Tag Archives: preference

November 10, 2015

The Tenth Circuit Joins the Sixth, Seventh and Ninth Circuits in Holding that a First-Time Transaction May Qualify for the Ordinary Course Defense under 11 U.S.C. sec. 547(c)

In issuing its decision in Jubber v. SMC Electrical Products, Inc. (In re C.W. Mining Company), 2015 WL 4717709 (10th Cir. 2015), the Tenth Circuit joined the Sixth, Seventh and Ninth Circuits in holding that a first-time transaction between the debtor and a creditor may qualify for the ordinary course defense of § 547(c). [1]  In C.W. Mining the debtor purchased equipment from SMC with the intent of changing its mining operation from continuous mining to longwall mining.  The debtor and SMC had never conducted business with each other before.  The debtor paid SMC $200,000 on for the equipment within ninety days before filing bankruptcy.  The bankruptcy trustee asserted the payment was a preference, but SMC contended the payment was made in the ordinary course.  While noting that it construes preference defenses narrowly, the court reiterated that the ordinary course defense is “intended to leave undisturbed normal financial relations,” and a payment will be within the defense if it is in the ordinary course of both the debtor and the transferee.  The court noted that several bankruptcy courts have held that first-time transactions cannot qualify for the defense, interpreting the statute as requiring the transaction to be in the ordinary course of business between the debtor and the transferee.  The Tenth Circuit declined to follow these decisions and instead agreed with its sister circuits to decide the issue that a first-time transaction can qualify for the defense.

In reaching its conclusion, the Tenth Circuit looked to the language of the statute itself, and noted that it stated the defense refers to ordinary course of business or financial affairs of the debtor and the transferee, not to the business or financial affairs between the debtor and the transferee.  The Tenth Circuit agreed with the Seventh Circuit’s analysis in Kleven  that “the court can imagine little (short of the certain knowledge that its debt will not be paid) that would discourage a potential creditor from extending credit to a new customer in questionable financial circumstances more than the knowledge that it would not even be able to raise the ordinary course of business defense, if it is subsequently sued to recover an alleged preference.”  Kleven, 334 F.3d at 643). 

The court stated that it had previously defined “ordinary business terms” to mean “those used in ‘normal financing relations’: the kinds of terms that creditors and debtors use in ordinary circumstances, when debtors are healthy.”  In re Meredith Hoffman Partners, 12 F. 3d. at 1553.  As a result, the court said that determination of what is ordinary contemplate an examination of what is ordinary in the relevant industry, not what is ordinary in each party’s respective practices.  Agreeing with the Ninth Circuit in Ahaza, the Tenth Circuit concluded that a “first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties.”  In re Ahaza Sys., Inc., 482 F.3d at 1126. 

The Tenth Circuit’s decision reached a balance between the justification for allowing an ordinary course defense for a first-time transaction and the general policy of the preference statute to discourage unusual action by either the debtor or its creditors during the debtor’s slide into bankruptcy.

[1] The sister circuit opinions are:  (1) Gosch v. Burns (In re Finn), 909 F.2d 903 (6th Cir. 1990); (2) Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003) and (3) Wood v. Stratos Prod. Dev., LLC (In re Ahaza Sys. Inc.), 482 F.3d 1118 (9th Cir. 2007).

August 4, 2015

In a Case of First Impression at the Circuit Level, Ninth Circuit Holds an Insider Who Waives his Right to Indemnification from the Debtor is not a “Creditor” for Purposes of Preferential Transfers Under Sec. 547 of the Bankruptcy Code

In a case of first impression at the Circuit Level, the Ninth Circuit has held that an insider who waives his right to indemnification from a debtor is not a “creditor” for purposes of preferential transfers under § 547(b)(4). The facts before the court in Alberta Stahl, Chapter 7 Trustee v. Simon (In re Adamson Apparel), 2015 WL 2081575 (9th Cir. 2015) were straightforward.  Arnold Simon was an insider of Adamson Apparel and personally guaranteed its debt to CIT Group.  The guaranty provided that Simon to irrevocably waived his right of indemnification by Adamson Apparel in connection with the loan.  There was no indication that the waiver was a sham.  More than 90 days before Adamson Apparel filed bankruptcy, it paid almost $5,000,000 to CIT in partial satisfaction of its debt.  Following Adamson Apparel’s bankruptcy filing, Simon paid with his personal funds the remaining $3,500,000 owed to CIT by the debtor.  Simon did not file a proof of claim against the bankruptcy estate for the funds he personally paid to CIT on account of his guaranty.  The Trustee filed an adversary proceeding against Simon seeking recovery from him of the $5,000,000 paid by the debtor to CIT as a preference. 

The issue before the court was whether the trustee could recover the debtor’s payment to CIT from Simon as a preference because the payment benefitted him, or whether the trustee’s recovery was precluded by the fact that Simon was not a creditor of the debtor as a result of his waiver of his right of indemnification by the debtor.  In addressing this issue, the Ninth Circuit noted that there was a split among the bankruptcy courts on this issue but no opinions at the district or circuit level answering the question.

