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Bankruptcy Amendments
Improve Preference Defenses

By Lynnette R Warman

Jenkens & Gilchrist

Beginning with cases filed on October 17, 2005, unsecured creditors will have improved preference defenses to use to defeat attempts by debtors or trustees to obtain the return of payments deemed preferences under the Bankruptcy Code. On April 20, 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act"), ending nearly a decade of debate about the most major revisions to the Bankruptcy Code in nearly 30 years. The main focus of the legislation is to modify consumer bankruptcy provisions, most notably imposing the requirement that a consumer must pass a "means test" as a condition to filing a chapter 7 bankruptcy proceeding. However, there are significant modifications of corporate bankruptcy provisions as well, including changes to the preference statute.

The primary statute governing preferences under the Bankruptcy Code is 11 U.S.C. 547, which defines preference causes of action and defenses. Under the Act, Section 547 of the Bankruptcy Code has been changed in several ways to improve creditor defenses. Other statutes which work in conjunction with Section 547 have been changed as well.

Perhaps the most significant change in Section 547 as to unsecured creditors is the amendment which will make it easier for creditors to raise the "ordinary course of business" defense to preference actions. Before the Act becomes effective, a creditor must show that an alleged preferential payment 1) was made on a debt incurred in the ordinary course of business, 2) was made in the ordinary course of business, and 3) was made according to ordinary business terms, in order to prevail on the ordinary course of business defense to a preference.

Under the Act, a creditor asserting the ordinary course defense must only satisfy the first element and then either the second or third element of Section 547(c)(2). Specifically, the creditor must show that the disputed transfer was 1) payment of a debt incurred in the ordinary course of business and either (2)(A) made in the ordinary course of business or (2)(B) made according to ordinary business terms. The net effect of these changes will be to lessen the number and the amount of lawsuits and damages potentially recovered in preference actions. These provisions should be a real benefit to most unsecured creditors.

The second major change in the Act which will affect preference lawsuits is the imposition of minimum amounts for which preference demands may be made. The revised Section 547 provides that a trustee (or debtor) will not be able to avoid transfers that are or affect less than $5,000 in a case where the debts are primarily commercial debts. The debtor or trustee is also prohibited from recovering transfers that are or affect less than $600 in an individual debtor case involving primarily consumer debts. There may be some disagreement as to whether a series of payments within the preference period can be aggregated to meet this minimum, so this issue may be decided by the courts.

The third major change limits the venue, or the location of the court in which a preference action may be filed. If the preference lawsuit is filed to recover an amount less than a certain amount, it must be filed in the district in which the defendant resides. For example, in a suit against a creditor involving a commercial debt, if the amount demanded is less than $10,000, the lawsuit must be filed in the district in which the creditor resides.

The fourth change involves the "DePrizio Rule". Some of us still remember issues regarding preference exposure to lenders when payments were made to the lender between ninety days and one year prior to a bankruptcy filing which reduced an insider's liability to the lender. Many commentators believed the issue was laid to rest by the amendments to the Bankruptcy Code which became effective in 1994. Apparently, however, there was a fear that some potential liability to lenders survived the 1994 amendments, so in order to eliminate any doubt, the Act amends Section 547 of the Bankruptcy Code to provide that if the trustee avoids a transfer given by the debtor to a noninsider for the benefit of an insider creditor between 90 days and one year before filing, that avoidance is valid only with respect to the insider creditor.

Finally, there are several other changes which will affect potential preference liability. The definition of "transfer" is changed to include the creation of a lien and the retention of title as a security interest. This makes clear that obtaining a lien within the preference period is a transaction that could be avoided as a preference. However, the impact of that change is somewhat lessened by another change under the Act, which amends Section 547(e)(2) of the Bankruptcy Code to increase the perfection period from 10 to 30 days for the purpose of determining whether a transfer is an avoidable preference. That will give creditors a much longer time to get filings in order and avoid, or at least have a good defense, to a preference demand.

While these changes are a positive development for unsecured creditors, and do provide additional defenses, it is important to understand the amendments for the relief they provide, and for what they do not provide. The new amendments only make available certain additional defenses to creditors. As a result, the appropriate defense actually be asserted by the creditor, wither in response to a preference demand or in a pleading filed if a lawsuit is filed. The amendments do not prohibit trustees or debtors from asserting preference claim. So, the bad news is that preference demands won't just go away after October 17, 2005, and, if they are asserted, creditors will still have to respond to them.

In short, the amendments to the Bankruptcy Code as to preferences are a good start. Once the amendments become effective and are implemented, there should be fewer preference demands made and fewer lawsuits filed. However, if history is any indicator, it may take some time before the full impact of the amendments becomes fully apparent to all parties, and an actual reduction occurs in the number of preference demands that are made upon creditors.

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