You've finally received payment on a past due account. You're breathing easier. Looks like you won't have to deal with another bad debt, and your cash flow situation is brightening. Then, the other shoe drops. You receive notification that the customer that just paid has filed for bankruptcy. And soon the postman brings the dreaded letter from the bankruptcy trustee asserting a preference claim against the cash you just collected. What now?

First of all, do not immediately send off a check. Not all payments made just prior to bankruptcy are preferences. And there are several defenses that can save you at least some portion of that hard earned cash. Take some time to study the payments at issue. Consider contacting a bankruptcy attorney for advice. And, don't give away the farm without putting up a fight.

Preferences: What and Why?

A preference or preferential transfer under Section 547(b) of the federal bankruptcy code is:

A payment (or transfer of an interest in property) received by a creditor within a defined period prior to the payer (debtor) filing bankruptcy.

The purpose of the law is to discourage disparate treatment of creditors in a bankruptcy situation. The theory behind the law is that, as an insolvent debtor slides into bankruptcy, there will be preferential treatment of some creditors, perhaps those that are aggressive or those that are on especially friendly terms with the debtor.

There are basically three types of preferences.

Insider preferences. Payments or transfers to individuals and entities designated as "insiders" of the debtor under Section 101(31) of the Bankruptcy Code. Insiders generally include relatives, general partners, directors, officers, persons in control, managing agents, affiliates etc. The period for insider preferences has been increased from one year prior to the bankruptcy filing to two years prior to the filing by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (S.256).

Fraudulent transfers. Related to preferences, but addressed under Section 548 of the Bankruptcy Code. These are generally payments or transfers occurring within the year preceding bankruptcy. However, under some state laws, a bankruptcy trustee can recover fraudulent transfers made within four years, or even up to seven years prior to the bankruptcy filing.

Fraudulent transfers don't necessarily involve some kind of "illegal" (as the term "fraudulent" would seem to imply) activity. For instance, note the following example from "When Your Customer Files Bankruptcy" by Benjamin S. Seigal of Buchalter, Nemer:

You sell goods to the buyer who then runs into financial difficulty. He asks you to take back the goods for full credit. Instead, you offer to take them back for a credit of 30 cents on the dollar. Your buyer agrees, returns the goods, gets the credit and files bankruptcy. The buyer/debtor, or a bankruptcy trustee, could conceivably sue you on a fraudulent transfer theory claiming that he/the buyer received less than fair equivalent value on the return and demand the payment of the other 70 cents on the dollar.

Non-insider preferences. Payments or transfers to non-insiders that occur within 90 days prior to the bankruptcy filing.

Most preference claims are of this type, against "non-insider" payments or transfers, generally to unsecured creditors. Therefore, it is the non-insider preference we will discuss in this article.

Note that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (S.256) bars bankruptcy trustees from asserting preferences on amounts less than $5,000. It also requires that preferences claims for non-insider business debts less than $10,000 must be filed in the district where the creditor has its principal place of business. The purpose of this reform is to protect small, non-insider creditors from "nuisance" preference claims and often crippling preference defense costs.

When is a payment preferential?

The initial burden of proof in a preference claim is on the bankruptcy trustee/debtor. A payment is only preferential if the payment:

Is for the benefit of the creditor - Section 547(b)(1). This sounds pretty simple for the trustee to prove. However, there are some exceptional circumstances outlined in Part 3 of Robert S. Bernstein's "Primer on Preferential Transfers in Bankruptcy."
Is on a past due account - Section 547(b)(2). Again, this seems straightforward, but Bernstein points out some problematic issues in Part 4 of his Primer.
Is made while the debtor is insolvent - Section 547(b)(3). Under Section 547(f) of the Bankruptcy Code, a debtor is presumed insolvent on and after 90 days preceding the bankruptcy filing. Therefore, the payment would have to be made within this 90-day period. But, even if it is within the presumed "insolvent period", in some instances a defense on this point has proven successful. (See Preference Defenses below.)
Is made within 90 days preceding bankruptcy filing - Section 547(b)(4).
Enables the creditor to receive more than it would have if the debtor was liquidated under Chapter 7 - Section 547(b)(5). In order to prove this point, the trustee will have to first determine the creditor's appropriate class (as defined in Section 501 through Section 510). Then he must assess the distribution that class would have received under Chapter 7 if the transfer had not been made.

Because Chapter 7 distributions to unsecured creditors are generally less than 100%, any payment to an unsecured creditor during the preference period would be construed to provide the creditor more than it would have received under liquidation. Thus making the trustee's burden of proof uncomplicated in most instances.

Defenses against Preference Claims

According to William T. Hohmann, Esq. of Hohmann, Boukis & Curtis Co., Cleveland Ohio in a presentation to the NACM Greater Cleveland Mass Merchants credit group:

Many creditors make the mistake of paying a Trustee or debtor immediately upon receipt of a preference demand letter. Other creditors make serious admissions against interest or otherwise implicate themselves in responding to such demand letters. You must be very careful in what you say or do, as all such correspondence can be used against you. Many preference claims can be successfully defended or compromised if creditors more fully understand the available defenses and how to use them.

