I. Preference Actions and their Defenses

This section of the presentation will focus on the defenses to a preference action. While the first strategy (and sometimes the only strategy) that a defense attorney learns is “stall, stall, stall” this strategy cannot be effectively employed in the United States Bankruptcy Court for the District of South Carolina (the “Bankruptcy Court”). At least this author has never been able to effectively employ this strategy in this Bankruptcy Court. Thus, this article will focus on other defenses to a preference action.

First, to understand the defenses to a preference action, one must know what a preference action is. Of course, the first defense will be challenging one of the elements of a preference action and in order to challenge the elements, one needs to know what those elements are. Thus, this article will first discuss the elements of a preference action while examining possible challenges to these elements. Also, in this section, we will discuss the recent amendments to the choice of forum that may impact the use of preference actions.

Second, the largest area of litigation concerning preferences is the “ordinary course of business” defense. 11 U.S.C. §547(c)(2) (title 11 of the United State Code of Laws will herein be referred to as the “Bankruptcy Code”). This defense will be discussed in the second section of this article. We will also discuss briefly the change in this defense resulting from recent amendments to the Bankruptcy Code. While the discussion will be brief, please understand that the change is an enormous alteration in the burden of proof on this defense.

Third, one of the most interesting defenses for individuals planning to receive a payment from a distressed company is the contemporaneous exchange exception. Many have sought to structure payments received from distressed companies in such a way as to provide for this defense to any possible preference action.

Fourth, one of the most recognized and most easily proved defenses to a preference action is the new value defense. What constitutes new value and how to prove this defense will be discussed in the third section of this article.

Lastly, there is an increasingly litigated area in preference actions in situations where a debtor operates the business under a Chapter 11 between the filing of the petition and the bringing of the preference action either by a subsequent Chapter 7 Trustee or by some entity on behalf of a liquidating trust pursuant to a plan. In these cases, the idea for the defense is to try to get the court to take into consideration the events that happened during the Chapter 11 proceeding to decide whether the Trustee or Liquidating Trust has a cause of action for a preference. These defenses and this developing area of preference litigation will be discussed in the fourth section of this article.

1. Elements of a Preference Cause of Action

Pursuant to section 547(b) of the United States Bankruptcy Code, a Trustee may avoid any transfer of an interest of the debtor in property:

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made --

(a) on or within 90 days before the date of the filing of the petition; or

(b) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if --

(a) the case were a case under chapter 7 of this title;

(b) the transfer had not been made; and

(c) such creditor received payment of such debt to the extent provided by the provisions of this title.

11 U.S.C. § 547(b). It is the plaintiff’s burden to prove each and every one of these elements by a preponderance of the evidence. 11 U.S.C. § 547(g); Danning v. Bozek (In re Bullion Reserve of N. Am.), 836 F.2d 1214 (9th Cir. 1988). Failure to satisfy this burden on any one element precludes a finding that a transfer is a preference. Hood v. Brownyard-Sharon Park Center Inc. (In re Hood), 118 B.R. 417, 421 (Bankr. D.S.C. 1990); Norman v. Jirdon Agri Chemicals, Inc. (In re Cockreham), 84 B.R. 757, 761 (D.Wyo. 1988). Further, because the elements above are objective, the intent of the debtor is irrelevant. Marathon Oil Co. v. Flatau (In re Carig Oil Co.), 785 F.2d 1563 (11thCir. 1986). Accordingly, it is the effect of the transfer which is controlling. Barash v. Public Fin. Corp., 658 F.2d 504, 510 (7th Cir. 1981).

1.1. Transfer of an Interest of the Debtor in Property

Section 101 of the Bankruptcy Code defines a “transfer” as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor’s equity of redemption.” 11 U.S.C. § 101(54). This definition is exceptionally broad, and therefore this author previously thought that it included virtually every conceivable transfer, including the creation or fixing of judicial liens. [1]

Apparently, this definition was not broad enough for some courts [2] and in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “BAPCPA”), Congress decided to make the definition even more broad. Under the BAPCPA, a transfer is now:

(A) the creation of a lien;

(B) the retention of title as a security interest;

(C) the foreclosure of a debtor’s equity of redemption; or

(D) each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with -

(i) property; or

(ii) an interest in property

Section 1214, BAPCPA. Precisely because the past definition was so broad and the new definition is more broad, the true test is not whether a transfer occurred, but whether the debtor had an actual or constructive ownership interest in the transferred property. In re Hood, 118 B.R. 417 at 419; In re Flooring Concepts, Inc., 37 B.R. 957, 961 (9thCir. 1984). [3] In this regard, ownership is determined by the debtor’s ability to control the disposition of the property.

For example, in In re Cybermech, Inc., 13 F.3d 818 (4th Cir. 1994), the Fourth Circuit Court of Appeals addressed the question of whether a debtor corporation’s return of another corporation’s down payment on the purchase of office machines constituted an avoidable preference. In this case, the court held that the debtor did have an interest in the payment funds because the debtor, upon receipt of the funds, could deposit it, commingle it with other funds, withdraw from it, transfer it or otherwise use the payment funds in anyway it so desired. Id. at 820. Therefore, the debtor’s “ability to exercise complete ‘dominion and control over the funds’ [was] sufficient to ‘demonstrate an interest in property’ under the preferential transfer provision . . . was a transfer of an ‘interest of the debtor in property.’” Id. at 821 (quoting In re Smith, 966 F.2d 1527 (7th Cir. 1992)).

Another illustrative case is In re Hood, 118 B.R. 417 (Bankr. D.S.C. 1990). There, the debtor was facing an imminent sheriff’s levy when a friend of the debtor’s intervened by offering to personally pay the debtor’s debts. The debtor’s creditors, however, refused to accept her checks. The debtor then took his friend’s personal checks to the bank where they were exchanged for cashier checks and used to pay off the creditors. After finding that the transfer satisfied the other elements of a preference, the court turned to the ultimate question of whether or not the debtor possessed an interest in the transferred funds. Accordingly, the court held that the debtor did not have an interest in the funds because the debtor did not and could not control the disposition of the funds.

In so holding, the court adopted and applied the “earmark” doctrine. See also, Hovis v. Powers Construction Company, Inc. (In re Hoffman Associates, Inc.), 194 B.R. 943 (Bankr. D.S.C. 1995). This doctrine essentially states that funds loaned to a debtor by a third party that are “earmarked” for a particular creditor do not belong to the debtor. Its application requires:

(1) The existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt. Where the payment is made directly by the third party to the creditor, this requirement is inapplicable;

(2) Performance of that agreement according to its terms; and

(3) Transaction, when viewed as a whole, including the transfer of new funds out to the old creditor, does not result in the diminution of the estate.

