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.
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.