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Bankruptcy Preferences
Last Edited: 1/20/2012
A bankruptcy trustee or debtor in possession can sue to recover creditors payments made shortly before
a bankruptcy filing. This is somewhat shocking when you first find out
about it. You can get sued for the return of money you were paid on valid debts?
The answer is, yes.
The concept is that when a company is insolvent, creditors with the same class
of debts should share equally. Consequently, when a pre-bankruptcy payment gives a creditor more than
it and other creditors would get in the bankruptcy case, the payment must, under
some circumstances, be returned to the debtor in possession or trustee so that it can be
shared among the creditors body.
In general, payments on debts (including vendor trade debt) received in the 90 days before
a bankruptcy are recoverable as preferences.
What is a preference?
The preference section of the Bankruptcy Code is
Section 547. What kind of
payments are preferences? Generally, a payment must be on a past debt when the debtor is insolvent
and within 90 days of a bankruptcy which allows the creditor to receive more than if the payment had not been made and the claim was paid
out through a Chapter 7 bankruptcy case.
What are not preferences?
Some typical payments are not preferences. For example, most payments to fully secured
creditor are not preferences. The secured creditor, in having a right to
the collateral, would not get more than he would have in bankruptcy due to the
payment.
What are some defenses to preference claims?
Defenses to the recovery of a preference are found in 11 U.S.C. 547(c), some are:
- contemporaneous exchanges;
- payments made in the ordinary course of the business or on ordinary credit terms;
- amounts of subsequent credit extended and unpaid; and
- new value.
These are affirmative defenses and must be raised in an answer
to a preference complaint. The creditor has the burden of proof on these
defenses, while the trustee has the burden of proof on insolvency (though
insolvency in presumed for the 90 days proceeding the bankruptcy filing).
Trustees and debtors in possession often sue everyone who received payment
during the preference period based on a simple review of a check register. Often there
are several good defenses to these claims. A good attorney can save you a lot of money if you are
sued on a preference.
Insider preferences are a special issue. In general, insiders are relatives,
corporate officers or directors, or other entities related to the debtor. For
insiders, a trustee or DIP can look back to payments within a year of a bankruptcy, not just 90 days. In insider preference cases, there is no
presumption that the debtor was insolvent when the payment was made, so the
plaintiff has a more difficult task in proving their case.
What is the ordinary course defense to a bankruptcy preference?
This law was changed in 2005. Most of the information about this
defense on the web relates to the old law. The current ordinary course
defense is an either/or test: either in the "ordinary course of business"
between the debtor and the transferee or made according to "ordinary business
terms". If the preference defendant satisfies either test, they keep the
money.
However, this is a
"fact-bound" defense, and this makes sure that there is no sure-fire to prevail
short of trial. Consequently, most cases involving payments arguably
subject to the defense still settle with the creditor
paying money to the trustee to avoid funding a trial. However, even if
settlement is ultimately advisable in light of cost and risk, the deal you strike will always be better if you present your fact defenses
capably through counsel.
Section 547(c)(2) is where the defense is found. It provides:
(c) The Trustee may not avoid under this section a transfer --
(2) to the extent that such transfer was in payment of a debt incurred by the
debtor in the ordinary course of business or financial affairs of the debtor and
the transferee, and such transfer was -
(A) made in the ordinary course of business or financial affairs of the debtor
and the transferee; or
(B) made according to ordinary business terms.
The first key prong of the defense (subsection A) asks whether the
payments were made in the ordinary course of dealing between the debtor and
creditor. This requires looking at the days between invoice and payment
within the preference period (90-day period before bankruptcy) and before it and
doing a comparison. The average number of days from bill to payment in
each respective period matters, but it also matters if special collection
efforts took place during the preference period. Coercive collection
tactics, special deals, workouts and the like, are not usually considered
ordinary and can undermine the defense if they occurred during the preference
period. This puts vendors of a struggling company in a tough spot--damned
if they do and damned if they don't--in deciding when and if to collect
coercively.
The "ordinary course of business" prong (subsection A) of the
defense is often called the "subjective test" because it examines the course of
dealing between the particular creditor and debtor in the case. However,
stated credit terms between the parties are not dispositive. For example,
if the parties had the longstanding custom of paying and accepting payments at
60 days from invoice, that may be held to be ordinary despite net 30 day terms.
As one
bankruptcy court put it
when considering the subjective prong of the ordinary course of business defense.
Factors that are relevant in determining the ordinary course of business between parties:
(1) the length of time the parties have engaged in the type of dealing at issue;
(2) whether the subject transfer was in an amount more than usually paid;
(3) whether the payments were tendered in a manner different from previous payments;
(4) whether there appears any unusual action by either the debtor or creditor to collect or pay on the debt;
(5) whether the creditor did anything to gain an advantage (such as gain additional security) in light of the debtor's deteriorating financial condition.
[...]
An important indicator to determine ordinary course of business is whether the
timing of preference period payments was consistent with the timing of similar
payments during the pre-preference period. [...]
When there is a difference between pre-preference and preference period payment
times, determining whether that difference is substantial enough to be
considered outside of the ordinary course of business is a very fact-specific
inquiry.
The second prong of the defense is "ordinary business terms" test (subsection
B). This is often referred to as the "objective test" because it examines the
industry as a whole and what constitutes ordinary timing and manner of payment
within its confines. To meet one's burden against a trustee on this prong
of the defense, it is usually necessary to hire a testifying expert to opine on
the number of days from invoice to payment with the relevant time period and
industry subgroup.
What do you do if you are sued for a preference?
We will defend you in a preference case affordably. Our number one goal
is not maximize the net advantage to you in the case. In other
words, legal fees are a factor and we know they are a factor. We are always
straightforward and strategic. We work to find
the cheapest and most efficient ways to resolve a case.
If you are looking to retain an attorney, consider calling us to have a discussion.
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