In re Hood, 118 B.R. at 420 (citing McCuskey v. Natl. Bank of Waterloo (In re Bohlen Enter.), 859 F.2d 561 (8th Cir. 1988)). Applying the doctrine in Hood, the court found that (1) the debtor and his friend entered into an agreement that earmarked the funds for the payment of the debtor’s creditors; (2) the debtor’s friend directly paid the creditors; (3) the agreement was performed according to its terms; (4) the funds transferred were never property of the debtor nor did they become property of the debtor; and (5) the transfer did not diminish the debtor’s bankruptcy estate. Id. Therefore, the court concluded that the transfer was not an interest of the debtor in property simply because the debtor did not and could not control the disposition of the property. Id. at 421.

Similar to the earmark doctrine, some have argued that if the debtor holds certain funds in trust, the payment to the beneficiary of the trust should not be a preference. In addition, in the area of construction contracts and sub-contracts in South Carolina, we have a statutory scheme as part of the mechanic’s lien statutes that earmarks certain funds for payment to subcontractors. Specifically, if a contractor receives a payment from an owner, the sub-contractors “shall have the first lien on the money received by such contractor.” See S.C. Code Ann. § 29-7-10 (Law. Co-op 1991). Because the debtor only holds the funds subject to this first lien, the theory would be that the transfer was not of an interest of the debtor, but instead, earmarked, by statute, for the benefit of the subcontractor.

1.2. To or For the Benefit of a Creditor

Section 101 of the Bankruptcy Code defines a “creditor,” in relevant part, as an “entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor.” 11 U.S.C. § 101(10)(A). Further, a “claim” means:

(A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or

(B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.

11 U.S.C. § 101(5)(A)-(B). In construing these terms, the United States Supreme Court stated in Ohio v. Kovacs, 469 U.S. 274, 105 S.Ct. 705, 83 L.Ed.2d 649 (1985) that Congress intended for them to be used in their broadest possible sense.

The courts have obliged by finding “creditors” in even the most contingent and remote cases. See, e.g., Sigmon v. Royal Coke Co. (In re Cybermech), 13 F.3d 818 (4th Cir. 1994) (buyer was a creditor of the seller because the buyer had paid for the goods, and therefore had a claim against the seller for a right to payment or a right to an equitable remedy for breach of performance); Nolden v. VanDyke Send Co. (In re Gold Coast Seed Co.), 751 F.2d 1118 (9th Cir. 1985) (holding that a seller acquired a claim against the buyer at the time the buyer received and accepted the goods).

The transfer, however, must also benefit the creditor. Accordingly, this benefit can either be direct, see, e.g., Bucki v. Singleton (In re Cardon Realty Co.), 146 B.R. 72 (Bankr. W.D.N.Y. 1992) (holding that debtor’s payment to creditor/assignee of loan obligation benefitted the creditor/assignee, regardless of what she did with the money after she received it, because it paid off an antecedent debt), or indirect, see, e.g., Sommers v. Burton (In re Conrad Corp.), 806 F.2d 610 (5th Cir. 1987) (holding that the debtors’ transfer of restaurants in exchange for a simultaneous assumption of their debt by a third party benefitted the creditor, and therefore, constituted a voidable indirect transfer to the creditor).

Thus, if the creditor received something of value, in a preference action, the plaintiff can seek the return of that something of value.

1.3. For or on Account of an Antecedent Debt

An antecedent debt is simply a debt that the debtor incurs before he makes the alleged preferential transfer. 4 COLLIER ON BANKRUPTCY § 547.05 (15th Ed. 1991). This element is present to promote the central concept governing the existence of a preference action -- the preservation of the debtor’s assets. Accordingly, any transfer to a creditor that occurs during the preference period on account of an antecedent debt serves only to deplete the debtor’s bankruptcy estate, and therefore is in derogation of this policy of preservation.

While the term “antecedent” is easy enough to grasp, the existence of a “debt” depends upon the existence of a claim. In In re Cybermech, the creditor, Royal Cake Co. Inc., (hereinafter “Royal”) entered a sales agreement with the debtor, Cybermech, Inc. (hereinafter “Cybermech”) whereby Royal paid Cybermech a substantial down payment for various equipment. Due to financial troubles, however, Cybermech soon informed Royal that it would be unable to perform the contract and returned the down payment. Three weeks later, Cybermech filed a voluntary Chapter 7 petition. The trustee quickly moved to have the returned down payment set aside as a preference. Royal, however, challenged the trustee and alleged, among other things, that the returned payment was not an antecedent debt because (1) Cybermech never owed a debt to Royal and (2) even if Cybermech did, the debt was not antecedent to the transfer. The court disagreed and held that because Royal possessed a claim against Cybermech for performance under the contract, Royal was a creditor, and Cybermech owed Royal the debt of performance. In so holding, the court stated that the terms “claim” and “debt” were coextensive; where one exists then so does the other:

The Code defines “debt” as “liability on a claim.” 11 U.S.C. § 101(12). By making “claim” the operative term in the definition of debt, “Congress gave debt the same broad meaning it gave claim.” [Citation omitted]. Indeed, it is clear that “the terms ‘debt’ and ‘claim’ are coextensive: a creditor has a ‘claim’ against the debtor; the debtor owes a ‘debt’ to the creditor.” [Citations omitted]. By defining debt as “liability on a claim,” Congress did not impose an additional element, namely that legal liability be established through litigation. “[W]hen a claim exists, so does a debt.” [Citation omitted]. They are but different windows in the same room.

Id. at 822. Therefore, Cybermech did owe a debt to Royal and said debt was antecedent to the transfer because Cybermech contracted the debt well before it returned the money.

This definition seems consistent with the discussion of whether a recipient of a payment is a creditor. Again, the definitions are extremely broad. Simply, if an entity received something of value from the debtor because of some obligation, chances are, the court is going to find a debt, a creditor, and the transfer on account of the debt.

1.4. Ninety Day Reachback Period; “Insider” Extension of the Preference Period

Subsection (b)(4)(A) of section 547 provides that a transfer can only be avoided where it was made on or within ninety days before the filing of the petition. 11 U.S.C. § 547(b)(4)(A). While this is generally an absolute rule, subsection (b)(4)(B) immediately follows and provides that where the transfer was made to an “insider,” the time limit for avoidance is extended to one year pre-petition. An “insider,” in the conventional sense, is simply someone who stands in a close relationship with the debtor and who possesses the ability to control the debtor’s actions. Pineview Care Center, Inc. v. Mappa (In re Pineview Care Center, Inc.), 152 B.R. 703 (D.N.J. 1993). [4] The most common examples include a relative or general partner of the debtor in the cases where the debtor is an individual or a partnership, and the director(s) or officers of the debtor in the cases where the debtor is a corporation. 11 U.S.C. § 101(31).

As it relates to the time that the transfer is made, the courts generally look at when the debtor parted with the thing of value. Thus, for checks, the important date for when the transfer took place is the date that the debtor’s bank honored the check. If the honoring of the check was within the preference period, the Court will generally find that the transfer took place during the preference period. See Barnhill v. Johnson, 503 U.S. 393 (1992).

