Stop: Don't just pay that preference claim
Chances are if you are a provider of goods or services and do business pursuant to some form of a short-term or long-term credit arrangement that you have received correspondence from a bankruptcy Trustee or a Chapter 11 debtor demanding money on the basis of an alleged “preference.” Perhaps some of you have even been served with a formal complaint demanding the same. If so, then this article is meant to take some of the mystery out of preferences and to offer some advice as to what to do when you receive such a correspondence.
What is Preference?
In answering that question, it makes the most sense to initially dispel what a preference is not. A bankruptcy Trustee's allegation that you received a preference does not mean that you did anything wrong – considerations of fault, intent, or even a devious motive never enter into the equation with preference litigation. Moreover, despite its namesake, it does not actually mean that you were “preferred.” After all, from your perspective, you merely received payment for goods or services that you already provided. Instead, nine times out of 10, being the subject of a preference action simply means that you received a payment from a bankruptcy debtor within the 90 days preceding the debtor's bankruptcy filing. See 11 U.S.C. 547(b) (detailing the requirements that must be met in order for a transfer to be a preference).
Preference actions are rooted in the Bankruptcy Code's goal of equitable distribution of bankruptcy estate assets. When an individual (or a business) chooses to file bankruptcy, all of their assets are initially placed into a bankruptcy estate. At that time, a bankruptcy Trustee, or a Chapter 11 debtor-in-possession, is appointed to oversee the administration and distribution of estate assets pursuant to certain rules set out in the Bankruptcy Code. With that backdrop, the bankruptcy Trustee is charged with effectuating the goal of equitable distribution by protecting the interests of all creditors of the debtor.
Preferences, or payments or transfers made within the 90 days preceding bankruptcy, may be avoided and brought into the bankruptcy estate so that the Trustee may distribute those funds more equitably. In allowing a Trustee to avoid such transfers, the Bankruptcy Code makes the assumption that any transfer made by a debtor within 90 days of filing bankruptcy must have been made with knowledge of the debtor's poor financial condition and the looming potential of a bankruptcy filing. Thus, preference actions seek to avoid the undesirable circumstance where a debtor, recognizing his financial troubles, siphons off all of his assets to his “preferred” creditors prior to filing bankruptcy to the exclusion of his seemingly less-preferred creditors.
There are Many Defenses to Preference Claims
If you receive a preferential payment from a bankruptcy debtor, it is not a foregone conclusion that you are liable for the full extent of that payment. The Bankruptcy Code contains nine codified defenses to preference allegations, see 11 U.S.C. § 547(c), and others exist at common law (like the judicially created ear-marking doctrine). Of those defenses present in the Bankruptcy Code, the Ordinary Course of Business defense and the New Value defense arise most commonly in preference litigation involving trade creditors. Both defenses are grounded in the congressional policy objective to encourage creditors to continue to conduct business with financially troubled debtors in the hopes of avoiding the need for bankruptcy altogether.
The Ordinary Course of Business defense prevents a Trustee from avoiding a payment to a creditor which would otherwise be deemed preferential if the payment was made in the ordinary course of business. See 11 U.S.C. § 547(c)(2). In order to determine whether a transfer or payment was made in the ordinary course of business, courts review the business relationship between the debtor and the creditor both prior to the 90-day period and during the 90-day period. Often, a court's determination of whether a transfer was ordinary comes down to two things: 1) whether payments and invoicing made within the 90-day period were reasonably consistent with payments and invoicing prior to the 90-day period, and 2) whether the creditor or debtor did anything totally unusual that is easily connected to the debtor's financial troubles. As an example of the second circumstance, a creditor's refusal to continue to extend credit to a debtor unless the debtor grants the creditor a secured lien in response to a recent swath of missed payments by the debtor would likely be construed as unusual and not in the ordinary course of business.
The New Value defense similarly rewards creditors who continue to do business with a financially troubled debtor. See 11 U.S.C. § 547(c)(4). While the calculations involved in determining the proper amount of a new value defense are sometimes awkward, the concept is simple: Preferential payments received by a creditor during the 90-day period prior to the bankruptcy filing should be offset by any new value given by the creditor to the debtor subsequent to the preference payment. For example, Creditor, who is a car manufacturer, sends Debtor, a car dealership, 50 cars, along with an associated invoice, on January 1, 2014. Thirty days later, Debtor pays the invoice and, 60 days later, files bankruptcy. Debtor's payment is a preference. However, Creditor, on day 31, provides 50 additional cars to Debtor. If no other payments are made to Creditor following the additional 50 cars (the new value) through the date of the bankruptcy filing, then Creditor is allowed to offset the earlier preferential payment to the extent of the value of the 50 additional cars.
If you receive correspondence (or a formal complaint) from a bankruptcy Trustee seeking to collect an alleged preference from you or your business, do not automatically pay the asserted amount. The wisest course of action is to speak to an attorney familiar with preferences and the multitude of available preference defenses. It is rare to see a situation where a Trustee's preference claims is not at least reduced by an available defense. Moreover, there is always room to negotiate. Keep in mind that a preference action is brought on behalf of a debtor's bankruptcy estate. The Trustee's directive is to maximize the value of the estate for the benefit of all creditors and to minimize the associated costs. As those costs increase through litigation, a Trustee's incentive to make a deal increases. As a bottom line, defending against a preference claim is typically advisable and having a knowledgeable lawyer negotiate with a Trustee is a good start toward that defense.
In addition, you can take steps to put yourself and your business in the best position to utilize the preference defenses. While you cannot predict which of your customers will ultimately file bankruptcy, you can utilize your awareness of the preference defenses to guide your actions. In preference litigation, the clarity of your record-keeping can make the difference between asserting a successful or unsuccessful Ordinary Course or New Value defense. Moreover, your knowledge of those defenses can guide your interactions with financially troubled customers. Consistency is the key and a good bankruptcy attorney can advise you as to the proper course even before a preference action is alleged.