Tuesday, February 25, 2014

Must Read Opinion on Preference Issues

Judge Tony Davis has authored an opinion which should be recommended reading for anyone litigating preference issues.   The opinion encompasses the court’s rulings on both summary judgment and trial on the merits and touches on both procedural and substantive issues.   Ciesla v. Harney Management Partners (In re KLN Steel Products Co.), No. 13-1013 (Bankr. W.D. Tex. 2/18/14).   The opinion can be found here.

What Happened

KLN Steel Products made and sold furniture.   In February 2011, it hired Harney Partners to provide business consulting and restructuring services.   Then initial agreement provided for weekly invoices to be paid by wire transfer within three business days.    KLN was never quite able to meet Harney’s terms and the agreement was modified several times.  Nevertheless, Nevertheless, KLN paid its bills on a regular basis by wire transfer through most of the engagement.   However, this changed in September and October 2011 when KLN made one payment entirely by check and one partially by check and partially by wire transfer.

Things got interesting during the month prior to bankruptcy.   Harney abruptly resigned the engagement on November 1, citing recent discoveries and potential improprieties.   The parties made up and signed a new engagement agreement a week later.    However, KLN apparently decided not to retain Harney for its bankruptcy proceeding and the parties proceeded to negotiate terms of final payment.   KLN’s attorney contended that Harney refused to release its papers without payment, while Harney denied this and asserted that the parties reached an arms-length agreement.   Regardless of the cause, Harney was paid $50,000.00 on the day of bankruptcy.  

The Debtor filed a liquidating plan.   The Plan and Disclosure Statement proposed to retain “any and all” chapter 5 causes of action but also referred to a list of payments on a schedule.   Adding to the confusion, the disclosure statement referred to an exhibit that was not attached.

 When the liquidating trustee filed suit against Harney, he filed a bare bones complaint asserting that he wished to recover “at least $168,594.85” in transfers.   This was the amount of 90 payments received by Harney without counting the day of bankruptcy transfer.   The complaint did not contain a list of the transfers to be avoided.

Harney filed a motion for summary judgment.   The Court ruled that about half the transfers received during the preference period were subject to the ordinary course defense.   At the hearing, Harney pointed out that the trustee had not specifically pled for recovery of the $50,000 day of bankruptcy payment.    Nevertheless, the trustee did not seek to amend his complaint.   However, both parties listed the payment as an issue to be decided in their pre-trial orders.

The case proceeded to trial with regard to four specific transfers:
  • A transfer of $23,351.26 by check on October 4, 2011
  • A transfer of $12,142.93 by check on October 18, 2011
  • A wire transfer of $7,500.00 on October 18, 2011
  • A transfer of $50,000.00 on November 22, 2011.

How the Court Ruled

The Court ultimately ruled that all of the disputed payments were not made in the ordinary course of business but that Harney was entitled to a new value defense for $2,280.00 for a net recovery of $90,714.19.   However, to get there, the Court had to wade through a procedural maze, including Stern v. Marshall, standing and proper pleadings.   

Stern v. Marshall

The Court should be commended for its candid approach to Stern v. Marshall.   Judge Davis noted that Harney had not filed a proof of claim and that the Fifth Circuit had negated consent as a solution to the authority question.    As a result, two easy avenues for resolution were not available to the court.   Instead, the Court simply noted that in the face of compelling arguments for both sides that it would follow its statutory authority to enter a final judgment and that the District Court could treat its ruling as proposed findings of fact and conclusions of law if it was wrong.

Judge Davis wrote:
So then: The creditor not having filed a proof of claim, and the parties’ consent being unavailing, can the Court issue a final judgment in this avoidance action? Since Stern, courts have been divided on whether bankruptcy courts can enter final decisions in preference actions under such conditions. (citation omitted). The arguments for and against are sound.   (citation omitted).   The issue appears finely balanced. It is not decisively resolvable without further guidance from the Fifth Circuit or the Supreme Court. Because there is no clear precedent altering the status quo in this respect, the Court will adhere to the pre-Stern practice of issuing its ruling on this core matter as a final judgment, as Congress permitted under 28 U.S.C. § 157(b)(2)(F). If the District Court concludes that this course of action was in error, and that this Court lacks constitutional authority, the “final judgment” can be construed as “proposed findings of fact and conclusions of law,” with a final judgment to be entered by the district court. See Order of Reference of Bankruptcy Cases and Proceedings at 1-2 (W.D. Tex. Oct. 4, 2013). 

Opinion, pp. 3-4.   I give Judge Davis credit for judicial humility.   Rather than engaging in legal gymnastics, he simply acknowledged that there was not a clear answer and ruled as best he could.


Under Matter of Texas Wyoming Drilling, Inc., 647 F.3d 547 (5th Cir. 2011), a plan must contain “specific and unequivocal” language reserving claims in order for the post-confirmation debtor to have standing to pursue them.   Here, the plan proposed to retain any and all chapter 5 causes of action, which should have been good enough.   However, the plan went on to refer to the payments listed on an attached schedule.   The attached schedule did not include the day of bankruptcy payment.    The Disclosure Statement stated that the payments to be recovered included those on the attached list but failed to attach the list.