One of the more interesting situations occurred when the plaintiff attempted to recover a transfer to a non-insider creditor that benefitted an insider creditor. Such an action was referred to as a “Deprizio Action.” The most common example of this scenario exists where the insider creditor guarantees a loan and then directs the debtor’s payment to the creditor advancing the loan. In Levit v. IngersollRand Fin. Corp., 874 F.2d 1186 (7th Cir. 1989), the court examined such a situation and set forth the “Deprizio” doctrine. This doctrine essentially allowed the plaintiff to recover from non-insider transferees payments made during the extended preference period which benefitted insider creditors. While many courts adopted the “Deprizio” doctrine, see, e.g., Ray v. City Bank & Trust Co., 899 F.2d 1490 (6th Cir. 1990), other courts vehemently refused to apply its reasoning. Prior to the Amendments in 1994, South Carolina bankruptcy courts followed the Deprizio doctrine. See In re Hoffman Assoc., 179 B.R. 797 (Bankr. D.S.C. 1995).

The drafters of the 1994 Bankruptcy Reform Act thought that they had done away with the Deprizio doctrine, except in pre-1994 actions. They did so by adding subsection (c) to section 550. This section states:

(c) If a transfer made between 90 days and one year before the filing of the petition -

(1) is avoided under section 547(b) of this title; and

(2) was made for the benefit of a creditor that at the time of such transfer was an insider; the trustee may not recover under subsection (a) from the transferee that is not an insider.

11 U.S.C. § 550(c). This author thought the resolution was pretty simple. You cannot recover from a non-insider transferee.

However, some courts continued to apply the doctrine under certain circumstances. In the case of Roost v. Associates Home Equity Servs. Inc. (In re Williams), 234 B.R. 801 (Bankr. D. Or. 1999), the debtor and his non-debtor wife financed the purchase of their mobile home and pledged as collateral the mobile home and its real property. The secured creditor did not file the lien contemporaneously but did file the lien more than 90 days before the bankruptcy. The trustee sought to set aside the transfer because it benefitted the debtor’s wife, an insider. The trustee argued that he was not seeking to recover anything, the property was already property of the estate under Section 541 of the Bankruptcy Code. He was only seeking to avoid the security interest. The court agreed saying that recovery of a payment would be precluded by section 550(c) but the avoidance of the security interest is not a recovery and therefore is not precluded.

The BAPCPA has added yet another anti-Deprezio section. Specifically, sub-section (i) to Section 547 states:

If the trustee avoids under subsection (b) a transfer made between 90 days and 1 year before the date of filing of the petition, by the debtor to an entity that is not an insider for the benefit of a creditor that is an insider, such transfer shall be considered to be avoided under this section only with respect to the creditor that is an insider.

See § 1213, BAPCPA. As it relates to this particular section, it applies to any case that is pending or commenced on or after the date of the enactment of the BAPCPA. So, this probably means that Deprezio is no more.

1.5. Made While the Debtor was Insolvent . . .

A debtor is essentially insolvent when his liabilities exceed his assets. 4 COLLIER ON BANKRUPTCY § 547.06 (15th Ed. 1991). [5] In this regard, there is a presumption of insolvency during the ninety day reachback period. Id. See Also 11 U.S.C. § 547(f). In Transit Homes, Inc. v. South Carolina Nat’l Bank (In re Transit Homes, Inc.), 57 B.R. 40 (Bankr. D.S.C. 1985), however, the court held that the presumption of insolvency can be rebutted by the introduction of the debtor’s filed schedules. So, if the debtor files schedules saying that the value of its assets exceed the amount of its liability, the defendant may have a built-in defense to the preference litigation.

1.6. That Enables the Creditor to Receive More Than Such Creditor Would Have Received in a Hypothetical Chapter 7 Case.

Subsection (b)(5) is merely a codification of the United States Supreme Court holding in Palmer Clay Products Co. v. Brown, 297 U.S. 227, 56 S.Ct. 450, 80 L.Ed. 655 (1936). In this case, the court held that whether a transfer is preferential should be determined “not by what the situation would have been if the debtor’s assets had been liquidated and distributed among his creditors at the time the alleged preferential payment was made, but by the actual effect of the payment as determined when bankruptcy results.” [Emphasis added]. In this regard, the court in Elliot v. Frontier Prop./LP (In re Lewis W. Shurtleff. Inc.), 778 F.2d 1416, 1421 (9th Cir. 1985) stated:

This analysis requires that in determining the amount that the transfer “enables [the] creditor to receive,” 11 U.S.C. § 547(b)(5) (1982), such creditor must be charged with the value of what was transferred plus any additional amount that he would be entitled to receive from a Chapter 7 liquidation. The net result is that, as long as the distribution in bankruptcy is less than one-hundred percent, any payment “ on account” to an unsecured creditor during the preference period will enable the creditor to receive more than he would have received in liquidation had the payment not been made. [Emphasis theirs]. [6]

This section is also applicable to secured creditors. In Smith v. Creative Fin. Management, Inc. (In re Virginia Fin. Corp.), 954 F.2d 193, 198-99 (4th Cir. 1992), the court stated:

While the bankruptcy code recognizes and respects the preeminent status given to the secured creditor by state commercial codes, a creditor is “secured” under the code only to the extent of the value of his interest in the property of the estate . . . Section 547(b)(5) does not, as Creative seems to argue, add any special protections for the secured creditor. Indeed, the term “secured creditor” is not even included in that section . . . As the plain language of [section] 547(b)(5) conveys, the court must focus, not on whether a creditor may have recovered all of the monies owed by the debtor from any source whatsoever, but instead upon whether the creditor would have received less than a 100% payout in a Chapter 7 liquidation.

See also 4 COLLIER ON BANKRUPTCY § 547.08 (15th Ed. 1991) (“The analysis [for unsecured creditors] is similar for secured creditors . . . .”).

1.7. Impact of BAPCPA on Elements of Preference Action

The BAPCPA added some procedural hurdles to the elements of a preference action. Specifically, the BAPCPA provides:

A. Corporate debtors cannot avoid transfers of less than $5,000. See BAPCPA, § 409 (Oddly, Congress actually adds a paragraph 9 to subsection 547(c) thereby making this limitation an affirmative defense. So technically, a plaintiff can bring an action to avoid a transfer of less than $5,000 thereby requiring the defendant to raise the affirmative defense.).

B. Plaintiffs must bring an action in the district court for the district in which the defendant resides where the recovery is for less than

(i) $1,000 against an insider;

(ii) a consumer debt of less than $15,000; or

(iii) a debt against a non-insider of less than $10,000.

See BAPCPA § 410.

C. The 10 day grace period provided for in Section 547(e)(2) for the perfection of security interests is expanded to a 30 day grace period. See BAPCPA § 403.

D. The 20 day grace period provided for in Section 5478(c)(3)(B) for perfection of a security interest in a purchase money security interest is expanded to a 30 day grace period. See BAPCPA § 1222.

It is clear from these amendments that Congress wants fewer small preference actions and wants fewer actions in situations where the timing of the perfection of a security interest is close to being contemporaneous.