The court noted first the plain language of § 547(b)(4), which provides that a preference includes a transfer made between 90 days and one year before the bankruptcy filing if the creditor involved is an insider of the debtor.  There was no dispute that Simon was an insider, and the focus of the court’s analysis was whether he should be considered a creditor despite his waiver of indemnification.  The trustee relied on numerous bankruptcy court decisions which hold that insider waivers of indemnification are invalid because the insider could conceivably purchase the debt rather than just paying under the guaranty.  Bankruptcy courts adopting this line of reasoning do so on the opinion that such waivers are sham provisions unenforceable as a matter of public policy.  Other bankruptcy courts have concluded that such waivers are not ipso facto against public policy and have held that an insider who waives his indemnification right in good faith is not a creditor and, therefore, not subject to preference liability under the plain language of the statute.

The Ninth Circuit agreed with those courts who hold that a good faith waiver of indemnification insulates an insider from preference liability.  The court stated that the potential that a waiver may be a sham does not mean it actually is, rejecting an analysis based on what could happen and holding a court instead should focus on what has happened in the case before it.  In the present case, Simon irrevocably waived his right of indemnification in the guaranty, and nothing in the guaranty or other loan documents gave him a contractual right to purchase the debt from CIT.  As a result, the court concluded that, had Simon approached CIT with a proposal to purchase the debt, there was no certainty that CIT would have agreed to sell it to Simon.  The court considered the absence of this contractual right a key factor, stating that had Simon had a contractual right to purchase the debt but did not do so, the court would be more concerned with the waiver being a sham.  With these facts before it, and the plain language of § 547 requiring the insider to be a creditor, the court concluded that the trustee could not recover the debtor’s payment to CIT from Simon.

February 18, 2014

Sixth Circuit Answers Two Questions of First Impression in Connection with Motions for Relief—(1) A Creditor Bears the Burden to Prove Validity of its Lien and (2) A Trustee May Allege an Expired Preferential Transfer Defensively to Defeat Relief from S

The Sixth Circuit in its recent opinion in Grant, Konvalinka & Harrison, P.C. v. Still (In re McKenzie), 737 F.3d 1034 (6th Cir. 2013) recently addressed two questions of first impression in the circuit:  (1) as between the creditor and the bankruptcy trustee, who bears the burden under § 362(g) to prove the validity (or non-validity) of the creditor’s lien and (2) if the trustee’s action to avoid the lien as a preference is barred by limitations under § 546, may the trustee nevertheless use the preference to defeat the secured creditor’s motion for relief?  The Sixth Circuit held the secured creditor bears the burden to prove the validity of its lien under § 362(g) and the trustee may use a preference claim defensively to defeat a motion for relief.

In connection with the burden of proof issue, the creditor contended that the burden is on the trustee to establish the invalidity of the secured creditor’s lien or security interest.  The creditor argued that § 362(g) itself mandated this conclusion.  Section 362(g) provides that, in a hearing on a motion for relief, the party seeking relief from stay has the burden of proof on the issue of the debtor’s equity in the property, and the party opposing relief has the burden on all other issues.  The creditor contended that the plain language of the statute required the burden to be placed on the trustee to prove the lien to be invalid.  The court disagreed, stating that “while this plain-language argument by [the creditor] has some surface appeal,” the argument ignored the fact that whether the debtor has equity in the property in question will be determined in large part by whether the secured creditor’s lien is valid and enforceable against the property.  In short, determining the validity of the asserted lien was part and parcel of determining whether the debtor has an equity in the property.  The court noted the lack of any case authority at the circuit or district level on the issue, but did cite to a number of bankruptcy court decisions throughout the country which were in accord.  Further, the court stated that placing the burden of proof on the creditor made sense as a matter of sound judicial policy because the creditor would likely be in the best position to establish whether its lien is valid. 

The issue whether the trustee could assert his preference claim defensively against the motion for relief presented another interesting matter of first impression for the court.  The preference arose from the debtor’s pre-petition conduct in executing a promissory note and granting a security interest in various assets in payment of an antecedent debt.  The trustee did not seek to avoid the grant of the security interest within the time required by § 546(a)(1).  However, the trustee asserted that the bankruptcy court properly denied the motion because the assets which were the subject of the motion had been preferentially transferred to the secured creditor.  Thus, the trustee argued that, even though he was precluded from avoiding the lien as a preference, the secured creditor should not be allowed to foreclose its security interest in the assets.  The trustee’s argument was grounded in § 502(d), which requires a bankruptcy court to disallow a claim of any creditor who received a preference, unless the creditor has turned over the property for which the creditor is liable under § 550.  The Sixth Circuit concluded that the trustee could use the preference as a defense to the motion for relief, and based its decision on the language of § 502(d).  However, the cases cited by the court for support of its conclusion were in the context of objections to claims.  In re Meredosia Harbor & Fleeting Serv., Inc., 545 F.2d 583, (7th Cir. 1976), a bankruptcy referee under the Act sold assets which were subject to preferential liens.  The secured creditors did not object to the sale, but did assert claims to the proceeds, and the trustee countered that the liens were preferential and the claims to the funds should be treated a general unsecured claim.  The Seventh Circuit held that the trustee’s preference claim was in the nature of “recoupment” and therefore could be asserted defensively even though limitations to avoid the liens had run.  In re Cushman Bakery, 526 F.2d 23 (1st Cir. 1975), under the Bankruptcy Act, the First Circuit held that a trustee properly asserted a barred preference action to defeat the creditor’s asserted unsecured claim.  The Sixth Circuit also relied on the 9th Cir. BAP’s decision in In re KF Dairies, Inc., 143 B.R. 734, where the BAP stated that “statutory time-bars are inapplicable to matters of defense, where no affirmative relief is sought.” 143 B.R. 734, 737-38. 

