Chapter 11 bankruptcy, otherwise known as "business reorganization," is designed to give the debtor a chance to restructure the debts and assets of a failing business. The goal of a Chapter 11 proceeding is to ultimately return the business to profitability.
In order to facilitate reorganization, Section 363(c) of the Bankruptcy Code allows a Chapter 11 debtor to remain in control of ordinary business operations. Specifically, this section grants the debtor the right to "enter into transactions...in the ordinary course of business, without notice or a hearing." One of the purposes behind this provision is to allow a business to continue its daily operations without excessive court or creditor interruption, and ultimately to facilitate a successful reorganization.
Trustee's Right to Avoid Preferential Transfers
Under the Bankruptcy Code, the bankruptcy trustee has the power to avoid certain transfers called "preferential transfers." Preferential transfers are transfers between the debtor and a creditor-transferee. The trustee can recover the transferred funds for the estate by way of a proceeding in the bankruptcy court called an "adversary proceeding." These actions, referred to as "preference actions," may be brought in any Chapter 7, 11, 12, or 13 case. In a Chapter 11 case, a preference action is brought by either the "debtor in possession" or the trustee appointed by the bankruptcy court to oversee the reorganization against the creditor-transferee. The thresholds in which a trustee may initiate a preference action are an aggregate $5000 for businesses and $600 for individuals.
Ordinary Course of Business Defense
The trustee may not avoid a preferential transfer if it was made in payment of a debt in the ordinary course of business. The 2005 amendments to the Bankruptcy Code reduced the requirements for such transfers to be in the ordinary course of business. A transfer is in the ordinary course of business if (1) the transfer is a payment made in the ordinary course of both the debtor and transferee, or (2) if the payment is made according to ordinary business terms. Before 2005, the creditor had to prove both prongs to invoke this affirmative defense successfully. Now, if the creditor proves either prong of this test, then the transfer cannot be avoided.
In order to determine whether the first prong has been satisfied, courts must apply a factual analysis on a case-by-case basis. However, for purposes of determining which transactions satisfy the second prong, courts have applied two tests, both of which must be satisfied: (1) The Vertical Test, and (2) The Horizontal Test.
The Vertical or "Creditor's Expectation" Test
Under the Vertical Test, courts ask whether the transaction subjects a creditor to risks that a reasonable creditor would not have expected upon entering into a contract with the debtor. For example, in a leading case on the issue, the court concluded that a reasonable creditor would not expect a physician facing over 70 malpractice claims to cancel his medical malpractice insurance policy.
The Horizontal or "Industry-Wide" Test
In addition to the Vertical Test, courts apply the Horizontal Test. The Horizontal Test involves analyzing whether the transaction at issue is one that other similar businesses in the debtor's industry would enter into. In the aforementioned insurance policy case, the court held that a reasonable physician in a situation similar to the debtor's would not have cancelled his insurance policy. The court reasoned that the debtor was involved in high risk procedures, was facing a multitude of malpractice claims, and had lost the ability to generate income due to turmoil in both his personal and professional life.
Applying both tests to the physician's cancellation of his insurance policy, the court held that the transaction was null and void because it fell outside the ordinary course of the physician's business. On the other hand, if a transaction satisfies both tests, then it will likely be considered to have been performed in the ordinary course of business. If so, the debtor is not required to first give notice, nor attend a hearing on the matter, before entering the transaction.
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