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It Is Time to “Sunset” Preference Law As We Have Known It Or at Least To Test Its Underlying Basis Empirically .

posted by david lander

It is time to “sunset” preference law as we have known it or at least to test its underlying basis empirically .

Ten years ago or so Lynn Lopucki helped to focus our attention on the unfairness of the treatment of unsecured creditors vis a vis secured creditors.  In the past decade things have only become worse for unsecured business creditors as Revised Article 9 tightened the hold of secured business creditors, but that topic has seemed to have fallen  off of the radar screen.

This is a good jumping off point for examining the one area of technical bankruptcy law that most unsecured creditors love to hate “preference law.“ Preference law has outlived whatever usefulness it might have  had. The effort to separate the wheat from the chaff  is not worth the energy.  The litigation costs and aggravation costs far outweigh the benefits.  What are the benefits?  The recoveries are intended to be redistributed among all unsecured creditors. Although few studies have been done it does not appear that this redistribution is meaningful when the litigation costs, extorted settlements and bad feelings of defendants are measured against those net redistributions. Moreover, the courts have held that those recoveries may be pledged to a DIP Lender and in those cases the general unsecured creditors have money taken out of their pockets and receive no benefit from this “redistribution.” Some commentators feel that the threat of preference recovery limits the potential preference payments that a failing debtor may make, or that overreaching creditors may demand and collect, but there is simply no evidence that this is accurate and the only study indicates that this is not true.  Finally, some preference aficianados justify preference recoveries on the basis of equality of distribution and fairness and justice.  Just ask unsecured creditors that are caught in a bankruptcy and  you are likely to find that the opposite is true; the efforts at recovery are deemed unfair and unjust. The only lobby for current preference laws seems to be people who are outraged by apparent  unfairness of one creditor receiving more than others, or who believe that the existence of these laws promotes “better” conduct among debtors and creditors in the wake of financial distress, those who benefit from the litigation spawned by preference laws and perhaps bondholders who believe these avoidance actions increase their recoveries.

Ten years ago or so Lynn Lopucki helped to focus our attention on the unfairness of the treatment of unsecured creditors vis a vis secured creditors.  In the past decade things have
only become worse for unsecured business creditors as Revised Article 9 tightened the hold of secured business creditors, but that topic has seemed to fall off of the radar screen. 

This is a good jumping off point for examining the one area of technical bankruptcy law that most unsecured creditors love to hate “preference law.“ Preference law has outlived whatever usefulness it might have  had. The effort to separate the wheat from the chaff  is not worth the energy.  The litigation costs and aggravation costs far outweigh the benefits.  What are the benefits?  The recoveries are intended to be redistributed among all unsecured creditors. Although few studies have been done it does not appear that this redistribution is meaningful when the litigation costs, extorted settlements and bad feelings of defendants are measured against those net redistributions. Moreover, the courts have held that those recoveries may be pledged to a DIP Lender and in those cases the general unsecured creditors have money taken out of their pockets and receive no benefit from this “redistribution.” Some commentators feel that the threat of preference recovery limits the potential preference payments that a failing debtor may make, or that overreaching creditors may demand and collect, but there is simply no evidence that this is accurate and the only study indicates that this is not true.  Finally, some preference aficianados justify preference recoveries on the basis of equality of distribution and fairness and justice.  Just ask unsecured creditors that are caught in a bankruptcy and  you are likely to find that the opposite is true; the efforts at recovery are deemed unfair and unjust. The only lobby for current preference laws seems to be people who are outraged by apparent  unfairness of one creditor receiving more than others, ,  or who believe that the existence of these laws promotes “better” conduct among debtors and creditors in the wake of financial distress, those who benefit from the litigation spawned by preference laws and perhaps bondholders who believe these avoidance actions increase their recoveries.

A  very quick and summary review of preference law in the United States might provide useful background. Section 547(b) defines a preferential transfer which is avoidable and places the burden of proof for most of these requirements on the plaintiff; section 547(c) defines several  defenses that will each defeat the avoidance of a preferential transfer and places the burden of proof for each of these defenses upon the defendant.  The broadest and the most often litigated of the 547(c) defenses is the “ordinary course of business” defense.  This defense and its history and its difficulty beautifully expose and represent the “preference recovery dilemma.” One way of stating that dilemma is to pose this question:  Is it possible to define  the kinds of transfers that “should” be recovered in a way that is neither underinclusive nor overinclusive, is  “fair” and will not result in “excessive” litigation costs.  No legislature has succeeded yet although many including New Zealand and Australia are currently trying again. 

Prior to the enactment of the Bankruptcy Reform Act of 1978,  preference law focused on subjective elements including the creditor’s state of mind or the debtor’s state of mind and their state of knowledge at the time of the transfer.  The 1978 statute eliminated as important elements both the intent of the transferor  and whether the transferee had reasonable cause to believe that the transferor was in financial distress.  These elements were replaced largely by the “ordinary course of business defense” which was initially limited to payments that were no more than forty five days “late.” There were hundred of cases interpreting this defense and the Courts required that the original transaction have been in the ordinary course of business of both parties, and that the payment have been ordinary as measured by both the previous transactions between the parties and by the standards of the relevant industry.
 
The forty five day limitation was eliminated by Congress and the Supreme Court ruled that the ordinary course of business defense was applicable to payments on long term obligations.
Then in  2005 Congress tinkered with the ordinary course of business defense by holding that  that although the defendant must prove that the original transaction have been in the ordinary course of business of both parties they need only prove that the payment was ordinary as measured by EITHER the previous transactions between the parties OR the standards of the relevant industry but not necessarily both. These and several other more minor changes were a reaction partly to a study done by the American Bankruptcy Institute and recommendations by the Bankruptcy Review Commission.

