When debtors file for bankruptcy, certain payments made in the days preceding the filing are subject to demands that the payments be turned over to a bankruptcy trustee or returned to the debtor (the “bankrupt”). These payments are referred to as “preferences.” Preference targets are creditors, such as trade creditors, who did business with a troubled company that ultimately files for bankruptcy. The primary purpose of this provision of the Bankruptcy Code is to promote and attempt to uphold the equality of the distribution of a debtor’s assets among its creditors. However, it often has the effect of “punishing” creditors who continued to do business with a financially distressed debtor by requiring them to pay back the money they received during the pre-bankruptcy preference period.
1. Elements of a Preferential Transfer
To claw back a preference payment, the debtor (or bankruptcy trustee) must establish the following:
- A transfer of an interest of the debtor in property (usually a payment);
- Made to or for the benefit of a creditor;
- For or on account of a debt owed by the debtor;
- Made while the debtor was insolvent;
- Within 90 days before the date the bankruptcy case was filed, or within 1 year for “insiders”; and
- That enables the creditor to receive more than it would have received in a Chapter 7 liquidation.
2. Timing
The “preference period” is 90 days before the bankruptcy filing for typical creditors and 1 year for “insiders.” Insiders are defined as relatives of the debtor, a general partner of the debtor, or if the debtor is a corporation, officers, directors, or a person in control of the company.
Under the Bankruptcy Code, a preference case normally must be commenced by the later of 2 years after the case is filed or 1 year after the appointment or election of the first trustee in the bankruptcy case.
3. Defenses
While it may seem like any creditor doing business with a troubled debtor will be forced to return funds received within 90 days of the bankruptcy, there are several available defenses under the Bankruptcy Code.
a. Substantially contemporaneous exchange
If the payment or other transfer the creditor received from the debtor was intended by both parties to occur at the same time as the sale or transfer of something of new value to the debtor, the preferential payment may be completely exempted from turnover. New value is defined as money or monies worth in goods, services, new credit, or the release of property previously transferred, but it does not include substituting one obligation for another. There are no hard and fast rules as to how “contemporaneous” the exchange must be, but courts generally require that the transfer occur within 1 to 14 days of the transfer of new value to the debtor.
b. Payments made in the ordinary course
This is possibly the most heavily litigated preference defense. In 2005, the ordinary course defense was modified to make it easier for creditors to establish ordinariness. A creditor will need to show that the transaction at issue was incurred in the ordinary course of business or financial affairs of the debtor – a factor often easily met. Additionally, a creditor will need to establish either (1) that the transfer was made in the ordinary course of business or financial affairs as between the debtor and creditor; or (2) that the transfer was ordinary in the business or trade in which the debtor is involved. Thus, a creditor can point to either its specific dealings with the debtor in the past or, if there is no established course of dealing between the parties, that the transfer is considered ordinary by industry standards.
c. Purchase money security interests
This defense protects lenders that have loaned funds to a debtor to purchase a specific item, as long as there is a specific security agreement describing the property, the funds are used exclusively to purchase the item, the debtor does purchase said item, and the creditor perfects its security interest within 30 days of the debtor receiving the item.
d. New value
This defense provides that a transfer may not be avoided to the extent that after the transfer, the creditor gave new value to the debtor on an unsecured basis. The policy underlying the new value defense is to encourage creditors to extend new credit to financially troubled companies by allowing the new credit to act as a defense to a subsequent preference lawsuit.
e. Floating liens or improvement in position
A floating lien is a lien in a constantly changing pool of collateral (i.e., inventory, accounts receivable, crops). A holder of a perfected security interest in inventory or accounts receivable will not be avoided as a preference unless the creditor improves his position during the preference period. In determining whether the creditor has improved its position, courts consider the creditor’s position on the petition date as compared to its position 90 days before filing.
f. De minimis payments
The Bankruptcy Code excludes from preference liability transfers that are deemed too minimal. For debtors whose debts are not primarily consumer debts, a transfer may not be avoided if the aggregate value of the transfers is less than $6,425.00 (to be readjusted effective April 1, 2019). For debtors whose debts are primarily consumer debts, the de minimis limit is $600.00.
g. Standing
The Bankruptcy Code limits standing to pursue a preference action to (1) the debtor-in-possession; (2) the creditors committee, if the right to pursue preference actions has been assigned via court order; (3) the plan administrator or liquidating trustee in a Chapter 11; (4) the bankruptcy trustee; and (5) a purchaser at a sale of substantially all of debtor’s assets, provided the purchaser acquired the rights to the debtor’s preference actions.
h. Contact Our Attorney
Perhaps the most important thing to take away is that if you receive a preference demand letter, immediately contact your attorney. An experienced attorney can help to reduce the amount owed or eliminate any liability. A thorough knowledge of preference law, defenses, and procedures provide the foundation for using these preference defense strategies. Moreover, failure to pay attention to any lawsuit could result in a default judgment.