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.
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”.
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.
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.
following is a more detailed explanation of each of the seven elements to
better understand the avoidable preference as defined by the Bankruptcy
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.
of the Debtor:
This is rather clear-cut. Excluded, however, is property held by the
debtor in trust for another.
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.
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.
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.
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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