2. Defense -- The Ordinary Course of Business Exception

While section 547(c) sets forth a number of instances where a trustee cannot avoid a preference transfer, the most litigated of these “defenses” is the ordinary course of business exception. This section will discuss this defense and then discuss the change to this defense adopted in the BAPCPA.

2.1. The Ordinary Course of Business Exception

This exception is embodied in the text of subsection (c)(2) which provides that a trustee cannot avoid a transfer:

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor or the transferee; and

(C) made according to ordinary business terms.

The essential purpose of this exception is “to leave undisturbed normal financial relations because it does not detract from the general policy of the section to discourage unusual action by either the debtor or its creditors during the debtor’s slide into bankruptcy.” Morrison v. Champion Credit Corp. (In re Barefoot), 952 F.2d 795, 801 (4th Cir. 1991). In this regard, the creditor who claims the exception also possesses the burden of proof. Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044, 1047 (4th Cir. 1995). Further, the creditor must satisfy its burden by a preponderance of the evidence. Id.

In the case of Harman v. First American Bank of Md. (In re Jeffrey Bigelow Design Group), 956 F.2d 479 (4th Cir. 1992), the Fourth Circuit Court of Appeals held that subsection (c)(2)(A) and (B) are analyzed pursuant to a subjective test. The Fourth Circuit states that the “‘focus of [the] inquiry must be directed to an analysis of the business practices which were unique to the particular parties under consideration.’” Id.at 486 (quoting Waldschmidt v. Ranier (In re Fulghom Constr. Corp.), 872 F.2d 739, 743 (6th Cir. 1989)). This inquiry is “‘peculiarly factual, . . .’” Id. (quoting First Software Corp. v. Curtis Mfg (In re First Software Corp.), 81 B.R. 211, 213 (Bankr. D.Mass. 1988)), and “[a]ttention should be drawn to the reality of the situation and not the formal structure.” Jeffrey Bigelow 956 F.2d at 488. In this regard, the court emphasized that “form must not be elevated above substance.” Id.

Basically, the formal structure is the contractual relationship between the parties. The Fourth Circuit is basically saying, just because an invoice says pay within 30 days, does not mean a payment received more than 30 days after the invoice is outside of the ordinary course of business. Also, if the parties do not have a long history upon which to determine their prior practices, the contractual terms of the agreement become more important in determining the ordinary course of business between the parties under (c)(2)(B). The Honorable John E. Waites, United States Bankruptcy Court for the District of South Carolina, analyzed this situation in Hovis v. Aerospace Solutions, Inc., (In re Air South Airlines, Inc.), 99-80256 (January 14, 2000). In this opinion, the Bankruptcy Court states:

ASI and Debtor had never, prior to those two transfers, entered into transactions on similar payment terms; thus, there is no prior course of dealings between the parties on such terms. Where the debtor and creditor do not share a pre-preference course of dealing, some courts have held that the ordinary course of business exception cannot be used as an affirmative defense. See e.g., Miller v. Kibler (In re Winters), 182 B.R. 26, 29 (Bankr. E.D. Ky. 1995) (“It is clear that §547(c)(2) applies if the debtor and the transferee have an ongoing, ‘recurring’ business relationship. It does not apply to single, isolated transactions such as the one between the debtor and the defendants herein.”); Brizendine v. Barrett Oil Distributors, Inc. (In re Brown Transport Truckload), 152 B.R. 690, 691 (Bankr. N.D. Ga. 1992) (“If there is no prior course of dealings between the parties, the transferee cannot satisfy [§547(c)(2)(B)], and the transfer may be avoided.”). As the court in Gosh v. Burns (In re Finn) concluded, “[o]bviously every borrower who does something in the ordinary course of her affairs must, at some point, have done it for the first time.” In re Finn, 909 F.2d 903, 908 (6thCir. 1990). This Court holds that, as a general rule, a transaction between the parties may be deemed to be in the ordinary course of financial affairs” of the parties even if there is no prior history of dealings and the transaction is the first to take place between the creditor and the debtor. Remes v. ASC Meat Imports, Ltd. (In re Morren Meat & Poultry Co.), 92 B.R. 737 (W.D. Mich. 1988) (“[T]his Court is not convinced that § (B) requires a history of prior dealings as a sine qua non in order to afford a transferee the protections of §547(c)(2).”); see also Tomlins v. BRW Paper Co. (In re Tulsa Litho, Co.), 229 B.R. 806, 808 (10thB.A.P. 1999).

The next issue to be resolved is what indicia courts may consider in determining whether the transaction took place in the “ordinary course of business.” Courts in various jurisdictions have come up with different views on the issue.

When there are no prior transactions with which to compare, the court may analyze other indicia, including whether the transaction is out of the ordinary for a person in the debtor’s position, In re Finn, 909 F.2d 903, or whether the debtor complied with the terms of the contractual arrangement, Payne v. Clarendon Nat’l Ins. Co., (In re Sunset Sales, Inc.), 220 B.R. 1005, 1021 (10th Cir. BAP 1998), generally looking to the conduct of the parties, see Remes v. ASC Meet Imports, Ltd. (In re Morren Meat & Poultry Co.), 92 B.R. 737, 741 (W.D. Mich. 1988), or to the parties’ ordinary course of dealing in other business transactions, Riske v. C.T.S. Systems, Inc. (In re Keller Tool Corp.), 151 B.R. 912, 914 (Bankr. E.D. Mo. 1993).

Meeks v. Harrah’s Tunica Corp. (In re Armstrong), 231 B.R. 723, 731 (Bankr. E.D. Ark. 1999). This Court adopts the view set forth in In re Morren Meat & Poultry Co. and holds that the preprinted terms in the invoices that ASI sent to Debtor do not definitely define the ordinary course of business between the parties; rather, the Court considers the conduct of the parties to determine whether any unusual conduct took place which would require the Court to set the subject transaction aside as preferential transfers.

Id. at 13-14. Judge Waites then examined the invoices and finds that the three preference payments that were made either within the terms of the invoice (within 30 days) or close to the terms of the invoice (34 days) were in the ordinary course and the single payment made well outside of the invoice terms (54 days) was outside of the ordinary course of business. Id. at 15.

Compared to §547(c)(2)(B), the Fourth Circuit and the Bankruptcy Court utilizes a different approach when examining subsection §547(c)(2)(C). In Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044 (4th Cir. 1995), the creditor was a direct mail advertising firm that required its customers to prepay for its services. In the ninety-day period preceding the debtor’s bankruptcy petition, the debtor made twelve payments to the creditor. Two of the payments were prepayments while the remaining ten payments were for services previously rendered. The creditor had waived the requirement for pre-payment on the last ten payments and had allowed the debtor to pay when able. Shortly after the debtor filed for Chapter 11 protection, the trustee moved to avoid the latter ten payments as preferences. The creditor countered that said payments fell within the ordinary course of business exception, and therefore, were unavoidable.

