Preferential Transfers in Bankruptcy: How to Minimize the Preference Risk
For suppliers of goods and services, nothing may be more unsettling than discovering that a customer has filed for bankruptcy. To add insult to injury, there is a risk that any recently received payment or settlement might be recaptured by the bankruptcy trustee as a preferential transfer or “preference”. Do not give up on issues in bankruptcy thinking that creditors cannot win in bankruptcy court. Approach the process with the thought and goal of winning!
Fortunately, there are defenses that can be raised against preference claims. Creditors should be aware that there are contexts in which payment can be extracted from a debtor without fear that the transfer will be avoidable at some future date. Below, we provide a basic overview of the criteria that gives rise to bankruptcy preferences, and also highlight some common defenses available to creditors in preference actions.
What is a “preference” payment?
Section 547 of the Bankruptcy Code governs preferences. Under this section, a trustee or debtor-in-possession may recover – as preferences” – any payments or other transfers of assets by a debtor to a creditor within 90 days of the debtor’s bankruptcy filing. There are two main purposes for this policy: to prevent a debtor from favoring any of its general unsecured creditors over others and to discourage creditors, upon hearing that the debtor is about to file bankruptcy, from storming the courthouse to collect their individual debts.
The elements of a preference claim are typically stated as follows: (1) the debtor transferred property to or for the benefit of the creditor (i.e., made a payment); (2) the transfer was made on account of a debtor’s pre-existing debt to the creditor; (3) the debtor was insolvent at the time of the transfer; (4) the transfer was made within 90 days of the debtor’s bankruptcy filing, or within one year if the creditor is an insider on account of an old debt; and (5) the creditor obtained a larger sum from the transfer than they would have in a Chapter 7 liquidation had the transfer not occurred. Note that payments to a fully secured creditor fail to meet these criteria, as the secured creditor will not receive any more from the debtor than the value of the collateral, which is what he would receive in bankruptcy.
Common Preference Defenses
The bankruptcy code provides a series of defenses that creditors can assert to evade preference claims. These defenses are primarily aimed at encouraging creditors to continue doing business with financially troubled companies. Some of those most frequently asserted are (1) the contemporaneous exchange for new value defense, (2) the ordinary course of business defense, and (3) the small transfer defense. If a creditor is to routinely evade preferences, a working knowledge of these defenses is imperative.
1. The Contemporaneous Exchange for New Value Defense
The contemporaneous exchange defense is codified at Section 547(c)(1) of the Bankruptcy Code. It excuses any payment or other transfer that the debtor and creditor intend as a contemporaneous exchange for new value, and that is, in fact, a substantially contemporaneous exchange. In other words, if a creditor provides new goods and/or services and receives payment at substantially the same time, the payment will not receive preference treatment. An example of such a contemporaneous exchange would be payments received on a C.O.D. basis.
2. The Ordinary Course of Business Defense
Under Section 547(c)(2) of the Code, payments received in the ordinary course of business on debts incurred in the ordinary course of business are excepted from preference treatment. A creditor may utilize the ordinary course defense in either of the following contexts: (1) where payment is received in its ordinary business with the debtor, or (2) where payment is received according to the ordinary business in that industry.
As to the first test, the court’s basic inquiry involves a subjective evaluation of the debtor/creditor relationship. This generally takes the form of a consideration of the length of time the parties have had a business relationship, and whether the amount or form of payment at issue differed from past business practices between the parties. The longer the business relationship, and the lesser thedifference between the payment history before the preference period and that within the preference period, the greater the likelihood that the supplier will prevail.
As to the second test, a more objective inquiry is utilized. The supplier must establish that the terms by which it extended credit to the debtor were “ordinary” within industry standards. This does not mean that all invoices are required to be paid within the invoice terms. The creditor need only show that payments are made sporadically or outside invoice terms in the particular industry involved, or at least in a manner and form consistent with the payment practice being challenged.
3. The Small Transfer Defense
This defense bars preference claims in the case of primarily non-consumer debt for payments of up to $5,000. Creditors should keep this ceiling amount in mind when structuring payment from debtors. As a matter of strategy, creditors may prefer payments of $4,999 to payments not appreciably greater than that amount. However, a caveat is in order: any payments received during the 90-day preference period cumulate against the maximum protected amount. Thus, if a monthly payment schedule is in place, the $4,999 maximum must be distributed among the preceding three months.
Often, bankruptcy trustees will file preference claims against all creditors who have received payment from the debtor in the 90 days immediately preceding a bankruptcy filing. The strategy is to file the claims upfront, and then sort out the merits later in the process. A basic understanding of preferences can help creditors avoid making a reflexive, yet unnecessary, refund payment. Nonetheless,as demonstrated by the cursory outline above, these matters can be complex and are best addressed with the assistance of a lawyer with experience representing creditors in bankruptcy cases. More importantly, do not give up on issues in bankruptcy thinking that creditors cannot win in bankruptcy court. Approach the process with the thought and goal of winning!