Preference Payments and Defenses in Bankruptcy

A “preference payment” sounds like a good thing.  To a credit manager, believe me, it is not.  Imagine a situation where a customer, way behind on his invoices, suddenly comes current with a $20,000 payment.  You accept the payment, and for good reason.  Payroll is due, and fortunately the client paid you in time to fund payroll and your business survives another month.  Two months later, your client files for bankruptcy protection, and you get a notice of the filing, but you say “phew! Glad I got the money when I did!”

This euphoria may only last for a few weeks, however, when, in a letter from a bankruptcy trustee or debtor in possession, you discover a term you wish you’d never heard: Preference Payment.

If your customer files for bankruptcy within 90 days after he gives you a full or partial payment on his outstanding balance, it may be considered a “preference payment”. Preference payments are called that because they arise in situations where a creditor “prefers” you over other creditors at a time when they were insolvent, which is considered to be unfair to other creditors similarly situated.

Fortunately for you, there are defenses that you can raise against a preference claim, namely:

·         contemporaneous exchange,

·         new value, and

·         ordinary course of business.

These defenses exist mainly to encourage creditors to continue doing business with, and extending credit and new inventory to, financially challenged customers.

But what is a preference?

The Bankruptcy Code allows a trustee or debtor-in-possession (typically a Chapter 11) to recover any payments or other transfers of assets by a debtor to a creditor within 90 days of the debtor’s bankruptcy filing.

The preference provision has two main purposes: (1) to prevent a debtor from favoring any of its general unsecured creditors over the others in the downward spiral; and (2) to discourage creditors, upon hearing that the debtor is about to file bankruptcy, from rushing the courthouse and disperse the assets of the debtor.

Proving a preference. To back up the preference claim, a trustee or debtor-in-possession must show that five conditions applied to the payment:

·         The debtor made a payment or transferred property to, or for the benefit of, the creditor.

·         The payment or transfer occurred within 90 days of the debtor’s bankruptcy filing (or a full year for payments to insiders) (the “preference period”).

·         The debtor made the payment to reduce an existing debt owed to the creditor.

·         The debtor was insolvent when the payment occurred (this is presumed.

·         As a result of the payment or transfer, the creditor received more from the debtor than he would have received in a Chapter 7 liquidation of the debtor.

Defenses

OK, so you took a payment.  All is not lost, as there are some defenses, although narrow, that may allow you to keep the payment even if it was received with 90 days of the customer’s bankruptcy filing.  

Contemporaneous Exchange Defense.  The first defense to a preference, which would not apply in the $20,000 example above, is contemporaneous exchange.  This is a situation like a cash on delivery (or C.O.D.) for inventory items, or items sold at the same time (or relatively the same time) as payment is received.  This defense exists whether or not you had a previous relationship with the customer.  The point here is that you provided goods/services in exchange for payment, and that payment was before or around the time the goods/services were provided.

New Value Defense.  The new value defense, similar to “contemporaneous exchange”, is available to a creditor if, during the preference period, a creditor provides “new value” to the debtor for which a serious of payments to the creditor could be attributed.  For example, let’s say Debtor Company (“DC”), even though they are extraordinarily $10,000 behind on their invoices, places an order for $10,000 worth of new goods and you delivered the goods the same day, which happened to be 60 days before DC filed bankruptcy.  Now, two weeks before the bankruptcy filing you get a check for $20,000.  The New Value defense would allow you to keep at least $10,000 of the $20,000 simply because you provided new value to DC during this preference period.  Basically, this defense recognizes it would be unfair to a creditor that is increasing the value of the bankruptcy estate during the preference period to be penalized for having done so.  These computations can be complicated, so it is imperative that you work with professionals to determine these amounts accurately.

Ordinary Course of Business Defense. The most common defense asserted for payments beyond a contemporaneous exchange is ordinary course of business. Fortunately, the test takes into account not just the credit and collections practices that are appropriate to your industry but also the payment history between you and your customer.

To successfully raise the “ordinary course of business” defense, the creditor must prove both of the following: The debt on which you received the payment was incurred in the ordinary course of business between you and the debtor; and the payment was made in the ordinary course of business between you and the debtor, according to ordinary business terms.

Whether the debt was incurred or the payment was made in the ordinary course of business is relatively objective and easy to prove or disprove.  Basically, was it a normal, everyday credit transaction (like between a seller and a buyer of inventory).

The second consideration in each element is more subjective, as it takes into account the specific, historical invoicing and payment relationship that existed between you and the debtor prior to the 90-day preference period. If the alleged preference payment was consistent with the manner in which previous payments were made, that strengthens your defense against the preference claim.

Example A: DC was a long-time customer that paid its bill, with charges ranging from $500 and $6000, between 35 and 60 days after the due date.  Two weeks before filing its bankruptcy petition, DC made a $5,000 payment on its account, 52 days past the due date but obviously within the 90-day period. When a preference claim is made against that payment, you would have a strong case that the payment was consistent with DC’s existing payment history, and therefore the payment was not a preference but in the ordinary course of business.

Example B: For its first six months as a customer, Debtor Company II paid its bill on or before the due date. However, charges for the seventh month went unpaid for 80 days before a check finally arrived within the preference period. A week after you received that payment, DCII filed for bankruptcy protection. The inevitable preference claim will be much more difficult to defend as “ordinary course” than in the case of DC, because of (a) your short credit experience with DCII and (b) the variety between DCII’s payment history and this payment.

Although it is not fun to receive a preference payment demand letter from a trustee, it is important that you have adequate counsel to discuss the applicability of these defenses to your situation.  

By: Marc Lippincott