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New Bankruptcy Decision Sheds Light on Ordinary Course Defense to Preferences

Posted on Feb 22, 2013 in Bankruptcy, Bankruptcy Information, Wisconsin

A recent decision in the Eastern District of Wisconsin educates us on the old – preferences – and the new – a novel defense.  This will be helpful in both Chapter 7 and Chapter 13 cases.

First – what is a preference?

11 U.S.C. § 547(b) defines preferential transfers.

Section 547 provides that the trustee may avoid (or set aside) transfers of the debtor’s interest 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 the petition was filed; or (B) if the creditor was an insider, on or within one year before the date the petition was filed; and
  5. that enabled the creditor to receive more than the creditor would have received if – (A) the case were a case under Chapter 7 of the Bankruptcy Code; (B) the transfer had not been made; and (C) the creditor received payment of such debt to the extent provided by the provisions of Chapter 7

How does this work in real life?  Let’s take a recent example.  This client did not file a Chapter 7 for the reasons below (as well as concerns about equity in her property).

Daughter borrows $20,000 from her father.  This is treated as a loan, not a gift.  There likely is no written contract, but payments are made regularly and are expected.  Therefore, father is a creditor.  Prongs 1 and 2 are satisfied.  Payments are made in the year before filing, so prong 4 is satisfied.  The debtor, while she may have equity in assets, was still likely insolvent due to her high credit card debt, so prong 3 is satisfied.  Prong 5 might be a question, because we don’t know what amount her father would have received from the trustee if she filed and held equity.  Still, the odds were high that the father would have been sued by the trustee to recover the money she repaid him.

One defense to a preference payment is discussed in a case called In re Grisham.
The defense is called “the ordinary business defense”.  How do we establish this?

First, the debt must be incurred in the ordinary course of business  or financial affairs of the debtor and vendor.  Second, the transfer must have been made in the ordinary course of business or financial affairs of the debtor and vendor. This element is often referenced as the “subjective” test to the ordinary course of business defense  Third, the transfer must have been made according to ordinary course of business terms within the respective industry. This element is often referenced as the “objective” test of the ordinary course of business defense.  See “In Defense of a Preference,” Business Credit,  Sept., 2004, Pages 36-39

This case is important because it establishes that repayment of a personal loan to a family member could fall under the ordinary course defense.  Both the Judge and trustee appeared surprised by the arguments of the debtor and the case law they provided.  But the debtor ultimately lost because she couldn’t produce any evidence that the loans were in the ordinary course of her uncle’s business.  Make no mistake, proving this defense is very difficult and rare.  It isn’t often that both a debtor and their family member are both in the business of borrowing and repaying money.

The moral here is that sometimes there are defenses to these preferences.  Talk to Lakelaw before filing about pre-filing transfers of money, repayments of loans, and we’ll see if we can argue against a turnover of the money.

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