JOURNAL
AMERICAN
BANKRUPTCY
INSTITUTE
Issues and Information for Today’s Busy Insolvency Professional
Prosecuting Preference Actions Post-BAPCPA:
Another View Toward a Reliable Statistical Model
Written by:
Gregory S. Abrams
A·S·K Financial LLP; Los Angeles
[email protected]
Joseph L. Steinfeld Jr.
A·S·K Financial LLP; Minneapolis
[email protected]
Joseph A. Hess
A·S·K Financial LLP; New York
[email protected]
I
n “Defending Preference Actions:
Optimal Strategies for Comprehensive
Mathematical Analysis,” published in
the October 2006 issue of the ABI
Journal, Kurt A. Winiecki advocated
using certain statistical tools to augment
a defendant’s claim
that
challenged
transactions may be
within the subjective
course of prior
business dealings.
While Mr. Winiecki
is to be commended
for using a matrix
approach
to
Gregory A. Abrams
formulating
a
subjective “ordinary
course of business” (OCB) defense to
preference liability, his methodology,
standing alone, fails to enunciate the basis
for establishing the critical element of that
defense—identifying the proper historical
baseline between the debtor and the
preference recipient. Instead, Mr.
Winiecki merely postulates various
potential deviations from the historic
average payment time to see what the
result will be with respect to remaining
liability. His purpose, of course, is to draw
a range of normalcy that minimizes the
net claim amount.
We take a different approach by assessing ordinariness based on the statutory
purpose of avoiding discrimination
About the Author
Gregory Abrams is the founding principal
and co-managing partner of the A S K
Financial LLP and architect of its custom
software. Joseph Steinfeld is the comanaging partner and heads the firm’s
litigation practice. Joseph Hess is A·S·K
Financial’s resident partner in New York.
among creditors while acknowledging the
need for debtors to receive normal and
consistent payments on credit to avoid
premature bankruptcy filings. This is the
only way to produce a meaningful and fair
result as is necessary to ensure equality of
alternatively, using a
“days
to
pay”
approach when a
term change occurs
during or just prior to
the preference period
(a sign indicative of
abnormality). Other
statistical tools such
as age bucketing, use Joseph A. Hess
of weighted averages,
establishing running balances, evaluation
of improvement in position and analysis of
individual checks and associated invoices
(to establish batching or unusually large
payments) are necessary if one is to fully
and fairly evaluate the subjective OCB
Feature
treatment of creditors.
Behind all statistical arrays there also
must be a rationale that will move
opposing counsel and/or the court to an
advocate’s position. To accomplish this,
we
take
Mr.
Winieck’s analysis
to the next level. We
explore
various
methodologies from
which to establish
the parties’ baseline
of dealings for
purposes of the
subjective prong of Joseph L. Steinfeld Jr.
the OCB defense.
Also, we explore the rational bases for
setting a range of normalcy, including
reference to the statistical array of historic
payments, the use of deviation
percentages and accounting for the credit
term as indicative of an acceptable range.
Further, we discuss using a “days past due”
approach when one desires an objective
element in the case snapshot, or
defense. Finally, we consider the changes
implemented by the Bankruptcy Abuse
Prevention and Consumer Protection Act
of 2005 (BAPCPA) on the OCB defense.
Illustrating the “Baseline of
Dealings” for Purposes of the
Subjective OCB Test
The OCB defense contains three
elements. First, the debt at issue must
have been incurred in the ordinary course
of the parties’ business relationship. 11
U.S.C. §547(c)(2)(A). This is rarely at
issue and is usually conceded. Second,
the payment must accord with the parties’
prior course of conduct (the Subjective
Test). 11 U.S.C. §547(c)(2)(B). Historically, this has been the most litigated
aspect of the defense as it is less
expensive to prove than the industry
standard test, which often requires expert
testimony. The third element of the
defense is the so-called Objective Test,
which requires that the payment at issue
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accord with “ordinary business terms.” 11
U.S.C. §547(c)(2)(C). As BAPCPA now
makes the Subjective Test and Objective
Test disjunctive (the law changed the
“and” between these elements to an “or”),
parties are more likely to litigate this
issue, and perhaps the inquiry will be
more complex than was the case in the
past. (See our discussion below at Part
IV.)1 Thus, counsel on both sides of an
avoidance action will likely focus first on
the Subjective Test as the clearest
indicator of whether a preferential transfer
has occurred. This inquiry has several
steps.
