New Bankruptcy Act May Give Some Creditors Relief

7/22/2005

From a creditor’s point of view there is nothing more unfair than a preference claim. The very thought of returning money to a debtor to whom you provided goods and/or services stands the concept of fairness on its head. However, effective October 17, 2005, the preference statutes may finally get a bit more fair for creditors.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("Revised Code") includes three significant changes to the preference statutes. First, the Revised Code sets a new threshold for the dollar amount of total transfers made by the debtor to a creditor during the 90-day period before the petition date. Second, the Revised Code changes the venue requirements for cases less than $10,000, which now must be brought in the venue where the creditor resides. Third, the Revised Code significantly alters the evidentiary requirements a creditor must show to prevail on the ordinary course defense.

The Revised Code bars preference claims of less than $5,000, in total transfers, in commercial bankruptcy cases. Although the $5,000 limit is a complete defense to a preference claim in a commercial bankruptcy, it is not part of the debtor’s prima facie case. As such, there is no bar to a debtor sending a demand letter to a creditor in the hope the creditor is not aware of the Revised Code and will pay something in settlement of the demand. Arguably, only Bankruptcy Rule 9011, which provides for sanctions against an attorney who files a frivolous law suit, may prevent an attorney from filing a preference action in cases where the total amount of the transfers is less than $5,000.

The Revised Code also changes the venue requirements set forth in 28 U.S.C. § 1409(b), to require actions with total transfers of less than $10,000 to be brought in the venue where the creditor resides rather than in the venue where the debtor’s petition was filed. Before the revision, creditors were forced to engage in a cost-benefit analysis when making the decision whether to defend against a small case in a far away venue versus the cost of simply paying a settlement. The cost to the debtor to prosecute a small case in the venue where its petition was filed was only a fraction of the cost for a creditor who had to hire counsel in the venue and incur costs that were often well in excess of the total amount of the transfers. The Revised Code should force debtors to do a cost-benefit analysis that may sharply reduce the number of preference cases under $10,000 because of the significant cost to the debtor’s estate to prosecute such cases.


One of the main statutory defenses to a preference claim is the ordinary course of business defense. The current bankruptcy code ("Current Code"), 11 U.S.C. § 547(c)(2), provides that a debtor may not avoid a transfer to the extent a creditor can establish: (1) that the transfer was in payment of a debt incurred by the debtor in the ordinary course of business; and (2) made in the ordinary course of business between the debtor and creditor (subjective test); and (3) made according to ordinary business terms (objective test). Under the Current Code, a creditor must prove by a preponderance of the evidence that the transfers made by the debtor to the creditor during the preference period approximately match in manner and method the historical payment practices between the parties. If a creditor could meet its burden as to the subjective test, it was then required to prove the objective part of the test – that the transfers were made in accordance with industry standards. Although the ordinary course of business defense is raised by virtually every preference defendant, in practice it is the hardest defense to actually prove because the objective test has more evidentiary hurdles and requires the testimony of an expert witness that is not an employee of the creditor.

The Revised Code modifies 11 U.S.C. § 547(c)(2), and provides that a debtor may not avoid a transfer to the extent a creditor can establish: (1) the transfer was in payment of a debt incurred by the debtor in the ordinary course of business; and (2) made in the ordinary course of business between the debtor and creditor; or (3) made according to ordinary business terms. As such, the Revised Code requires the creditor to prove either the subjective or objective test. In reality, most creditors will choose to defend on the basis of the subjective test as the objective test is harder to prove and sometimes prohibitively expensive because of the cost of retaining an expert witness. However, it may still be possible that a creditor will have to rely on the objective test in cases where there is little or no history between the creditor and the debtor.


There is some question regarding the true effective date for changes to the preference statutes in the Revised Code. Some trustee’s and debtor’s counsel argue the Revised Code will not apply to preference actions filed as part of bankruptcy cases filed before October 17, 2005, thereby forestalling the actual effective date to as long as October 17, 2007. Creditor’s counsel argue Congress intended the Revised Code to apply to all preference cases filed after October 17, 2005. Creditors should be aware that it may take a short period of time for the courts to rule on the true effective date.

In the meantime, it is extremely important to continue to respond to preference demands and preference complaints as soon as your receive them. Do not assume that after October 17, 2005, you do not have to respond to a demand or complaint for less than $5,000, or a complaint between $5,000 and $10,000 that is not filed in your home state. Such an assumption could prove to be very costly to your company if a default judgment is entered. Please contact your attorney for advice as to how to proceed if you receive a demand letter or complaint.

The Revised Code is a first step in making the preference statute more equitable for creditors. It would have been helpful if Congress had gone a step further to resolve the split in the various federal circuits regarding the new value defense and revised 11 U.S.C. § 547(c)(4), the new value defense, to make clear new value provided by a creditor to a debtor does not have to remain unpaid as of the petition date. Nevertheless, the changes in the Revised Code should make defense of preference claims a little bit easier and somewhat more fair for creditors in the future.

Businesses should consult legal counsel before making any attempt to apply the law or any information offered above to their specific situations. This article was authored by Deb Swenson, who recently joined Lommen Nelson from A.S.K. Financial, LLP.  Ms. Swenson has a nationwide bankruptcy and collections practice, representing such entities as Ryder Truck Rental, Inc. and Xtra Lease, LLC.  Click here to find out more about Ms. Swenson's practice. For more information about bankruptcy or collection issues, contact either Ms. Swenson, debs@lommen.com, 612-336-9351, 800-752-4297, or Margie Bodas, margie@lommen.com, 612-336-9329,