The court began its analysis by refusing to apply subsection (c)(2)(A) and (B)’ s subjective test for subsection (C). Id. at 1048 (“[b]ecause subsection B and C are written in the conjunctive, the use of subsection B’s subjective approach under subsection C would render subsection C superfluous . . . [w]e refuse to say that Congress wrote a separate subsection for no reason at all.”). The court then held that subsection (C) should be analyzed under an objective test whereby a court looks to the industry norms for the determination of “ordinary business terms.” Id. The court then explained the application of this test:

[T]he extent to which a preference payment’s credit terms can stray from the industry norm yet still satisfy [section] 547(c)(2)(C) depends on the duration of the debtor-creditor relationship. “[T]he more cemented (as measured by its duration) the pre-insolvency relationship between the debtor and the creditor, the more the creditor will be allowed to vary its credit terms from the industry norm yet remain in the safe harbor of [section] 547(c)(2)(C).” Id. at 225. A “sliding-scale window” is thus placed around the industry norm. On the one end of the spectrum, “[w]hen the relationship between the parties is of recent origin, or formed only after or shortly before the debtor sailed into financially troubled seas, the credit terms will have to endure a rigorous comparison to credit terms used generally in a relevant industry.” Id. In such a case, only those “departures from [the] relevant industry’s norms which are not so flagrant as to be ‘unusual’ remain within subsection C’s protection.” Id. at 226.

On the other end of the spectrum, “when the parties have had an enduring, steady relationship, one whose terms have not significantly changed during the pre-petition insolvency period, the creditor will be able to depart substantially from the range of terms established under the objective industry standard inquiry and still find a haven in subsection C.” Id.

Id. at 1049 (quoting Fiber Lite Corp. v. Molded Acoustical Products, Inc. (In re Molded Acoustical Products, Inc.), 18 F.3d 217 (3d Cir. 1994)). In so holding, the court also emphasized that “subsection C never tolerates a gross departure from the industry norm, not even when the parties have had an established and steady relationship.” Id.at 1050.

Applying their “newly adopted” sliding scale approach to subsection (c)(2)(C), the court found that the creditor had failed to meet its burden of satisfying subsection (c)(2)(C). Because the creditor’s normal business practice was to require prepayment, their waiving of the requirement for the debtor constituted a gross departure from their industry norm. Therefore, and despite their longstanding relationship with the debtor, the creditor was held liable for the preference payment.

In performing the analysis for the ordinary course of business defense, it is important to note that the date of the transfer for checks is different under this analysis than the previous analysis dealing with whether the transfer was within the ninety day reach back period. In the previous analysis, one looks at when the debtor’s bank honored the check. See Barnhill v. Johnson, 503 U.S. 393 (1992). “For the purpose of section 547(c)(2)(B) of the Bankruptcy Code of 1978, a transfer of funds by check is effective on the date that the creditor receives the check so long as the debtor’s bank honors it within the 30-day requirement of U.C.C. §3-503(2).” Durham v. Smith Metal & Iron Co. (In re Continental Commodities, Inc.), 841 F.2d 527, 528 (4th Cir. 1988). In his opinion in Hovis v. Aerospace Solutions, Inc. (In re Air South Airlines, Inc.), Adv. Proc. No. 99-80256-W, (January 14, 2000, John E. Waites), Judge Waites discusses this aspect of the preference law and the fact that the date of the “transfer” under §547(c)(2) is different than the “transfer” under §547(b). Thus, in presenting the ordinary course of business defense, one would attempt to determine when the creditor received the payment by check and examine the pattern of conduct between the parties based upon this date. However, if the debtor’s bank does not honor the check within the ordinary period provided for in the Uniform Commercial Code, then the date of delivery becomes irrelevant to the analysis.

2.2. The Amendment to this Section by the BAPCPA.

Remember that little “and” between subsection (B) and subsection (C)? The BAPCPA changed that little “and” to an “or.” Prior to BAPCPA, the defendant had to prove (A) and (B) and (C). Now, the defendant has to prove former subsections (A) and (B) or (C). Specifically, §547(c)(2) will read:

to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was -

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

BAPCPA, § 409. Under the new law, the debt must still be incurred in the ordinary course of business. Once this element is established, the defendant can show either that the practice was ordinary between the parties or is ordinary in the industry.

In so amending the current law, it appears that Congress has abandoned the sliding scale approach found in Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044 (4th Cir. 1995). Instead, Congress appears to have adopted the analysis of In re Tolona Pizza Products Corp., 3 F.3d 1029 (7th Cir. 1993) (allowing the defendant to establish either ordinary course between the debtor and transferee or according to ordinary business terms). It is likely that initially, in examining the meaning of the amended statute, courts will use the analysis provided by the Seventh Circuit.

3. Defense -- The Contemporaneous Exchange Defense

Another defense worthy of mention is the contemporaneous exchange defense. It is embodied in section 547(c)(1)(A)-(B) which provides:

(c) The trustee may not avoid under this section a transfer --

(1) to the extent that such transfer was --

(1) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange.

The exception’s existence and purpose is to protect transactions that do not diminish the bankruptcy estate. ALFA Mutual Fire Ins. Co. v. Memori (In re Martin), 188 B.R. 689 (M.D.Ala. 1995). In this regard, it is the intent of the parties which constitutes the most critical element. See In re Hersman, 20 B.R. 569 (Bankr. N.D. Ohio 1982) (“The key inquiry, therefore, is whether the parties at the outset intended the exchange to be contemporaneous.”). Legislative history reveals the type of transaction that this exception was designed to cover:

However, for the purposes of this paragraph, a transfer involving a check is considered to be “intended to be contemporaneous,” and if the check is presented for payment in the normal course of affairs ... that will amount to a transfer that is “in fact substantially contemporaneous.”

H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 373 (1977), U.S. Code Cong. & Admin. News, p. 5787 (1978). A check, then, is the classic example. See Gover v. Ford Motor Credit Co. (In re Davis), 22 B.R. 644 (Bankr. M.D. Ga. 1982) (holding that the only type of credit transaction which would result in a transfer under the new value exception is a check transaction, which is for all practical intents and purposes really a cash transaction). Conversely, a credit card transaction is the classic bad example. In In re Hersman, the court explained:

Where goods are paid for by a check, the payor had funds in the banking institution upon which the check is drawn when he makes the check payable to the person furnishing the goods. The payee need only present the check for payment . . . When using a credit card to pay for goods, a consumer is generally seeking that which its name implies -- the extension and receipt of credit. By using a credit card, the credit card consumer does not intend a contemporaneous exchange for value. Instead, what is generally intended is the receipt of goods or services presently and time to pay for the same in the future . . . .

In re Hersman, 20 B.R. at 573.

A transaction, however, need not only be contemporaneous, but it must create new value as well. While the question of new value is always a question of fact, Creditors’ Committee v. Spada (In re Spada), 903 F.2d 971 (3d Cir. 1990), its form can be virtually anything. See Dowder v. Sharp Lumber Co. (In re Prescott), 805 F.2d 719 (7thCir. 1986) (stating that new value includes new credit, goods, services and property). In Babitzke v. Mantelli (In re Townsend-Robertson Lumber Co.), 144 B.R. 407 (Bankr. E.D. Ark. 1992), the court found new value in the retention of fees for the storing of a Chapter 7 debtor’s lumber. In In re Mantelli, 149 B.R. 154 (9th Cir. BAP Cal. 1993), however, the court held that a debtor’s payment to his wife of a civil contempt sanction did not create new value because the payment was not made for goods or services, but in lieu of a five day jail sentence.

