Is sponsorship a preferential transfer?

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As the residents of Lubbock, Texas prepared for Broadway’s annual Fourth Independence Day fireworks show and celebration, local car dealership Reagor-Dykes wanted to be top of mind. So, like the year before, he sponsored the event by donating $25,000 to Broadway Festivals, the charity that hosted the event. Just this year, shortly after the last bottle burst, Reagor-Dykes filed for Chapter 11. This sparked a dispute between the liquidator and Broadway over whether the sponsorship was a preferential transfer under the bankruptcy code. .

Preference claims

To avoid unequal treatment and everyone for themselves in the prospect of bankruptcy, a bankruptcy court may cancel certain “preferential” transfers with the following characteristics:

  • The transfer was made for the benefit of a creditor.

  • The transfer was made to pay a previous debt owed by the debtor before the time of the transfer.

  • The transfer was made while the debtor was insolvent.

  • The transfer was made no later than 90 days before the date of bankruptcy.

  • The transfer allows the creditor to receive more than they would receive if the bankruptcy case were a Chapter 7 liquidation had the transfer not been completed and the creditor received payment of the debt to the extent provided by Article 547 of the Bankruptcy Code.

Broadway was a Reagor-Dykes creditor who received money within 90 days of bankruptcy. Reagor-Dykes was presumed insolvent. The $25,000 was more than Broadway would receive under Chapter 7. So, at first glance, it looked like Broadway would need to return the money to the trustee.

Previous debt

Broadway made several arguments to keep the money. First, he argued that the sponsorship was not for past or past debt. Prior debt is debt incurred prior to the alleged preferential transfer. A debt is incurred when the debtor becomes obligated to pay it, and a debtor becomes obligated to pay a debt when he has received his consideration or the creditor has rendered services to the debtor. Broadway argued that the debt was not a prior debt because Reagor-Dykes paid the sponsorship on July 13, 2018, and received consideration after the July 4 event.

The Court rejected this argument. The primary consideration for Reagor-Dykes was pre-event commercials, VIP tickets to the event, and the ability to address the crowd and advertise at the celebration. Any further consideration was incidental. Additionally, Broadway admitted that Reagor-Dykes became obligated to pay on July 4.

The “New value” exception

Broadway then argued that the sponsorship was a contemporary exchange for new value and, therefore, could not be avoided. The “new value” exception encourages creditors to continue to deal with debtors in financial difficulty, so long as those transactions involve exchanges of equal value. To succeed on a new defense of value, the obligee must prove: (1) intent, (2) contemporaneity, and (3) new value.

The court determines intent by reviewing the parties’ mutual understanding of the payment arrangement, including evidence of how the payments were reflected in the parties’ books. Broadway billed local businesses ahead of the July 4 event, without requiring sponsors to pay the bill by July 4. Due to the discrepancy between the payment and the consideration received, the court determined that the parties did not intend to effect a simultaneous exchange.

The court also determined that there was no contemporaneity or new value. A transfer need not be simultaneous to be substantially contemporaneous, and what is substantially contemporaneous will be assessed on a case-by-case basis. But delays in payment that are not due to unforeseen or uncontrollable circumstances will not constitute substantially contemporaneous transfers.

The proof of the element of new value is simple: the creditor must demonstrate that the debtor received new value through the transfer. Broadway argued that because Reagor-Dykes had benefited from the sponsorship after the July 4 event, and that benefit was equal to the sponsorship payment, he had received new value. The court disagreed.

The “Ordinary Course” Defense

Finally, Broadway asserted the normal course of business defense. There are two approaches to the normal course of trade defense — an objective test and a subjective test. The objective test assesses what is ordinary in the industry. The subjective test assesses what is ordinary given the parties’ respective practices.

Broadway argued that the sponsorship was a transfer made in the normal course of business on the injury test. The subjective test involves a factual analysis of the parties’ historical business practices. To determine whether a transaction is ordinary on the injury test — would the transaction have proceeded as it did but for the debtor’s impending bankruptcy — courts generally ask:

  • How long have the parties committed to the transaction (or transactions)? Essentially, what is the history of the business relationship between the parties?

  • Does the amount or form of the offer in the transaction differ from past practice?

  • Was the debtor’s payment unusual or were the creditor’s collection efforts unusual?

  • Under what circumstances was the payment made?

  • Did the creditor-assignee benefit from the known deterioration of the debtor’s financial situation?

Some courts have determined that a single transfer is sufficient to establish what is ordinary between the parties, while others have expressed the need for a longer transaction history. A first debt may be ordinary in relation to the parties’ past practices with other counterparties in a similar situation or where the agreement between the parties describes the commercial terms. Although Broadway had a limited history with Reagor-Dykes, the court determined that the sponsorship was in the ordinary course of business on the injury test.

The court ruled that the timing of Reagor-Dykes’ payment – nine days after the event – was normal compared to other major fireworks and celebration sponsors. The court also noted that Broadway had never demanded payment and that the manner, amount and form of Reagor-Dykes’ payment was normal under the circumstances. Since Reagor-Dyke’s sponsorship payment was in the normal course of business with Broadway in anticipation of the annual fireworks display and celebration, the court declined to avoid the preferential transfer and Broadway did not had to return the $25,000 to the trustee.

Conclusion

Creditors engaging with clients on the verge of bankruptcy should know their transaction history with the debtor that will be reviewed by the court. Creditors should educate themselves about the elements of a preferential transfer and available defenses and structure their behavior to put themselves in the best position to avoid having their payments avoided.

© 2022 Ward and Smith, Pennsylvania. All rights reserved.National Law Review, Volume XII, Number 207

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