Chart 1
Chart 2
Step One: Choosing the
Relevant Historical Date Range
The most common factual inquiry focuses on the difference in relative aging of
payments. The gre-ater the deviation from
the historical baseline, the less likely a
defendant will be able to satisfy the
Subjective Test. Determining the relevant
historical baseline is a creative statistical
endeavor. Most attorneys simply compare
the prior 12-month history in its entirety
with the payments in the preference
period. However, one may choose
different universes of historical data (the
Selected Historical Range) depending on
what best suits the purpose of the inquiry,
to wit:
1. the one-year prior history before
the preference period;
2. the two-year prior history in toto;
3. the 21-month history (i.e., after
excluding the three months before the
preference period); or
4. the 18-month history (i.e., after
excluding the six months before the
preference period).
A 12-month period may be all the
data that is available. Or, it may be
preferable to using a two-year history
due to a previous bankruptcy or
intervening change in the debtor’s
business model. In a case where there
has been a relatively stable business
relationship, using a subset of the twoyear history probably makes the most
sense. Excluding the 90- or 180-day
pre-preference transaction period is
intended to foster a comparison to
when the debtor was presumably
financially healthy. Case law supports
our view that the comparative
1 BAPCPA became effective as of Oct. 17, 2005, as to petitions filed after
that date. Therefore, we will be living with the pre-BAPCPA statute for
some time. 11 U.S.C. §546(a)(1)(A) provides a two-year statute of
limitations from the order for relief. Trustees appointed or elected under
one of the qualifying sections set forth in §546(a)(1)(B) may bring
actions as late as one year from the appointment/election so long as the
trustee was elected/appointed before the expiration of two years from
the petition date.
3
4
historical baseline should be based on
the timeframe when the debtor was
financially healthy.2 Of course, any one
of these methods may be chosen for
tactical reasons as well.
Step Two: Selecting
the Baseline within Each
Historical Date Range
Once the Selected Historical Range is
chosen, the next step is to compute the
optimum historical weighted average
(Baseline Average). In so doing, counsel
should apply one of the following three
variables:
1. Calculate the weighted average
days past due based on every invoice
paid within the Historical Range;
2. Calculate the weighted average days
past due of only those invoices that
were paid within the 80 percent middle
band (i.e., after excluding the 10
percent of invoices on each extreme of
the days past due range); or
3. Calculate the weighted average of
days to pay (not by due date) by
computing the invoice-to-payment
2 See In re Carled Inc., 91 F.3d 811 (6th Cir. 1996); In re Molded
Acoustical Products Inc., 18 F.3d 217, 227 (3rd Cir. 1994) (“ordinary
business terms” for purposes of ordinary course of business preference
avoidance exception are those that prevail in healthy, not moribund
companies); In re Meridith Hoffman Partners, 12 F.3d 1549, 1553 (10th
Cir. 1993) (“ordinary business terms therefore are those used in ‘normal
financing relations’: the kinds of terms that creditors and debtors use in
ordinary circumstances, when debtors are healthy”); In re Furrs
Supermarkets Inc., 296 BR. 33 (Bankr. D. N.M. 2003).
3 We theorize that the debtor’s deteriorating financial condition extended
beyond the preference period. Transactions in the 90-180th day before
bankruptcy are therefore not reflective of the prior course of dealing. By
removing them the effect is to reduce the average days past due,
thereby creating a larger discrepancy to the preference period. (See
discussion infra).