Thus, for the exchange to be contemporaneous, the court examines whether the exchange was intended to be substantially contemporaneous and whether new value (not the satisfaction of an old value) was given in exchange for the preferential treatment. If both of these elements have been met, then the defendant has shown the affirmative defense of contemporaneous exchange.

4. Defense - New Value

Under Section 547(c)(4) the plaintiff cannot avoid a preferential transfer “to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor - (A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.” 11 U.S.C. § 547(c)(4). The new value provided can be in the form of goods or services. Basically, the courts will deduct from the preference amount the amount still due to the recipient of the payment from the debtor. In this analysis, it is important to note that (1) the new value is credited against only those payments that occur prior to the new value being given, and (2) the new value must remain unpaid at the time of the bankruptcy petition. To illustrate, the following chart may be helpful.

The value given on Days minus 70 and 60 are credited against the preference payment that occurs on Day minus 80. But no credit is carried forward. Preference Payment 2 on day minus 50 is only offset by the new value given on Day minus 40. Thus, the preference amount is $2,000 (the $5,000 Preference Payment minus the subsequent New Value).

Judge Waites has an opinion that does raise a question as it relates to the following fact pattern:

Judge Waites states that the new value exception is “netted only against the immediately preceding preference.” Hovis v. Powers Construction Company, Inc. (In re Hoffman associates, Inc.), 194 B.R. 943, 956 (Bankr. D.S.C. 1995). In this scenario, applying that logic, only the new value provided for in Day minus 70 would apply to the Day minus 80 preference payment. Thus, even though new value was extended in our scenario after both preference payments far in excess of those payments, it is possible that the Plaintiff still may recover for the $5,000 of the first preference payment.

This author believes that the use of the words “only” and “immediately” was inadvertence. Further, in examining the analysis actually performed in this opinion, one easily sees that Judge Waites does not apply the new value “only against the immediately preceding preference.” Instead, he applies it against all preceding preferences, not just the immediately preceding preference.

In fact, Judge Waites cites Crichton v. Wheeling Nat’l Bank (In re Meridith Manor, Inc.), 902 F.2d 257, 258-59 (4th Cir. 1990) for this proposition. In Meridith Manor, that bankruptcy court netted the new value “only against the immediately preceding preference.” Id. at 258. The district court then reversed this decision and opted to “off-set only prior (although not necessarily immediately prior) preferences.” Id. When faced with the decision as to which method was correct, the Fourth Circuit agreed with the district court. Thus, the correct analysis would allow the use of all subsequent new value extensions to be applied against all prior preference payments, not necessarily only the immediately prior one.

In addition to this bit of peculiarity in South Carolina, there is also a split of authority nationwide as it relates to the impact of actions that occur post petition. Specifically, is the new value exception eliminated if the new value is paid post-petition? SeeRosenthal, York and Coffey, The Impact of Post-Petition Events on Preference Liability,AMERICAN BANKRUPTCY INSTITUTE JOURNAL, Vol XXIV., No. 1, at page 28, (February 2005).

Some argue that because courts do not allow post-petition extensions of new value to be offset against preferences, that this argument should work both ways. See TennOhip Trans. Co. v. Felco Commercial Serv. (In re TennOhio Trans. Co), 255 B.R. 307, 310 (Bankr. S.D. Ohio 2000) (post-petition advances of new value may not be applied to offset preference payments). If credits cannot be used, then payments should not be used either. However, the case law seems to be split on this question. See Sun Bank/North Central Florida v. Estate of Thurman (In re Thurman Const. Inc.), 189 B.R. 1004, 1014 (Bankr. M.D. Fla 1995) (the new value must only remain unpaid as of the petition date, not when the court adjudicates the preference actions); contra Moglia v. American Psychological Ass’n. (In re Login Bros. Book Co.), 294 B.R. 297 (Bankr. N.D. Ill. 2003) (post petition payment does operate to reduce new value defense). South Carolina’s Bankruptcy Court does not appear to have weighed in on this subject.

5. Post-Petition Events Providing a Possible Defense

In situations where a debtor files a Chapter 11 proceeding, there are three events that could possibly provide a defense to later brought preference actions: (a) the critical vendor order; (b) the assumption of an executory contract and (c) the confirmation of a plan. Prior to the adoption of a plan, the logic is the same. Simply, if the pre-petition payment that is the subject of the preference action had not been made, then the cure required under the post-petition event would have been greater. Because the debtor cured the default during the Chapter 11 proceeding, and would have cured the greater default had the pre-petition payment not been made, then it does not seem appropriate to allow the court to reach back to recover pre-petition payments that were an integral part of the cure. After the confirmation of the plan, the defense seems to focus on whether the plan is sufficiently specific so as to preserve the preference action.

5.1. Treatment as a Critical Vendor

Similarly, under the critical vendor defense, the theory is that because the vendor is critical, the debtor would have cured any pre-petition default under its order authorizing payments to the critical vendor. Thus, the debtor should not be allowed to continue to deal with critical vendors during the Chapter 11 and then, recover pre-petition payments from them in a preference action. First, the courts appear to distinguish between the hypothetical critical vendor and the real critical vendor. Second, the courts seem to be less and less willing to imply a waiver of a preference action in the approval of a critical vendor payment.

In the case of Official Committee of Unsecured Creditors v. Medical Mutual of Ohio (In re Primary Health Systems, Inc.), 275 B.R. 709 (Bankr. D. Del. 2002), the Delaware Bankruptcy Court had approved a critical vendor order that allowed the debtor to pay pre-petition wage and benefits claims. Subsequently, the unsecured creditors committee brought an action against one of the providers of the benefits package for payments that it received pre-petition. The court held that its Order authorizing these critical vendor payments provided the defendant with a defense to the preference action.

Since 2002, the entire landscape of the law dealing with critical vendors has changed. See Kmart and Co-Serv. The question of whether the critical vendor defense was available was then addressed in the case of Zenith Industrial Corp. v. Longwood Elastomers, Inc. (In re Zenith Industrial Corp.), 319 B.R. 810 (D. Del 2005). In Zenith, the Delaware Bankruptcy Court had entered an order giving the debtor the discretionary authority to pay vendors that it deemed to be critical. The critical vendor order did not identify the critical vendors by name. Because it was discretionary, because no critical vendor was identified, and because the order was based more on the alleged relatively small size of the critical vendor claims rather than the actual “critical” nature of the vendor, the court found that the critical vendor defense was not available. In so doing, the Zenith court followed the logic of HLI Creditor Trust v. Export Corp. (In re Hayes Lemmerz International Inc.), 313 B.R. 189 (Bankr. D. Del. 2004). In Hayes Lemmerz, the court considered the following factors in deciding whether the critical vendor order provided a preferential defense: (a) whether the preferential payments were considered in issuing the critical vendor order; (b) whether the order was discretionary with the debtor; and (c) whether the defendant was explicitly named in the critical vendor order. After examining these factors, the Hayes Lemmerz Court declined to apply the critical vendor defense. Both Zenith and Hayes Lemmerzdistinguished themselves from Primary Health Systems by stating that Primary Health Systems dealt with claims that would be given an unsecured priority status in the bankruptcy proceeding whereas the claims that Zenith and Hayes Lemmerz were dealing with were general unsecured creditors.