Mr. Hohmann's key point in a nutshell: Don't assume you have to pay, just because you get a preference demand letter.

There are several possible defenses to a claim for preferential transfer, all outlined in Section 547(c) of the Bankruptcy Code.

"Ordinary Course of Business" Preference Defense

The Ordinary Course of Business defense is one of the most frequently asserted by creditors and also, according to Bernstein, one of the most litigated. It was formulated to induce creditors to continue dealing with a distressed debtor to increase its chances of surviving bankruptcy.

To succeed with this defense, the creditor must demonstrate that:

The debt paid was incurred in the ordinary course of business - Section 547(c)(2)(A);
The payment was ordinary between the debtor and creditor - Section 547(c)(2)(B); or
The payment was made according to ordinary business terms, that is, in conformance with industry norms - Section 547(c)(2)(C).

#1 is generally easy to prove and not often contested by the trustee.

#2, known as the "subjective test", requires that the relationship between the creditor and debtor be thoroughly examined. Payment history during the year prior to the preference period is compared to payment history during the period. Unusual collection activity against the debtor is studied. Although the courts generally ignore some dunning of the debtor, any "unusual" collection activity, like starting a lawsuit or requiring wire transfers where checks used to be accepted, will probably defeat this defense.

#3, known as the "objective test", requires the creditor to provide evidence of the range of terms considered normal in the industry.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (S.256) made a significant change in favor of the creditor to the requirements of the Ordinary Course of Business defense. Prior to October 17, 2005, when this provision of S.256 went into effect, the creditor was required to prove both #2 -- that the payment was ordinary between the debtor and creditor, and #3 -- that the payment was in conformance with industry norms. S.256 changed the law so that the creditor is only required to prove one or the other, not both.

This less rigorous standard is expected to reduce costs of presenting this defense as well as expand its application.

"Subsequent New Value" Preference Defense

This defense (Section 547(c)(4) of the Bankruptcy Code) is also frequently asserted. It is generally easier to prove than the "ordinary course of business" and usually applies where the creditor and debtor have an open or "running account" relationship. Its purpose, again, is to encourage extension of credit to financially troubled companies.

The defense applies if:

the creditor has received a preferential payment against which there is no defense;
the creditor advanced additional unsecured credit to the debtor after this preference payment; and
this additional credit remains unpaid (in whole or in part) as of the date of the bankruptcy filing.

Should this defense succeed, the creditor is allowed to reduce the preference exposure by the "new value" given the debtor. However, a simple netting out of the "new value" against the preference is not allowed. The creditor must prepare an analysis showing the date of each preference payment, along with the dates of invoices for debts claimed as "new value". Only those amounts invoiced after the preference payment, will be subtracted from the amount due back to the estate under the preference.

"Contemporaneous Exchange for New Value" Preference Defense

This defense, outlined in Section 547(c)(1) of the Bankruptcy Code, generally applies to payments that are cash on delivery (COD), cash in advance (CIA) or cash with order (CWO). However, even sales on terms that are paid within those terms, can sometimes qualify.

To succeed with this defense, the creditor must prove that:

The value given to the creditor (by way of payment) equals the value the debtor received.
The debtor and creditor both intended the transfer to be contemporaneous.
The exchange was, in fact, contemporaneous. The court will closely examine the timing of the exchange.
A specific measure of "new value" was provided to the debtor. The new value provided generally must actually enhance the worth of the debtor's estate.

"Solvency" Preference Defense

This is one of the toughest and often most expensive defenses to attempt as the Bankruptcy Code (Section 547(f)) presumes a debtor is insolvent on and after the 90 days preceding the bankruptcy filing. However, under certain circumstances it can be successful. (See Business Credit magazine, July/August 2003 issue: "Defending a Preference Claim Under the Solvency Defense: What the Vendor Must Prove by Scott Blakeley, Esq.)

To succeed, the creditor must prove, with financial evidence, that the debtor was not insolvent during the preference period. Expert testimony of a financial consultant is almost always required and, as there is no GAAP method for measuring the insolvency of a company, the proof can be very difficult.

Bankruptcy Preference Tips for Creditors

We've already said it twice, but it bears repeating. Do not automatically submit a check when you get a demand for return of a preferential payment. Start preparing your defenses and, if you have any doubts, contact a bankruptcy attorney to help.
Even if you haven't yet received a preference demand letter, if you were paid by the bankrupt debtor within 90 days of his filing, immediately begin preparing your preference defense. It's almost 100% certain you'll be getting the demand letter very soon.
Even if your defense is shaky, try negotiating a settlement.

Resources on Bankruptcy Preferences

A [15 Part] Primer on Preferential Transfers in Bankruptcy by Robert S. Bernstein, Esq. of Bernstein Law Firm, P.C.

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Disclaimer: This information is provided by ABC-Amega Inc. for informational purposes only and is not intended to be legal advice and is not a substitute for competent legal advice on the referenced subject.

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