Understanding Preference Actions Under the Bankruptcy Code

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 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:

  1. Payment on an “antecedent” (meaning a previously incurred as opposed to current) debt;
  2. Made while the debtor was insolvent (meaning its assets are less than its liabilities);
  3. To a non insider creditor, within 90 days of the filing of the bankruptcy;
  4. 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.

Defending a Preference Action:

The Bankruptcy Code also provides defenses to preference actions. The three most common are: 1) the “ordinary course of business defense”; 2) the “contemporaneous exchange for new goods or services” defense; and, 3) the “new value” defense. All three of these defenses are “affirmative defenses,” meaning that the creditor has the ultimate burden of proof on the issue.

To prove the “ordinary course of business defense” the creditor must show that the preference payments were made in the “ordinary course of business” between the creditor and the debtor. Typically, this is done by showing that the preference payments were: 1) not the result of any overt collection activity on the part of the creditor; and, 2) were made in a similar amount of time and under similar terms and conditions as previous, non-preference period payments made by the debtor to the creditor. Assuming that the payments were in fact made “in the ordinary course of business” of the parties, proving the defense is relatively simple and can usually be done with past invoices and payment dates, and testimony regarding the lack of collection activities. Alternatively, if the payments were not in fact made in the ordinary course of business between the parties, the creditor can show that the preference payments were made on terms and conditions prevalent in the respective industry. This is a harder form of the ordinary course defense to prove and should only be used as a fall-back position. All payments that are shown to have been made in the ordinary course of business are not avoidable as preferences and need not be repaid.

To prove the “new value defense,” the creditor only needs to show that goods or services were sold/provided to the debtor after one or more of the preference payments were made. The value of any “new” goods or services can be offset dollar-for-dollar against any preference payments made by the debtor.

The creditor proves the “contemporaneous exchange” defense by showing that the creditor provided new goods or services contemporaneously with (i.e. at or near the same time) a payment that was of equal value to the goods or services provided and that the parties intended the transaction to be a “contemporaneous exchange.” For example, if the creditor receives a $100 payment on June 1 and delivers goods worth $100, if the parties intended the $100 payment to be for the $100 in new goods, then the contemporaneous exchange defense applies. If the parties intended for the $100 to pay a previous invoice, then the contemporaneous exchange defense is not applicable.

Sometimes Bankruptcy Counsel can raise these defenses with the trustee before the complaint is filed and actually avoid the lawsuit altogether. Other times, the defenses can be used to significantly reduce the amount that the trustee will accept as full settlement of the claim. No matter how the preference defenses are used, the defenses are designed to ensure that viable, ordinary, good faith business transactions are not ultimately reversed by the bankruptcy court.

Attorneys at Bernstein-Burkley, P.C. will often have clients ask the following question: “I have a customer that is offering to make a large payment on their account. I know that they are about to go bankrupt. The payment will probably be a preference, should I take it?” The answer, of course, is “YES! TAKE THE PAYMENT!” At worst, you can almost always negotiate with the trustee and pay a reduced amount in full settlement of the preference claim. Perhaps the defenses illustrated above can be used to reduce your preference exposure. At best, the trustee will decide not to pursue the preference action and you will get to keep the entire payment. Preference actions are a natural part of bankruptcy law but, with knowledge, the right circumstances, and experienced counsel, a creditor can often avoid having to return the payments.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.


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