4 We theorize for purposes of illustration only that the day range
comprising 80 percent of all paid invoices constitutes the dominant
historical payment practice.
days (ignoring credit terms).
Normally, the weighted average days
past due creates the largest deviation, but
if there was a contraction in credit terms,
the invoice-to-pay method must be used
to enable the most accurate comparison
to the preference period.
Step Three: Applying a
Deviation Percentage Swing
to the Baseline Average
After the Historical Range and
Baseline Average are selected, the next
step in the evaluation process is to
compare the selected Baseline Average to
the Preference Period to arrive at a
difference “by days” and in percentage
terms. This is a statistical exercise, and as
with all statistics, data can be presented
in the manner that best suits the purposes
of the inquiry. The Chart 1 demonstrates
the advantages of using a days past due
approach as the measure of the change:
The Historical Baseline Average (as
expressed in weighted days past due) is
determined by selecting a particular
Historical Date Range. In Chart 2, a 30
percent +/- swing from the Historical
Baseline average is applied to arrive at
the day range that would be considered
“ordinary” as to preference payments
made within the 30 percent swing.
How we internally assign an appropriate swing percentage (in the above
example 30 percent) is a trade secret.
5 A “standard deviation” is a statistical measure of the amount by which
a set of values differs from the arithmetical mean. In plain English,
when the standard deviation number is applied to both sides of the
mean, the numbers that fall within the resulting range will encompass
67.76 percent of all numbers used to arrive at the mean.
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However, in general terms we determine
the swing percentage based on a series of
algorithms that take into account each
creditor’s credit term days, the “gap” in
days between the credit term and the
Historical Weighted Average Days Past
Due and the absolute value of the
Historical Weighted Average Days Past
Due. For example, if the credit term is
between 10-30 days, the closer the days
past due number is to one credit cycle, the
greater the likelihood is that the chosen
percentage will approximate one standard
deviation of the Historical Weighted
Average. Thus, if the credit term was 20
days and the Historical Weighted Average
Days Past Due was within a 15-25 day
range, the percentage would be at or close
to the standard deviation percentage.5 The
smaller the Historical Weighted Average
Days Past Due, the less meaningful is a
percentage-based “swing.” After all, a 50
percent swing on a Days Past Due of two
days would yield a range of one to three
days, irrespective of the credit term. In
these scenarios, we apply an algorithm
that computes a swing number by days.
Chart 3
Chart 4
Graphically Comparing
the Historical and Preference
Period Payments
Chart 3 demonstrates the end result of
a multifaceted baseline course of dealings
analysis. The green shaded areas are the
conceded OCB range. We have placed a
column for settlement purposes that
reflects potential for recovery of
preference payments that fall outside the
conceded OCB range. Also, we
summarize by percentage the baseline as
compared with the upper and lower
ranges so the viewer can see the
appropriateness of the selected band.
Chart 4 is a bar graph representation
of the age bucketing that compares the
Preference Period dollars per age bucket
with the selected Historical Baseline.
In Chart 5, we graphically demonstrate the Deviation Percentage Method
and the effects of widening the swing
percentage. This chart also shows an
improvement in position calculation that
can be used to highlight the effects of the
preference period payments.6
We also have the tools necessary to
explore whether the average check size
and the number of invoices paid per
check differed between the Preference
Period and the Historical Baseline. A
6 While improvement in position may occur for nonpreferential reasons
such as seasonality of purchasing of product, it can also alert one to the
potential of creditor pressure, change of terms or imposition of credit
limits.
significant batching of invoices per check
may indicate collection pressure.
Days Past Due vs. Days to
Pay: Factoring Terms Changes
Where there has been a terms change
in the preference period as compared with
the historic baseline, a Days-to-Pay
approach must be used. Otherwise, the
result will mask the disparate treatment
inherent in the varied term. For example,
if the historic term was 60 days and the
7 Pre-BAPCPA, the subjective test was given primary importance, except
where there was little prior history between the parties. Courts generally
considered the parties’ history as a better measure of what was normal,
rather than some general industry standard and applied a sliding scale
approach depending on the length of the parties’ course of conduct.
