, proceed with costly litigation
or settle the case. Given the time and cost often involved in litigation and
in recalculating the defenses, a PPR can be pressed into an unfavorable settlement
without knowing the effect of making different assumptions on its liability.
</p><p>The optimal analysis must also clearly present its results and calculations.
First, the analysis should summarize a PPR's liabilities given all combinations
of reasonable assumptions. As illustrated in the example below and Charts 3a
and 3b (p. 66), this information is imperative to an understanding of which
of the many combinations of assumptions are most beneficial to the PPR, which
can be legally supported, and which should be argued to the debtor. Second,
it is often beneficial for a PPR to present to the debtor an easily-understandable
spreadsheet that shows each separate calculation and which defense protects
which preference payment. If the underlying assumptions are supportable, providing
the debtor with the calculation can help resolve the matter.
</p><p>The following example best illustrates the benefits of a comprehensive analysis
combining the primary and SNV defenses. In this hypothetical, a debtor made
35 preference payments to a PPR, the SNV defense applies, and the only applicable
primary defense is the OCB defense.⁷ The PPR then makes the following sets of
assumptions (among many others) related to its OCB defense:
</p><p><i>Assumption Set 1 - Based on One-Year Historical Average of 49 Days</i>

</p><p>Those preference payments paid within that 11-day range of payment times from
44 to 54 days (49 +/- 5 days) are protected by the OCB defense. Based on these
assumptions, the PPR's liability is $347,299.94 (Chart 3a). Note that based
on the OCB defense alone (that is, without applying the SNV defense), the PPR's
liability would be $408,652.43 (Chart 1, "Not Protected by OCB" amount
for protected range of 44-54 days).
</p><p><i>Assumption Set 2 - Based on One-Year Historical Average of 49 Days </i>
</p><p>Those preference payments paid within that 21-day range of payment times from
39 to 59 days (49 +/- 10 days) are protected by the OCB defense. Based on these
assumptions, the PPR's liability is $144,023.44 (Chart 3b). Note that based
on the OCB defense alone (that is, without applying the SNV defense), the PPR's
liability would still be $144,023.44 (Chart 1, "Not Protected by OCB"
amount for protected range of 39-59 days).
</p><p>To allow comprehensive evaluation of the PPR's evaluation based on the different
assumptions, a chart should be prepared. A sample chart based on nine sets of
assumptions (including the two described above) would look like the Historical
Average chart on the left.
</p><p>A result chart allows for easy and effective evaluation of a PPR's liability
based on multiple assumptions. In this example, it is imperative to know (and
well worth trying to support) that those payments made within payment times
of 39-59 days (49 +/- 10 days) are protected by the OCB defense because the
PPR's liability under that scenario, $144,023.99, is significantly lower than
its liability under any other set of assumptions. Accordingly, a PPR would argue
that the historical average should be based on the one-year payment history
and that the OCB protected range should include those payments made within the
10 days above and below that 49-day historical average. However, if a PPR can
only support a historical average of 46 days, the PPR obtains no benefit by
arguing that the OCB protected range is 38 to 44 days (46 +/- 8 days) rather
than 36 to 46 days (46 +/- 5 days), since the PPR's liability is identical under
both sets of assumptions. While the above chart is effective for purposes of
illustration, a chart showing a PPR's liabilities based on all reasonable assumptions
(not just nine) provides a PPR the data necessary to evaluate a case. For example,
using data related to eight preference payments, Chart 4a provides a full chart
of liabilities based on 121 sets of ordinary-course assumptions. Charts 4b and
4c (p. 67) show the backup calculations for two sets of the assumptions used
in the eight payment analyses.
</p><p>Once it is determined which set of assumptions will be presented to the debtor
in negotiations or to the court in a motion or at trial, presenting the relevant
calculations in an easily-understandable format to the adversary can promote
resolution of the matter. The calculations shown in Charts 3a, 3b, 4b and 4c
clearly show each calculation and which defense protects which preference payments.
The easier a calculation is to understand, the easier it is to convince the
debtor that the calculation is correct and supported.
</p><p>In sum, the most effective analysis must provide for efficient, comprehensive
results of a PPR's liability based on numerous sets of primary defense assumptions.
Preparing a chart of liabilities based on different assumptions is essential
in formulating the optimal defense strategy. Importantly, the supporting calculations
must be understandable to the PPR (as well as its attorney), the debtor and
potentially the judge. The easier a calculation is to understand, the easier
it is to convince a debtor that the PPR's position is reasonable and supportable,
and the more likely the PPR will obtain the best settlement possible. Finally,
where the PPR performs this analysis early after notice of a debtor's bankruptcy,
the easier it is to gather the supporting documents for the analysis and defense
of the preference claim, again adding in the resolution of the claim.
</p><blockquote>
<blockquote>&nbsp;</blockquote>
</blockquote>

<hr>
<h3>Footnotes </h3>
<p>1 <i>See</i> 11 U.S.C. §547.</p>

<p> 2 Section 547(c)(4) of the Code provides that the debtor or trustee in bankruptcy
may not avoid (that is, it may not recover from a PPR) a payment "to the
extent that, after such transfer, such creditor [the PPR] gave new value to
or for the benefit of the debtor...on account of which new value the debtor
did not make an otherwise unavoidable transfer [payment] to or for the benefit
of such creditor..."). 11 U.S.C. §547(c)(4). Accordingly, if a PPR
provided new value, and the debtor never paid for the new value, the SNV defense
can be used, and the new value can offset a prior preference payment. Additionally,
if a PPR provided new value, and the debtor paid for the new value but did not
pay with a payment that is "otherwise unavoidable" (that is, if the
debtor paid for the new value with a payment that the debtor can recover), it
is as if the PPR never got paid at all. In this situation, the SNV defense can
be used, and the new value can offset a prior preference payment. The statute
therefore requires that the primary defenses be applied prior to the SNV defense.
</p>
<p>3 And as with all defenses to preference actions, the defenses are highly dependent
on the specific facts for each alleged preference. </p>
<p>4 The OCB defense includes other requirements not discussed in or relevant
to this commentary. Those requirements, as amended by BAPCPA, provided that
a creditor need show that the payment was ordinary as between the debtor and
the creditor, or as in the creditor's industry. </p>
<p>5 Other bases exist to support that a preference payment falls outside the
ordinary course of business. For example, if, prior to the preference period,
a debtor always paid a PPR by check, then the debtor made the only two preference
payments by wire, a debtor could argue that the preference payments were made
outside the ordinary course. Similarly, if a preference payment was made only
after a PPR's repeated phone calls pressuring the debtor to make the preference
payments, a debtor could argue that the preference payments were made outside
the ordinary course. </p>
<p>6 Some courts and practitioners in the Second (Connecticut, New York, Rhode
Island), Seventh (Illinois, Indiana, Wisconsin) and Eleventh Circuits (Alabama,
Florida, Georgia) conclude that for the SNV defense to apply, the new value
must remain completely unpaid by the debtor. Under this interpretation of §547(c)(4),
if a PPR provides new value to the debtor, and the debtor pays for that new
value, the PPR will never be able to use the new value to offset a prior preference
payment even if the payment was made by an otherwise avoidable transfer. As
discussed in Footnote 2, this interpretation fails to recognize the intricacies
of §547(c)(4). </p>
<p>7 If a PPR assumes that any preference payments were protected by a primary
defense other than the OCB defense or that any preference payment falls outside
of the ordinary course of business based on a reason other than its payment
time, the calculation should be easily adjustable to reflect these assumptions.</p>