The Sixth Circuit’s reliance on three decisions rendered in the context of claims litigation ends with a problematic result for trustees and creditors alike and requires us to question whether the language of § 502(d) should apply to motions for relief from stay.   The trustee in McKenzie succeeded in defeating the creditor’s motion for relief.  However, because his preference action is time-barred, he cannot avoid the lien and any sale of the assets in question will result in the creditors’ lien attaching to the proceeds of sale.  The result of the opinion may be simply to require secured creditors whose liens may have been preferential transfers to await abandonment of the property or a closing of the case before exercising their lien rights. 

December 10, 2013

Tenth Circuit BAP Holds Debt Incurred for New Operating Procedures can be “Ordinary” for Purposes of Section 547(c)(2)(A)

The Tenth Circuit BAP recently addressed a case which presented the question “how ordinary is ordinary?”  In its decision in Rushton v. SMC Electrical Products, Inc. (In re: C.W. Mining Company), 500 B.R. 635 (10th Cir. BAP 2013), the BAP addressed an appeal from a claim by a chapter 7 trustee asserting a preference action against an equipment vendor who defended the action asserting the incurring and payment of the debt was in the ordinary course of business under 11 U.S.C. sec. 547(c)(2)(A). 

The debtor, C.W. Mining, had operated a mine using a process known as the “continuous mining” process.  Prior to filing bankruptcy, the debtor contracted with SMC Electrical Products for the purchase and installation of a longwall electrical system.  Longwall electrical mining is a different process of mining from the continuous mining process, so the acquisition of the longwall electrical system from SMC enabled the debtor to change its historical method of operations.  SMC issued a purchase order to the debtor for the longwall system, and the agreement between the debtor and SMC provided that the debtor would make progress payments as it received invoices from SMC.  The last invoice issued before the debtor was placed into involuntary bankruptcy exceeded $800,000.  This invoice was paid through five payments from three different sources, including at least one payment from an affiliate of the debtor.  The payment by the debtor which the trustee sought to avoid had been made 28 days after the invoice was issued.  SMC introduced evidence showing that it customarily received payments of large invoices over the course of several payments, payments from affiliates of its customer and payments utilizing the same timing as was the case with the debtor.

The ordinary course defense provides that a trustee may not set aside a payment of a debt that of a “debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor.”  11 U.S.C. sec. 547(c)(2).  The trustee argued that, because the debt was incurred by the debtor in order to effect a complete change of its mining system from continuous mining to longwall mining, the debt would not be considered as having been incurred in the ordinary course of the debtor’s business.  The BAP disagreed.  The BAP stated that the purpose of the preference statute is to “prevent creditors from exerting undue pressure on struggling debtors” and to “discourage ‘unusual action’ that might ‘favor certain creditors or hasten bankruptcy by alarming other creditors and motivating them to force the debtor into bankruptcy to avoid being left out.’” (citing Milk Palace Dairy, LLC v. L&N Pump, Inc. (In re Milk Palace Dairy LLC), 385 B.R. 765, 771 (10th Cir. BAP 2008)).  The BAP further stated that the purpose of the ordinary course defense is “’to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor’s slide into bankruptcy.’” (citing In re M&L Business Machine Co., 84 F.3d at 1339-40). 

The BAP further noted that the fact that the debtor and the creditor had no prior dealings before the transaction in question does not preclude application of the ordinary course defense.  The term “incurred” for purposes of section 547(c)(2) focuses on whether the debt was incurred in a typical, arms-length commercial transaction that occurred in the marketplace, or whether it is atypical, fraudulent or not consistent with an arms-length commercial transaction.  (citing 5 Collier on Bankruptcy ¶ 547.04[2][a][i]).  Consequently, the fact that the transaction between the debtor and SMC was one under which the debtor effected a significant change to its business operations was not determinative.  Instead, focusing on the fact that the underlying transaction was a typical arms-length transaction in the marketplace, the court concluded that the debt arising from the transaction was incurred by the debtor in the ordinary course of its business.   In short, the transaction need not be common, just ordinary.  (citing Huffman v. New Jersey Steel Corp. (In re Valley Steel Corp.), 182 B.R. 728 (Bankr. W.D. Va. 1995)).