There have been only a handful of cases interpreting these changes and they focus mostly on the degree to which the courts can use the prior law as controlling and what industry to use in determining whether the transfer was made according to ordinary terms of that relevant industry.

We need a good study to supplement the survey done by the American Bankruptcy Institute.  Maybe the ABI Trade Creditor committee will convince the ABI to fund such a study and have  it done by one of the many empirical bankruptcy scholars.

My guess is that such a study will demonstrate that the only winners in the preference game are the plaintiffs, and the trustees and lawyers who represent the plaintiffs.  On a more subjective basis my guess is that the level of bitterness among unsecured creditors far outweighs the net return of dollars to be redistributed and finally that few if any creditors refrain from aggressively collecting or accepting payments on the basis of the fact that they may have to be disgorged later. But that is just one person’s opinion; hopefully before long we will have a series of studies that will show whether we are on the right track or not.  If we are not then we can figure out if there is a way to trap the really outrageous transactions such as those to or for the benefit of insiders and leave the rest alone. 

Comments

The last time I got involved in a preference action, I represented the corporate defendant. The case evaporated when, after a couple of months, the defendant corporation filed bankruptcy itself. That left the preference action as a case of Trustee A versus Trustee B, and no one wanted to fight that litigation, for obvious reasons.

David,

I agree wholeheartedly. I generally represent creditors, both secured and unsecured. From my experience representing trade creditors, I find that the preference statute has the unintended effect of encouraging suppliers to suspend trade credit to financially troubled customers as soon as they learn of the company’s problems. The new value and ordinary course of business defenses are intended to encourage suppliers to continue providing trade credit to companies in financial distress, with the hope that this will allow a struggling company to avoid bankruptcy. But it is difficult, if not impossible, to predict whether a particular payment will be protected by these defenses. In particular, it is impossible for any supplier to feel safe behind the ordinary course of business defense. There is no bright-line test to provide certainty. The caselaw is all over the place—payments received early, late or pursuant to a payment plan all have been found to be outside the ordinary course in various cases. As a result, sophisticated suppliers often will require cash in advance from the troubled customer. Unfortunately, if all of its suppliers do the same, a troubled company’s liquidity issues will become even more serious and a bankruptcy filing all the more likely.

Has there been any analysis of whether preference lawsuits are cost effective? From my standpoint as a participant, the process strikes me as extraordinarily inefficient and I’m concerned that the present reporting requirements mask the inefficiencies of this process. I would be interested to know whether there have been any studies of preference lawsuits in large Chapter 11 cases. In particular, a comparison of: (i) the gross proceeds recovered (cash proceeds, not including claims waived as part of settlement), (ii) the legal fees and expenses incurred by the trustee, multiplied by two to estimate the legal fees and expenses of the preference defendants, (iii) the amount of proceeds diverted to pay administrative priority claims and (iv) the net amount of cash proceeds ultimately distributed to unsecured creditors. My hunch is that such a study would confirm preference actions against a debtor’s suppliers are not worth the effort.

So far as i know the survey by the ABI which is interesting was the only effort of this type. It is a survey of various folks involved in the process but the comments are anecdotal. I am not aware of any empirical study of the type you mention and think this is very important. I have reached out to a couple of empiracally minded bankruptcy profs over the years to engage them but so far nothing. That is why i think funding by the ABI woudl be the starting point.

the case against preference laws makes sense except for one exception: insiders. It seems both efficient and just to consider all payments to insiders suspect up to a fixed time period prior to filing.

As a longtime bankruptcy teacher, I can't believe that David forgot to mention one large constitutency that would benefit from the elimination of preferences from bankruptcy law-- our students. Every year teaching preferences occupies a week of the semester and while I generally enjoy the experience, my students would probably be delighted to have one fewer concept to master!

David has hit two home runs in his commentaries and I fully agree with this one. There needs to be a revamping of preference in bankruptcy law. I know of no study of reliable data that shows any benefit to unsecured creditors in consumer bankruptcy cases.

Keep them coming David!

Man, this is way out of my league…. but if you were in a situation say like you were an employee and your wages/commissions/etc. were rolled up in a 11 or 7 for that matter, but your employer paid off tio "chato"(flower supplier) and tio "chatos" compadre (lard supplier) 1-2 months prior to filing. I think you would feel differently, if you understood what a preference was. (maybe I don’t ?) I would be like "hey, you got to make and sell all of those tortillas and they got paid and not me!” Que pasa? Now I have to wait for my wages? In the context of an asset or no asset 7 I think it would make more of a difference than if it were in an 11. In a no asset 7 at least I would maybe get something instead of nothing, even if the Trustee had to hire counsel or do it himself to get that preference back into the coffers. If I am getting this concept all wrong, sorry. I am still learning. Don’t see too many in consumer bks. The ones I do see are brought by the 7 Trustee. I know, my example indicates an insider but what if it was not? In a 11 and say the example was a mortgage co. and 14-15k of my commissions were in that 11, not only will I have to wait for a distribution, which would seriously put a damper on my parting, but I would not get as much when I get it. (lejos down the line). All the while the Co. is selling and piecing off all of the loans. The fraudulent transfer of property or even paying the lease on a building or a big fat bonus to a CEO or CFO, when the co. should have seen the writing on the wall, would not sit well if it were me.

So a debtor should just be able to pay whatever debts he wants and then file bankruptcy? Maybe the law could be clearer but don't throw out the baby with the bathwater.

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