So, which controlled:  the general statement or the specific listing?   Judge Davis held that the purpose of the specific and unequivocal requirement was to place creditors on notice.   Harney knew that they were subject to being sued for some payments.   As sophisticated restructuring consultants, they should have known that receipt of a payment on the day of bankruptcy would paint a target on them.   As a result, the requirement was met.   The Court stated:
On this close issue, however, in the Court’s judgment, the best reading of the Plan and Disclosure Statement and their attachments is that KLN wished to preserve avoidance actions very generally. By listing some—even if not all—payments to Harney, KLN gave ample notice that payments to Harney might be the subjects of attempted recovery. What was included was sufficient to put Harney (and any other party in interest) on notice that Plaintiff might pursue not only the specific listed payments but also the $50,000 day-of-bankruptcy payment—a payment that Harney was well aware of, even if KLN omitted it. Also, a sophisticated restructuring consultant such as Harney would be well aware that this day-of-bankruptcy payment was certain to be a likely contestant for avoidance, more so than many of the payments that were listed. In fact, it is the unusual, last-second nature of this payment that likely caused it to be omitted from the list of the more typical payments made in the Preference Period. The opposite ruling here would have the effect of discouraging the filing of such lists in favor of the more general retention language approved of in Texas Wyoming. It seems preferable to encourage more rather than less disclosure, even if the more detailed disclosure includes the occasional, relatively minor error.
Opinion, p. 22.    Judge Davis’s analysis is instructive.   Rather than taking a formalistic approach, he looked at the practical realities.   This is in keeping with the spirit of the Federal Rules of Civil Procedure which focus on notice more than the use of magic words.


The Court reached the same result on adequacy of pleadings but for much different reasons.   The Complaint said that Plaintiff sought to recover all payments within 90 days, including “the total of at least $168,594.85.”   Mathematically, the total of $168,594.85 did not include the $50,000 day of bankruptcy payment.  As a result, the Defendant contended that this payment was not included within the Complaint.   The Court found that the pleading was “so bare-bones and open-ended that it hardly can be said to omit or include the $50,000.”   Opinion, p. 24.  

The Court noted that the Complaint could have been subject to a valid motion under Rule 12(b)(6) but that one was not filed.
Although Harney never filed a motion to dismiss the complaint, there might have been a basis for such a dismissal. Courts have required more detail from preference complaints than contained in Plaintiff’s Complaint. In most cases, it appears at a minimum that complaints should include basic details of the alleged preference payments, an explanation of the relationship between the parties, and basic facts to support the other required elements—in other words, at least “sufficient factual matter, accepted as true, to ‘state a claim that is plausible on its face.’”   (citation omitted).   The Complaint here can hardly be said to have met that basic standard.
Opinion, p. 24.   Even though the complaint was clearly inadequate, the Court found that it did not bar recovery of the disputed payment.    The Court found that trial by consent was present where both parties briefed the day of bankruptcy payment in their summary judgment papers and included it within their pre-trial orders.    The Court explained that the pre-trial order “supersedes all pleadings and governs the issue and evidence to be presented at trial.”     Opinion, p. 25. 

Additionally, the Court found that “the Trial record shows that Harney put on extensive and well-prepared evidence concerning the day-of-bankruptcy payments, and hotly contested the story Plaintiff sought to tell about those payments.  In other words, Harney’s trial conduct supports the position in Harney’s Pre-Trial Order, to the effect that Harney consented to trying the day-of-bankruptcy payment alongside the other challenged payments.”  Opinion, p. 26.  

This is probably one of the few times in litigation when a party lost an argument due to being too well-prepared.   Once again, the Court took a functional approach despite the Plaintiff’s sloppiness.  

Ordinary Course Defense

The Court spent a lot of time on the ordinary course defense.   This is good because preference issues are not often litigated which makes it hard to find current precedents.   

The defense has two parts.   First, the debt must be incurred in the ordinary course of business of the debtor and the transferee.   Second, the payment must be made either in the ordinary course of business between the parties (the “subjective test”) or “made according to ordinary business terms” (the “objective test”).   Prior to BAPCPA, there was an “and” between the subjective test and the objective test.   Now there is an “or” meaning that either one will suffice.

The Trustee challenged the incurred in the ordinary course of business element on the basis that the Debtor was in the business of making furniture rather than hiring restructuring consultants.   The Court noted that this is not quite what Congress meant.   It wrote that:

To meet the “debt incurred” element of this affirmative defense, all that is required is that a debt be incurred in a “subjectively” ordinary course of business, just as a transfer is protected if it is made in the “subjectively” ordinary course of business. In both instances, the test is whether there is a discernable pattern in the parties’ “subjective” relationship, within which pattern the challenged debts and transfers are “ordinary.” (citations omitted).    Plaintiff attempts to shoehorn a different, more stringent standard into this phrase in the “debt incurred” context than the meaning it holds in the “payment made” context. That effort must fail, as a plain matter of textual interpretation. 
Thus, applying that legal conclusion to the facts of this case, if the Preference Period debts were incurred consistently with how the pre-Preference Period debts were incurred, they pass the “debt incurred” portion of the test.
Opinion, pp. 12-13.  The Court also noted the practical concerns raised by the Plaintiff’s argument, noting that if restricting consultants were punished for doing business with a debtor prior to bankruptcy, they would not do business and the chances of the debtor avoiding bankruptcy would plunge to close to zero.    

