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.