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Published: 2008-03-26

Understanding Bankruptcy Preference Law Just Saved My Business a Bunch of Money



Introduction

A popular, nationally-known insurance company advertises that it can save its audience/customer base "a bunch of money" if they takes fifteen minutes of their time to analyze their present insurance costs. Like this insurance company, businesses that extend unsecured trade credit to their customers can save a bunch of money by educating themselves about the bankruptcy laws concerning preferential transfers.

What is a preferential transfer?

Generally speaking, federal bankruptcy law allows a debtor to recover certain payments or "preferential transfers", that were made to a creditor a short time before the filing of the debtor=s bankruptcy. Specifically, section 547 of the United States Bankruptcy Code sets forth six elements of a preferential transfer under federal bankruptcy law. These elements are:

(1)the existence of a transfer;
(2)the transfer is for the benefit of the creditor;
(3)the transfer must be on account of a prior existing debt;
(4)the debtor must have been insolvent at the time of the transfer;
(5)the transfer must be 90 days prior to the filing of the debtor's bankruptcy (or one year if the creditor is an "insider" as defined by bankruptcy law); and
(6)the transfer must have enabled the creditor to receive more than the creditor would have otherwise received if the case was a chapter 7 bankruptcy, the transfer had not been made, and the creditor received payment of its debt to the extent provided under chapter 7.

One notable omission from the preceding list of elements is "intent." In other words, bankruptcy preference law generally does not consider whether the business knew that the debtor was insolvent or if it was trying to beat other creditors to the debtor's last bit of available cash. Therefore, even "good guys" can fall victim to a preference lawsuit if all six elements are present. The end result of a successful preference claim is that the plaintiff gets the ability to avoid or take back the transfer from the creditor, and the creditor has a corresponding claim against the debtor's estate.

Defenses to Preferential Transfer Lawsuits

The good news for businesses that are creditors of a debtor is that they can often protect themselves from a preference lawsuit. The creditor's initial attention should be focused on whether the plaintiff can ultimately prove the six elements needed to successfully establish its claim. If the creditor can show that the plaintiff failed to prove one of the six elements, the plaintiff will lose its case. Alternatively, even if the elements of the debtor's case seem easily provable, the business can assert defenses to a "successful" claim under section 547(c) of the Bankruptcy Code.

One of the most common defenses - if not the most common defense – against a preference claims is that the transfer was an "ordinary course" transfer. There are three components to this defense that the creditor must prove in order to successfully assert it. One, the debt that the transfer satisfied must have been one that typically existed between the creditor and the debtor. Two, the transfer must have been paid in a time and manner that is consistent with other prior payments made by the debtor to the creditor. Third, the transfer must be consistent with other transfers that are standard in the creditor's or debtor's industry; expert testimony is often used to define these "industry standards."

Other common defenses include the "new value" defense, which rewards creditors that continued to do business with the debtor during the final weeks prior to its bankruptcy filing; the "contemporaneous exchange" defense, which includes COD transfers and the like; and the defense for transfers in situations in which (a) the creditor is granted a purchase money security interest 90 days before the bankruptcy filing to enable the debtor to receive inventory, and (b) the creditor perfects the security interest on or before 20 days after the debtor receives the property. Other rarely used defenses are available, but are not discussed due to the scope of this article.

Pre-emptive Measures for Reducing the Risk of Preference Liability

Of course the best way to beat preference lawsuits is to avoid them all together. A business can apply this strategy and reduce its risk of preference liability by taking certain proactive measures. First and foremost, a business should carefully examine whether it can stop taking credit and instead require advance payment or COD. Alternatively, if the business must have credit terms to accommodate its customers, then it should strive to maintain consistency. If the parties have agreed to certain arrangements, then the business should stick to them as much as possible.

A business should also make sure that its terms are consistent with the terms of others in its industry. If a business is in a position in which its purchaser often pays "past due", the business should discuss with the purchaser ways where the business can define the terms and make them consistent with the relevant industry standards. Also, when the purchaser is late with its payments, a business should not engage in collection measures that are unusual compared to the practices of its other customers or the general industry practice. Payments resulting from such collection activity are more difficult to insulate from preference liability. In addition, a business should maintain meticulous records of all transactions with its customers because thorough and complete records are crucial for establishing defenses against preference claims. For example, keep copies of purchase orders, invoices, contracts, canceled checks and bank statements in a well-organized file. Finally, even if a business is concerned with the issue of whether it should accept a payment that may become the subject of a preference lawsuit, it should still accept the payment.

Properly Responding to Preference Allegations

A business facing a preference allegation usually learns of the allegation from one of two sources. The business may get a letter from a representative of the debtor's estate that details the allegation and typically demands payment based on the allegation or proposes a settlement. Alternatively, the business may be served with a complaint filed with a bankruptcy court where the debtor's bankruptcy is pending.

The initial (and sometimes persistent) reaction to a formal or informal preference demand is anger and frustration. The business, particularly one facing preference allegations for the first time, often fumes over the seemingly unfair notion that the debtor has the right and audacity to recover a payment for a legitimate debt from one of its loyal customers. Often, this anger and frustration may tempt the creditor to simply ignore the preference demand.

Although ignorance is bliss, the business should not succumb to the temptation of wishing away the preference allegation. For example, ignoring an informal demand letter may result in the business squandering an opportunity to achieve a cost-effective and generous settlement that gets pulled off the table once formal litigation is initiated. Worse, ignoring a complaint or other formal legal pleading may result in the loss of a common, meritorious defense to the preference allegations. Therefore, when a business receives a notice of a preference complaint it should adequately and timely respond to the allegations, preferably with the assistance of legal counsel.

Conclusion

Taking fifteen minutes to analyze and understand bankruptcy preference law could save a business a bundle of money. Avoiding transactions in which a business extends unsecured trade credit, or consistently adhering to defined credit terms that are common in the business's and its customers' respective industries may avoid a performance recovery. Also, understanding performance law will give a business great confidence and ability to respond to preference allegations in a sophisticated and pro-active manner, as opposed to foolishly ignoring such allegations. A business with questions or concerns regarding its potential exposure to preference liability should contact an experienced bankruptcy professional who is well-versed in this area for more information.