The unusually high number of bankruptcy filings has also created large number of preference claims by debtors and/or trustees against the bankrupt’s creditors. This in turn has led to many inquiries concerning preferences and what creditors should do when served with the notice of a preference claim. The following information is provided, not as legal advice, to explain what a preference is and to answer the primary question of how to respond to a request for repayment of a preference.

The U.S. Bankruptcy Code permits a debtor in bankruptcy or its trustee to force repayment of transfers made within 90 days of a bankruptcy filing (one year if the transferee was an insider). These transfers are referred to as preferences or preference payments. The transferee’s liability is often enforced by a lawsuit brought about by either the debtor or trustee against the preference creditor(s). These transfers are referred to in the Code as “avoidable transfers”. 

The preference laws recognize that a financially troubled debtor tends to pay only certain creditor obligations, whether out of loyalty or necessity, due to insufficient cash flow. Preference laws were created to promote the principle of equality of distribution among creditors, not only at the time of filing but also during the 90 days prior to the filing date for most creditors and one year if the transferee was an insider. 

An avoidable preference involves seven elements. One, it is a transfer; Two, of property of the debtor (cash or equivalents, and/or property); Three, to or for the benefit of a creditor; Four, on account of an antecedent debt; Five, made while the debtor was insolvent; Six, within ninety (90) days of bankruptcy or one year in the case of insiders; Seven, that enables a creditor to receive more than they would if the bankruptcy estate was liquidated in a Chapter Seven bankruptcy filing.  

The following is a more detailed explanation of each of the seven elements to better understand the avoidable preference as defined by the Bankruptcy Code. 

Transfer: The Bankruptcy Code broadly defines a transfer as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor’s equity of redemption.” Transfers not only include payments on antecedent debt but the transfer of property, including the return of previously sold inventory and/or equipment, the creation of liens, including judicial liens and security interests, the perfection of liens and the effectuation of property executions. 

Property of the Debtor: This is rather clear-cut. Excluded, however, is property held by the debtor in trust for another. 

To or for the Benefit of a Creditor: This is another straightforward element. However, a creditor may be determined to be the recipient of an indirect transfer, such as payment by a debtor on a debt guaranteed by a third party.  

Antecedent Debt: This is debt that arose prior to the transfer. A debt is considered to arise at the time the debtor becomes legally obligated to pay it. This generally takes place upon execution of a debt instrument, receipt of goods and/or services, upon receipt of an invoice, or on the date specified in the contract.

Insolvency: For preference purposes, a debtor is reputably presumed to be insolvent during the ninety-day period immediately preceding the filing date. This presumption does not apply for the remaining period of insider exposure. “Insolvent” is defined as: “. . . .a financial condition such that the sum of [the debtor’s] debts is greater than all of [the debtor’s] property, at a fair valuation ….” This definition excludes certain transfers deemed fraudulent. Insolvency must be determined as of the date of the transfer in question. 

Time of Transfer: This is the period applicable to non-insiders and is defined as ninety days preceding the filing date. The period applicable to insiders is the one-year period preceding filing. The term “insider” is nonexclusively defined to include relatives, general partners, partnerships in which the debtor is a general partner, directors, officers, persons in control, affiliates, and insiders of affiliates of the debtor. In the case of a transfer that is made by check, the transfer is considered to occur on the date the check is honored by the transferor’s bank as opposed to the date of its receipt by the payee. 

Receipt of More Than Under Chapter 7: It is by virtue of this element that secured creditors are immune from preference liability, at least to the extent of the value of their collateral. Because valid and perfected liens are unaffected by the bankruptcy, a payment on account of a debt fully secured by a valid and perfected lien does not enable the transferee to receive more than it would under a Chapter 7 filing. Where the debt is only partially secured, however, the creditor may receive a preference to the extent its secured position is improved during the preference period. This would occur under a general security agreement where a creditor has extended credit in excess of the value of the security. The same analysis may apply to a creditor with a right of setoff that increases during the preference period. The only other cases in which this test is generally relevant is one in which there are sufficient assets to pay all creditors in full, which is a rare occasion. Note, while creditors who hold a general security agreement are secured up to and including the value of their collateral and any excess debt is unsecured, Purchase Money Security Holders are always secured at one-hundred percent. 

The burden of proof in a preference action always lies with the either the debtor or the trustee. The only exception is with respect to the presumption the debtor was insolvent within the ninety-day period prior to the bankruptcy (but not the one year insider period). Also, the parties liable for preferences include not only the primary transferee, but also any party for whose benefit the transfer was made. 

There are nine defenses to a bankruptcy preference claim. Three defenses are most commonly used. These three defenses are: the ordinary course of business defense, contemporaneous exchange defense and the subsequent new value defense. We will discuss these along with three other defenses available to creditors in commercial bankruptcies. 

Ordinary Course of Business. This is the most commonly misunderstood defense in preference claims and many who rely on this defense often lose the avoidance because of their failure to understand the requirements and the complex issues of the defense. The ordinary course of business defense requires that, ONE, either the payment has been made in the ordinary course of business of both the creditor and debtor, or, TWO, the payment was made under “ordinary business terms”. Please note this is an either/or test. Prior to 2006 the test was an “AND” test and BOTH had to be proven. This was often very difficult to do. The period of time during which the creditors’ books and records are going to apply to this defense extends from the date of the payment and going back in time for over more than one year. This extended period is necessary to establish the historical timing of payments between the parties. Because of this, of all of the defenses, the ordinary course of business defense is the most demanding in terms of record keeping on the part of the creditor. If the creditor organization is lax in keeping detailed records this defense is not recommended. In defending preference claims, the debtor’s bankruptcy attorney or expert may state it has considered this defense. However, even slight changes in methodology of the analysis can produce a dramatic effect in terms of the creditors preference exposure. Experienced bankruptcy preference counsel will push for application of the most favorable methodology for the creditor. 

Contemporaneous Exchange.  This defense is one of the most often disputed defenses although it should not be that way. The focus of the defense is very narrow and centers on when the preference payment was received. Ideally, the payment should be received at or about the same time as the delivery of goods and/or services. A preferential transfer may not be avoided if it was intended by the debtor and the creditor to be, and in fact was, a contemporaneous exchange for new value given to the debtor and the antecedent debt of the creditor was not affected by the debtor’s payment. An example would be where a creditor with a past due balance provides the debtor goods on COD terms. The COD payment is for the goods supplied and not for payment of the antecedent debt. “New Value” generally means money or goods, services, new credit, or a release of property by the transferee. The determination of the parties’ intent is a question of fact and sometimes becomes difficult due to the loss of personnel, fading of memories and loss of books or poor recordkeeping. This is one of the best examples of pre-bankruptcy opportunities for the creditor to improve its chances of surviving a bankruptcy preference action. A well advised creditor will not only have placed the past due customer on COD, they will also have obtained a “Payment Agreement” whereby the customer acknowledges that payments are to be a “contemporaneous exchange” and the parties also agree on how past due payments are to be handled. Competent legal counsel who is familiar with bankruptcy preferences should always draft the payment agreement.  If the debtor will not sign an agreement and they have not filed bankruptcy there is still opportunity to document the contemporaneous exchange defense. Once again competent legal counsel should be consulted on the appropriate steps to be taken in preparing this documentation. 

 New Value.  The new value defense is perhaps the most used defense. It is from a books and records perspective and the easiest defense to prove. The focus is on the period of potentially preferential payment. This defense requires that two elements be proved. One, “new value” provided the debtor by the creditor after the creditor received payment and, two, the creditor never received payment for the “new value” provided. “New Value” can be anything that creates value in the debtor’s company. However, most often, it simply means that goods or services were provided after the date a payment was made. For this reason, when dealing with an antecedent debt, it is recommended to wait until the payment is received before providing “new value”. Goods and/or services should never be provided based on the promise that payment is either in the mail or forthcoming. There are some legal issues that have not been resolved regarding this defense and the scope of its application. Thus, while factually this defense is the simplest, the legal interpretation can be complex and again counsel from competent legal sources should be obtained.  

Purchase Money Security Interest.  A security interest created in property acquired by the debtor is not a preferential transfer to the extent the security interest secures new value given by the creditor to enable the debtor to acquire the property. It is important that the PMSI be perfected within 20 days and that includes not only the filing of the PMSI but also notification to other creditors who have a previously filed security interest in the same type of property. 

Small Commercial Preference Defense: In 2005, the Bankruptcy Code was amended to limit by dollar the amount that transfers could be avoided in a commercial case. This is commonly known as the “Small Commercial Preference Defense”. Originally, a transfer could not be avoided if the amount paid or other amount of value transferred was less than $5000. That amount was increased to $5,475 effective April 1, 2007. It will be increased (or decreased) again on April 1, 2010 in an amount tied to the change in the Consumer Price Index over the preceding three-year period. The Bankruptcy Courts have historically narrowed the benefit of the Small Commercial Preference Defense by permitting two or more small payments to be aggregated to exceed the threshold. Simply, this means the bankruptcy trustee is often permitted to add together all payments within the preference period for a single creditor to reach the $5,475 limit. For example, if a creditor receives $2,500 in one payment and $4,000 in another payment, both within 90 days before the bankruptcy filing, the trustee is allowed to add both payments and the preference claimed is $6,500. The Small Claims Preference defense becomes unavailable to the creditor. 

Venue Defense to Bankruptcy Preferences. When the Congress established a threshold requirement for bringing a preference claim, it also established a dollar-amount-in-controversy restriction on where small claims arising in a bankruptcy case may be brought. If a preference claim is made for less than $10,950, and depending on where the bankruptcy case is pending, there may be a requirement that a collection action be brought where the creditor does business, and not necessarily where the bankruptcy case is pending. It is important to note here that the applicability of this “local venue” requirement on preference actions varies from jurisdiction to jurisdiction. Also, the dollar threshold is going to be adjusted on April 1, 2010 based on changes in the Consumer Price Index for the preceding three years. So, the debtor files bankruptcy in Illinois. The creditor never has done business in Illinois and does not have an office or employ salespersons in Illinois. The bankrupt customer paid the creditor $7,700 within the preference period, 90 days, prior to the bankruptcy filing. The creditor receives a demand letter from the trustee who informs them that he or she intends to bring a preference action in Illinois to recover the $7,700 as an avoidable preference. Under this defense the creditor may inform the trustee they are ready to defend the preference claim and the creditor has no connections with the state of Illinois and so any action to collect the preference needs to be brought to a jurisdiction where the creditor does business. At that point the trustee has to decide the benefit to sue the creditor in another state before another judge. Because the costs outweigh the benefits, often is the case that the preference action is vacated. 

In conclusion, creditors in receipt of a demand for the return of an alleged preferential transfer should be aware that certain types of transfers are not subject to the preference rule. Creditors should always consult with competent legal counsel to determine whether the transfer at issue is in fact preferential or falls within one of the notable exceptions to the rule. In other words, never give the money or property back until your attorney tells you to.    

I wish you well.

The information provided above is for educational purposes only and not provided as legal advice. Legal advice should be obtained from a licensed attorney in good standing with the Bar Association and preferably Board Certified in either Creditor Rights or Bankruptcy.