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 demand.

Regardless, a preference payment should never be handed over to trustee or creditor committee unless advised to do so by your legal representative.

I wish you well.