The Defendant did not present evidence on the Objective Test.   The Court noted in a footnote that getting paid on the day of bankruptcy could be in the ordinary course of business for those in the restructuring industry but that the evidence was not presented.

In evaluating the Subjective Test, the Court identified several factors as helpful.
The “subjective prong” centers upon “whether the transactions between the debtor and the creditor before and during the ninety-day period are consistent.’”   (citation omitted). In analyzing this prong, “courts have come to a rough consensus as to what factors are most important. Typically, courts look to the length of time the parties were engaged in the transaction in issue, whether the amount or form of tender differed from past practices, whether the creditor engaged in any unusual collection activity, and the circumstances under which the payment was made (i.e. whether the creditor took advantage of the debtor’s weak financial condition).” (citation omitted).  
Opinion, p. 9.  

The Court found that it was significant that no payments were made by check, either before or during the preference period, other than the ones on October 4 and October 18.   Judge Davis explained that while the difference in payment was not enough to render the payments outside the ordinary course, the reason for the difference, namely that the Debtor was short on cash, was important.
The Court received conflicting testimony with regard to the day of bankruptcy payment.   Greg Milligan, testifying for Harney Partners, stated that the firm did not require payment as a condition of turning over its reports, while Patricia Tomasco, testifying for the trustee, insisted upon this condition.   The Court found that “The emails were more consistent with Mr. Milligan’s story, but Ms. Tomasco, counsel for KLN, gave specific and credible testimony to the contrary.”   Opinion, pp. 29-30.   The Court ultimately decided that it need not resolve the conflict in testimony because it could rest its ruling on other grounds.  

The Court found that the day of bankruptcy payment was not subjectively in the ordinary course of business.
(I)t bears mentioning that there is nothing improper about a professional seeking payment for services, including on the eve of bankruptcy (although of course the professional may risk avoidance under some conditions), and what appears to have happened here (as far as can be drawn out of the limited available evidence) does not rise to the level of impropriety or coercion, even if it might be sufficient to depart from an “ordinary course.”
Nonetheless, Harney’s defense is unsuccesful. Clearly, the timing of this last payment was dictated by the fact that KLN was filing bankruptcy the next day. Unlike most or all of the prior payments, the payment was made quite soon after the latest invoice (which was dated November 19), was made in payment of two separate invoices, and was significantly higher than any other single payment, whether before or during the Preference Period.  Each of these facts weighs against ordinariness. Moreover, there is no pattern of payments established under the renewed retention of November 8 against which to measure the ordinariness of this payment.  The November 8 retention letter could have provided for an eve-of-bankruptcy pay arrangement, but did not. While the terms of the governing engagement letter do not necessarily delineate the exact bounds of ordinariness, they are probative, particularly when there was not yet a pattern of payments under this renewed engagement letter, against which the eve-of-bankruptcy payment could be assessed. 
Finally, it again bears emphasizing that Harney had the burden. The Court finds that it failed to carry that burden.
Opinion, p. 30.

Final Thoughts

Several points come to mind from reading this opinion.  The first is that the opinion is a portrait of a judge trying to make the statutory scheme work notwithstanding the foibles of the Supreme Court or the lawyers.   Although the written opinion indicates that Harney Partners tried a good case, this was not sufficient to meet its burden of proof.    While we would like to think that cases depend upon superior advocacy, sometimes the facts just don’t cut your way.   Second, preference litigation is very fact-specific.   Several of the issues in this case turned on the fact that Harney Partners was a sophisticated restructuring consultant.    These issues might have turned out differently for a run of the mill trade creditor.   When trying your preference case, look for the facts that make your case different from the other hundred cases.   Finally, procedure matters. Defendants have the ability to require that Plaintiffs plead more than just a bare-bones complaint.   While failure to file a Rule 12(b)(6) motion probably did not change the result of this case, it was a tool that the Defendant could have used.   Additionally, parties should keep in mind that the pre-trial order supersedes the pleadings.   When there is a question over whether an issue has been properly raised, this dispute should be stated in the pre-trial order to avoid trial by consent.    

Disclosure:  Greg Milligan of Harney Partners is a business friend who used to live in the same neighborhood as me.   I am also well acquainted with both of the attorneys who tried the case.   My goal in discussing the case is to look for the practice points and not to critique attorneys who I work with.   However, if anyone wants to discuss a case where I represented the non-prevailing side or just didn’t have time to get around to, I would be happy to accept a guest post.   My only condition is that it needs to come from a Texas bankruptcy lawyer.  I also welcome substantive comments on anything I have written.

No comments: