There is perhaps nothing more frustrating than when one of your customers files bankruptcy and avoids paying money that they owe your company. However, anyone that has dealt with a “preference action” knows that merely writing off a debt as uncollectible is not the worst thing that can happen when a customer enters bankruptcy. A preference action has the potential to be much worse, because it is a lawsuit by the debtor or the bankruptcy trustee against your company, seeking to recover payments that were made by the debtor to your company before the bankruptcy. Fortunately, the Bankruptcy Code provides creditors with certain defenses that can be used to defeat a preference action.
The Bankruptcy Code permits the trustee to avoid and recover from creditors payments made within the 90-day period before the bankruptcy filing. The policy behind this provision is to prevent aggressive collection activities that often force the debtor into bankruptcy.
A “preference” is defined by Section 547 of the Bankruptcy Code as:
- Payment on an “antecedent” (meaning a previously incurred as opposed to current) debt;
- Made while the debtor was insolvent (meaning its assets are less than its liabilities);
- To a non insider creditor, within 90 days of the filing of the bankruptcy;
- That allows the creditor to receive more on its claim than it would have, had the payment not been made and the claim paid through the bankruptcy proceeding.
Section 550 of the Bankruptcy Code allows the trustee to avoid and recover any preference payments by filing a lawsuit against the creditor.
Typically, a preference action is often preceded by a “demand letter” from the debtor or the trustee. The demand letter sets forth the trustee’s claims and demands immediate payment. Often times the trustee is willing to settle the preference action for an extremely reduced amount if the settlement is reached before the lawsuit is filed. Consequently, when the creditor receives a “preference demand letter,” the creditor should always have experienced bankruptcy counsel review the case to determine whether the creditor has valid defenses. Bankruptcy counsel can often negotiate a favorable settlement and allow the creditor to avoid having to expend large sums of money in litigation.
If the parties do not reach a settlement, the preference action is initiated with a complaint filed with the bankruptcy court. The preference complaint is similar to any other lawsuit with the exception that its filed in bankruptcy court, rather than federal district or state court.