However, these cases seem to focus more on protecting the Judge’s failures, than on protecting either the creditors, the bankruptcy act or commercial practices. In Zenithand in Hayes Lemmerz, the Court is concerned about its decision to give a debtor discretion, its failure to consider the impact of the critical vendor order on preference actions and its failure to even require the debtor to provide it with the names of the alleged critical vendors. If a vendor is actually “critical” there is no justification to preserve the preference action and allow a debtor to (1) beg and plead with the vendor to continue to do business with and extend credit to the debtor, (2) pay post-petition for pre-petition debts, and (3) give a creditor assurances that they will be paid if the creditor continues to do business with the debtor. This is especially true when the creditor is likely not represented by counsel and likely does not even receive notice of the critical vendor proceedings.

In distinguishing themselves from Primary Health Systems, the Courts in Zenith and Hayes Lemmerz seem to recognize their own failings in determining whether the creditor is “critical.” In bankruptcy, unsecured priority creditors are given a higher status. They are more “critical” to business and are therefore treated better in our bankruptcy system. Thus, the Zenith and Hayes Lemmerz courts treat these critical vendors better than unsecured creditor vendors. But unsecured priority creditors have to wait, just like regular unsecured creditors, for distributions. “Critical” vendors are supposed to be of a higher priority than either general unsecured or unsecured priority creditors, because “critical” vendors get paid and do not have wait. If the creditor truly is “critical,” whether the creditor would also be general unsecured or unsecured priority is a distinction without a difference.

If a waiver of preference actions is not implied in a critical vendor order than it should be expressly stated in the order. See In re Tropical Sportswear Int’l Corp., 320 B.R. 15 (Bankr. M.D. Fla 2005) (expressly waiving preference claims against critical vendors). To do any less would be to allow a debtor, through the auspices of the Court, to perpetrate a fraud upon the very vendors that the debtor and the Court has deemed to be “critical” to the reorganization of the debtor’s business.

5.2. Assumption of an Executory Contract as a Defense.

The Fourth Circuit Court of Appeals does not appear to have addressed this situation. Four other circuits have. The Eleventh Circuit addressed this situation in the case of Seidle v. GATX Leasing Corp., 778 F.2d 659 (11th Cir. 1985). In Seidle, the executory contract involved the lease of an aircraft. The debtor was allowed to retain possession of the aircraft because of the cure of the default pre-petition. The court disallowed the trustee’s preference action using the following logic:

Under the trustee’s proposed interpretation, the debtor, anticipating his impending bankruptcy filing, could make all payments to the financer of the aircraft, creating no pre-petition defaults that would have to be cured under a stipulation. After entering into the stipulation and securing possession of the aircraft, the debtor or trustee could simply reclaim the payments made during the ninety-day pre-petition preference period. This result nullifies the financer’s guarantee that the debtor meet all previous contractual obligations in order to retain possession of the aircraft. Id. at 664.

The court reasoned that it would be incongruous to allow the debtor to make payments pre-petition, thereby lessening the amount needed to cure defaults post-petition, continue operation of the executory contract during the chapter 11 proceeding, assign the executory contract as part of a sale to the purchaser of the debtor’s property curing all defaults in this process and then recover the pre-petition payments using a preference action.

The Ninth Circuit addressed a similar situation in the case of Alvarado v. Walsh (In re LCO Enterprises), 12 F.3d 938 (9th Cir. 1993). In that case, the court specifically addressed whether the fifth element of a preference action had to take into consideration the events that transpired during the Chapter 11 proceeding. The fifth element is the hypothetical chapter 7 liquidation analysis. The Ninth Circuit specifically held that the Chapter 11 events must be taken into consideration during the Chapter 7 liquidation analysis. In LCO Enterprises, the debtor had made partial rent payments in the ninety days prior to the bankruptcy petition. In the Chapter 11 proceeding, the debtor continued to rent the space from the landlord and sought to assume the executory contract. The court held that in bringing the preference action, the debtor sought “to obtain the benefits of both assumption and rejection, i.e. continued possession of the property and recovery of the prepetition rent. That would not be possible in Chapter 7. It is not possible in chapter 11.” Id. at 943.

In the case of In re Superior Toy & Manufacturing Co., 78 F.3d 1169 (7th Cir. 1996), the Seventh Circuit addressed this area of the law. Again, payments were made prepetition on an executory contract, this time to cure a default in royalty payments that were due. When the case was converted, the trustee sought to set aside the payments as a preference. The court held that Section 365 “was clearly intended to insure that the contracting parties receive the full benefit of their bargain if they are forced to continue performance . . . ‘full benefit of his bargain’ must refer to the full amount due the contracting parties, not just the amount they are entitled to for future performance.” Id. at 1174. Thus, the Seventh Circuit joined the Eleventh Circuit and the Ninth Circuit in dismissing the preference action based upon pre-petition payments under an executory contract that was later cured, assumed, and assigned in a Chapter 11 proceeding.

Recently, in the case of Kimmelman v. The Port Authority of New York (In re Kiwi Int’l Air Lines, Inc.), 344 F.3d 311, 318-19 (3rd Cir. 2003), the Third Circuit joined in the logic of the other circuits and stated that:

The trustee’s characterization of the defendant’s claim as unsecured on the filing date seems to presuppose that a hypothetical Chapter 7 trustee would have elected to reject the debtor’s agreements with them. . . . However, the agreements here were not rejected, and they would not necessarily have been rejected in a hypothetical Chapter 7 liquidation. Once the debtor assumed the agreements, the defendants . . . were entitled, pursuant to § 365 to full payment of the amounts owed under the agreements.

The court reasoned that because the creditor would have been entitled to full payment, the preference action should be dismissed.

Thus, it seems that the assumption of the executory contract provides a pretty good defense to any preference action, even in situations where the possible preference action is never mentioned during the assumption process or the order allowing the assumption of the executory contract.

