Defense of a Preference Claim

By James B. Angell

There is no experience in a bankruptcy case more frustrating to our clients than a preference claim. A preference action typically presents itself as follows:

1. A company owes money to our client for goods or services and is late in making payments.
2. The company finally pays our client.
3. The company (the “debtor”) files for bankruptcy.
4. Our client receives a letter or complaint in the mail from the bankruptcy trustee or the debtor’s attorney.
5. Much to our client’s surprise, the trustee’s letter (or complaint) is a demand for the repayment of the money our client received before the bankruptcy was filed! Sometimes, the letter will set out the amount of the payments the client received, then offer to settle for a small discount of those payments.

This may happen even though the debtor owes our client large sums of money – insult added to injury. Luckily, there are several defenses available which may limit or even eliminate any preference liability.  This article explains the principles behind a preference action and highlights common defenses that may be available.

What is a Preference?

When a company files bankruptcy, it typically owes money to vendors, trade creditors and lenders with whom it did business. A bankruptcy trustee is sometimes appointed to administer the case, assess claims and recover assets. One means of recovering assets is a preference action.

Bankruptcy law authorizes the debtor or trustee to retrieve certain payments made within 90 days of the bankruptcy filing. The theory behind this 90-day reach-back is one of fairness: the law assumes that any creditor who received payments during the bankrupt company’s final days was preferred over creditors who did not receive payments. Return of these “preferential” transfers may be demanded by a bankruptcy trustee, for redistribution among all creditors of the bankruptcy estate. In simple terms, if A is owed $100 and B is owed $100, and the company pays $100 to A within 90 days prior to filing, the trustee may be able to require A to repay the $100 so that A and B will be treated the same in the bankruptcy.

Can I Avoid Liability?

When our clients come to us with the complaint or demand letter, we look to see whether any of the statutory defenses apply. The bankruptcy trustee may not avoid payments if they qualify for any of these defenses. The reason for the preference defenses is to encourage companies to provide goods and services to troubled companies without fear of having to repay payments.

First, we look at the two “new value” defenses. These can often be determined by mathematical calculations and are generally the clearest cut of the defenses.

Contemporaneous Exchange for New Value

A payment that is made in a contemporaneous exchange for goods, services or other value may be exempt from avoidance. The reason for this defense is that other creditors have not been hurt by the transactions since value went into the company at the same time (usually no more than a matter of days) that the payment was made to the creditor. “Value” can refer to money, goods, services, or new credit, among other things.

New Value after the Transfer

In addition to the “contemporaneous exchange of new value” defense, our client may have defenses if the client provided goods or services to the bankrupt company at any time after the payments were made. Again, the law reasons that if value was given after a payment was received, then to the extent of the value that was given, other creditors of the company were not harmed.

Next, after we reduce the amount of our client’s exposure by addressing new value, we look to the “ordinary course of business” defenses.

• Payments in the Ordinary Course of Business

If the payment is typical of the parties’ business dealings, it may qualify under the ordinary course of business exception. Although the “ordinary course” analysis can be complex, in simple terms the defense is applied by comparing the parties’ transactions during the 90-day period with the parties’ historic course of dealing before the 90 days. If there is nothing unusual about the 90-day period payments, the payments may be shielded from preference liability. Developing this defense requires a careful analysis of the payment history, including looking at reasons why payments may have varied in the past.

Alternatively, if a payment is typical in the industry, it may qualify for the ordinary course of business defense. Although this is a defense, it is murky territory for both the trustee and the client, as it may require testimony from experts in the industry – in the case of disagreement among the experts, the Bankruptcy Court decides the case on the basis of its assessment of their testimony. There is risk and potential expense for both the trustee and the client, which often leads to settlement.

Conclusion

Although you may receive a demand for return of payments from a trustee coupled with a discounted offer, you should not agree to the proposed settlement without a careful analysis of the defenses that might be available to you. A thorough analysis of the course of dealing between our clients and the troubled company frequently leads to savings in settling the case. Most preference claims do not result in a trial and are settled for a variety of reasons for a percentage of the original demand. The key to resolving the matter effectively and cost efficiently is to identify these issues at the outset so that both parties can get to the bottom line as quickly as possible.

If you are faced with a potential preference action and have questions about your rights, please feel free to contact one of our certified business bankruptcy specialists, Jim Angell jangell@hsfh.com or Nick Brown nbrown@hsfh.com or 919-8221-7700.