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Creditors should benefit from new limitations on preference recoveries in bankruptcy under both federal and state statutes
Posted in Litigation

Businesses that suffer losses on unpaid invoices when a customer files bankruptcy frequently have salt applied to the wound by being asked to return payments received from the debtor-customer. The federal Bankruptcy Code permits recovery of payments made by the debtor within 90 days of the bankruptcy filing (referred to as a “preference”) under certain conditions.

The amendments to the federal Bankruptcy Code which largely became effective October 17, 2005 improve the defenses to claims for recovery of preferences. Now a preference defendant may defend by proving either that the payment was made in the ordinary course of business between the debtor and the preference defendant or according to ordinary terms in similar businesses.

Two other recipient-favorable provisions are included in the amendments. First, no lawsuit to recover an alleged preference may be filed for an amount less than $5,000 (thereby giving a free pass to those who received preference payments under that amount). Second, any lawsuit for an amount less than $10,000 must be filed in the federal district where the recipient resides (thereby switching the inconvenience of litigating away from home).

Under the Bankruptcy Code, the trustee in a chapter 7 case for liquidation or the debtor in possession in a chapter 11 case for

reorganization has two years to file suit to recover under a preference either under federal or state law.

Most often the recipient of an alleged preference will receive a demand letter from the chapter 7 trustee or the counsel for the debtor or a creditors committee or a liquidating trustee in a chapter 11 case. The demand letter may represent a shotgun approach and not take into account – much less mention the possibility of - various defenses. Two primary defenses - ordinary course and subsequent new value - often require careful analysis of multiple transactions over a period measured in years. Software programs have been developed to analyze the data, both for prosecuting and for defending preference claims. Several states - including Kentucky and Ohio - have their own preference statutes. The amendments to the federal Bankruptcy Code did not however address state preference states.

With the amendments to the Bankruptcy Code, more emphasis on state preference remedies can be anticipated.

The statutes in Kentucky and Ohio permit recovery by an existing creditor (and hence by a trustee in bankruptcy) of payments made by a debtor to another creditor within six months of the date the creditor files suit. The payment by the debtor must have been made “in contemplation of insolvency” and “with the decision to prefer” the creditor who was paid.

Recent court decisions however have severely limited the threat of the Kentucky and Ohio preference statutes.

The Ohio statute was enacted in 1898. It has been considered only once by the Ohio Supreme Court, in 1903.

In August 2004, Chief Judge Thomas Waldron of the U.S.Bankruptcy Court for the Southern District of Ohio held that the Ohio statute does not apply to payment of money. That ruling totally eviscerates the Ohio preference statute. It is probable other courts will follow this ruling. It seems unlikely that the legislature will take action to put teeth back into the Ohio statute. In a subsequent ruling in the same case in which he addressed the Ohio preference statute, Chief Judge Waldron held that the new value defense under the federal Bankruptcy Code applies to “paid new value” as well as “unpaid new value.” A common understanding before that ruling was that a preference defendant could defend up to the amount he did not get paid on a later invoice. The ruling expands that defense to include the amount of the later sale even if the debtor paid for that later invoice.

Cases decided by both Kentucky and federal bankruptcy courts have limited the availability of the Kentucky statute by reading into the statute various defenses available in the federal bankruptcy context including: ordinary course, contemporaneous exchange, transfers to a fully secured creditor and inapplicability to transfer of exempt property. Consequently, the only item the Kentucky statute adds to the federal preference statute is to double the reach-back period from 90 days to six months. Further, the Kentucky statute may require proof of actual intent to prefer which is not necessary under federal law.

In sum, the federal Bankruptcy Code has been made more business friendly and, in addition, the Kentucky and Ohio statutes are now less available as substitutes for recovering money received on account from an insolvent customer that ends up in bankruptcy.

  • Senior Partner

    Mr. Boydston practices in the areas of bankruptcy (including representation of creditors, debtors and of committees and bankruptcy litigation), receiverships, debtor/creditor relations, and commercial transactions and ...

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