5.3. Preservation of a Preference Action in the Plan

This defense started in cases that did not deal with avoidance actions. In Eubanks v. Federal Deposit Insurance Corp., 977 F.2d 166 (5th Cir. 1992), the court was examining a post confirmation lender liability claim brought by the reorganized debtor against his secured lender based upon the secured creditors pre-petition actions. The Court held because the secured lender was a creditor under the plan, his claim was determined by the confirmation of the plan and any challenge to this claim could have been brought prior to confirmation. Id. at 174. The court went on to hold that the confirmed plan was res judicata as to the lender liability action. Id. Similarly, in Browning v. Levy, 283 F.3d 761, 774 (6th Cir. 2002), the Sixth Circuit held that the plan’s “blanket reservation” of causes of action did not preserve a malpractice claim and breach of fiduciary duty claim against a law firm that was also a creditor of the debtor. Both the Fifth and Sixth Circuits seem to hold that Section 1123(b)(3) requires plans to provide for settlement, adjustment or retention of some entity to prosecute the claims belonging to the debtor. This plan requirement, combined with the disclosure statements requirement of “adequate information,” seem to require some notice as to what claims are being settled, adjusted or retained. Both the Fifth and Sixth Circuits held that the blanket reservation failed to provide the sufficient notice and therefore, the action was not retained.

Some bankruptcy courts have applied this same logic to preference actions. In the case of Mickey’s Enterprises, Inc. v. Saturday Sales, Inc. (In re Mickey’s Enterprises, Inc.), 165 B.R. 188 (W.D. Tex. 1994), the court was examining a preference action against a creditor of the estate. The court held that the preference action stemmed from the same nucleus of operative facts as the debtor’s proof of claim, the “existing and continuing business relationship.” Id. at 192. The court went on to hold that res judicataapplied. As it relates to the same nucleus of operative facts, the superficial treatment of this analysis by this court suggests a lack of understanding of preference litigation. One only has to look at the elements of a preference action and compare them to an action on an invoice or open account to realize these two distinct legal theories do not stem from the same nucleus of operative facts.

Further, most Federal Courts do not even use the general term res judicata. Federal Courts examine the preclusive effects of prior determinations in terms of either claims preclusion or issue preclusion. See 18 FEDERAL PRACTICE AND PROCEDURE, § 4402, at 6 (1981) (“the distinctive effects of a judgment [are] separately characterized as ‘claim preclusion’ and ‘issue preclusion’”).

Claims preclusion has the “effect of foreclosing any litigation of matters that never have been litigated, because of a determination that they should have been advanced in an earlier suit.” Id.; see also Kaspar Wire Works, Inc. v. Leco Engineering & Mach., Inc., 575 F.2d 530, 535-36 (5th Cir. 1978). Under claims preclusion, a judgment does not preclude everything that may have been disputed between the parties, it only precludes matters within a certain sphere. 18 Federal Practice and Procedure, § 4406 , at 45 (1981). “Claim preclusion cannot extend beyond the limits of an action that can be brought before a single court.” 18 Federal Practice and Procedure, § 4407 at 51 (1981).

The contemporary approach uses a “transactional definition of a claim or cause of action” to determine the scope of claims preclusion. 18 Federal Practice and Procedure, § 4407 at 55 (1981); see also Restatement Second of Judgments, Section 24 (1981). Basically, a claim extinguished by a first judgment includes:

all rights of the plaintiff to remedies against the defendant with respect to all or any part of the transaction, or series of connected transactions, out of which the action arose. 18 Federal Practice and Procedure, § 4407, at 55 (1981); see also Restatement Second of Judgments, § 24 (1981).

Thus, the Court must examine the transactions associated with the claim, specifically the elements of the cause of action that would create the claim, and compare those with the elements of the cause of action or claim seeking to be precluded.

Issue Preclusion has the “effect of foreclosing relitigation of matters that have once been litigated and decided.” 18 FEDERAL PRACTICE AND PROCEDURE, § 4402, at 6 (1981); see also Kaspar Wire Works, Inc. v. Leco Engineering & Mach., Inc., 575 F.2d 530, 535-36 (5th Cir. 1978). Issue preclusion involves the determination of the following issues:

1. Issue preclusion arises in the second action on the basis of a prior decision when the same “issue” is involved in both actions;
2. The issue was “actually litigated” in the first action, after a full and fair opportunity for litigation;
3. The issue was “actually decided” in the first action, by a disposition that is sufficiently “final,” “on the merits,” and “valid”;
4. It was necessary to decide the issue in disposing of the first action and - in some decisions - the issue occupied a high position in the logical hierarchy of abstract legal rules applied in the first action;
5. The later litigation is between the same parties or involves non-parties that are subject to the binding effect or benefit of the first action;
6. The role of the issue in the second action was foreseeable in the first action, or it occupies a high position in the logical hierarchy of abstract legal rules applied in the second action; and
7. There are no special considerations of fairness, relative judicial authority, changes of law, or the like, that warrant remission of the ordinary rules of preclusion.

18 FEDERAL PRACTICE AND PROCEDURE, § 4416 at 138-39 (1981). Since the argument is that the avoidance action was not disclosed prior to the confirmation of the plan, it can hardly be argued that the preference action was actually litigated.

Thus, neither claims preclusion nor issue preclusion should be a basis upon which a court should hold that an avoidance action is not preserved by a blanket reservation. However, the requirement for adequate information provides a more difficult analysis.

In the recent case of Elk Horn Coal Co., L.L.C. v. Conveyor Mfg & Supply, Inc. (In re Pen Holdings, Inc.), 316 B.R. 495 (Bankr. M.D. Tenn. 2004), the Court was addressing a similar challenge against preference actions. In Pen Holdings, the plan defined “avoidance actions” as, among other things, the actions under sections 510, 541, 544, 545, 546, 547, 548, 550 and 553 of the Bankruptcy Code. Id. at 497. It then went on to retain the right to prosecute these avoidance actions. Id. The Middle Tennessee bankruptcy court found that the adequate information needed to retain actions was for creditors, not for defendants. Id. at 504. Therefore, naming specific defendants was not necessary. Id. That seems to be a pretty good argument. Adequate information means:

information of a kind, and in sufficient detail, as far as is reasonably practicable in light of the nature and history of the debtor and the condition of the debtor’s books and records, that would enable a hypothetical reasonable investor typical of holders of claims or interests of the relevant class to make an informed judgment about the plan ...

11 U.S.C. §1125(a)(1). So technically, adequate information is not directed at a creditor, it is directed at a “hypothetical reasonable investor typical of holders of claims.” Id. Clearly, adequate information is not directed toward defendants in avoidance actions.

The Pen Holding court found that avoidance actions are “fundamentally different” than the malpractice and breach of fiduciary duty claims found in Browning. 316 B.R. at 504. The court reasoned that they are fundamentally different because (a) they are so numerous that typically debtors do not even complete their preference analysis prior to proposing a plan and to require a debtor to do so is “not practicable,” (b) it is a common practice to simply preserve these actions in plans; and (c) nothing in Section 1123 requires that the matters be set out more specifically. Id. The court concluded that “preserving the value of preferences for distribution to creditors after confirmation should be easily accomplished in the plan without magic words or typographical traps.” 316 B.R. at 505.

6. Conclusion

Prosecuting and defending preference litigation is not for the generalist. The elements of a preference action pose a complex web of potential hazards for the one prosecuting and potential loopholes for the one defending. Similarly, the defenses are developing into ever more complex areas as the fact intensive and case specific holdings are sought to be generalized into principals that can be understood and implemented.