Advo-System Inc. v. Maxway Corp., 37 F.3d 1044, 1049 (4th Cir. 1994);
Molded Acoustical Prods. Inc., 18 F.3d at 226 (3rd Cir. 1994); see also In
re Tolona Pizza Products Corp., 3 F.3d 1029 (7th Cir. 1993).
preference period term was contracted to
30 days, and if the debtor because of its
computer payment system continued to
issue checks based on the due dates
entered in its system, a Days-Past-Due
analysis would make the predominate
payment pattern (in bold) appear
unchanged. Using a Days-to-Pay approach demonstrates that the debtor
substantially changed its payment pattern
with this creditor.
Below we graphically illustrate by use
of a running balance comparison how a
change in terms can result in an
acceleration in payments that allows the
creditor to reduce its credit balance at the
petition date (in this case Dec. 28, 2000).
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Implications of the Objective
OCB Test and BAPCPA
By changing the conjunctive “and”
between the Subjective and Objective
portions of the OCB defense to the
disjunctive “or,” Congress split the OCB
exception into two separate defenses.
Now, a preference defendant need only
prove that the subject transaction
complied with the parties’ prior course of
dealing, or that it comports with
“ordinary business terms.” At first blush,
this would appear to make proving an
OCB defense much simpler, which has
been the opinion of many commentators.
However, proving the Subjective Test is
the same as it always was, and there is
some indication that proving the new
“Ordinary Business Terms” defense will
be more difficult than proving the same
element under the pre-BAPCPA OCB
statute.
The first reported case to construe the
post-BAPCPA ordinary-business-terms
defense is In re National Gas Distributors
LLC, 346 B.R. 34 (Bankr. E.D.N.C.,
2006). In National Gas, the court noted
that post-BAPCPA there was a separate,
independent ordinary-business-terms
defense and that it was required to
determine whether the phrase had new
import in its new context. In making this
determination, the court found a “plain
meaning” analysis unhelpful, as the
phrase “ordinary business terms” is
substantially vague. The court also found
the legislative history of the BAPCPA
amendment to be equally unhelpful.
Thus, Judge Small made the determination based on prior case law now
overlaid by the new statutory scheme that
“ordinary business terms” has been
released from the controlling influence of
the “ordinary course of business
subsection,” and thus the sliding-scale
approach used by many courts was no
longer relevant. Id. at 404.7
The court also clarified that under
BAPCPA, an ordinary-business-terms
analysis not only required that both the
creditor’s and the debtor’s industry
standards be examined, but also “general
business standards” as well. Judge Small
stated: “If the ‘ordinary business terms’
defense only requires examination of the
industry standards of the creditor, there
would be no review or check on the
debtor’s conduct.” Id. By holding that the
terms of the transaction must be viewed
in the context of the rest of the debtor’s
financial affairs, Judge Small has
enunciated a subjective element to this
otherwise objective test, which may be
construed as expanding what need be
proven for a creditor to avail itself of this
defense. It remains to be seen if other
courts follow his lead.
Conclusion
Mark Twain famously commented
after reading his own obituary: “Reports
of my death were greatly exaggerated.”
Chart 5
Chart 6
Chart 7
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The same could be said regarding the
belief that preference litigation will
subside due to the bifurcation of the OCB
defense. While the preference defendant
need only prove one of the two OCB
defenses, the subjective course of
dealings will continue to be the dominant
battle ground in preference litigation.
Such battles will continue to be won by
the litigant who presents the most
compelling statistical analysis. ■
Reprinted with permission from the ABI
Journal, Vol. XXV, No. 10, December/
January 2007.
The American Bankruptcy Institute is a
multi-disciplinary, nonpartisan organization devoted to bankruptcy issues. ABI
has more than 11,500 members,
representing all facets of the insolvency
field. For more information, visit ABI World
at www.abiworld.org.
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