It should not surprise anyone that bankruptcy filings have
increased in the past two years to their highest levels since 1997. In
2001 bankruptcy filings increased over 19% for the two previous years.
Since January 22 when K-Mart, the largest retail bankruptcy filing in
history, filed chapter 11, 125 major businesses in this country have
filed for protection from their creditors. Those firms include Waste
Management, Polaroid, Kaiser, Standard Automotive and Sun Country to
name but a few. These have been attributed to a variety of
reasons: slow down in the economy, terrorism, accounting
irregularities, and the list goes on.
One issue that both the trustee and the unsecured creditors
committee addresses are payments made to creditors within 90 days of
the bankruptcy filing. These payments, known as preferences, can be
required to be returned to the bankrupt on the pretense that they will
be distributed to unsecured creditors so that no one creditor benefits
over other creditors. The reality is that no unsecured creditor will
ever see this money because attorneys, accountants, consultants and
secured creditors will get paid before any unsecured creditors. Sadly,
what the law says and how it is applied differs greatly.
The first rule when confronted with a preference demand is never
surrender the money without first consulting your legal counsel
(hopefully one who is well versed in bankruptcy law). The law allows
for exceptions to the bankruptcy preference and often the creditor
will qualify under one of these exceptions.
The most often stated is “ordinary course of business”. Under
this defense it must be proved that the debt was incurred and the
payment for that debt was made in the “ordinary course of
business” or in accord with industry standards. The example would be
the customer who always pays 60 days after the due date even though
the invoice has terms of net 30 days and the creditor does not enforce
the billing terms due to industry standards. Although, this
appears to be simple, many courts have ruled differently and
therefore, it is not as black & white as it may appear. In order
to prevail in this situation the creditor must have good documentation
supporting that this is the manner the bankrupt has always paid.
Another exception is known as “new value defense”. If the
creditor has continued to do business during the 90 day preference
period after receiving payment then those “new value” dollars can
be applied against the preference request. The critical element in
“new value” is that there was no change in terms after the
bankruptcy filing date.
A “contemporaneous exchange” is another exception where the
selling terms were COD, CIA, or CWO.
If the creditor had a perfected purchase money security interest in
its own goods then no preference existed. Purchase Money Security
Interests take preference over lien creditors..
Lastly, a preference may be avoided if it can be proven that the
payment received would be no greater if a Chapter 7 had been filed.
This can be tricky and consultation with legal counsel is strongly
suggested before using this as a reason not to honor a preference
Regardless, a preference payment should never be handed over to
trustee or creditor committee unless advised to do so by your legal
I wish you well.