Have You Been “Preferred”?

Date: October 20, 2004

As the wave of bankruptcy filings continues, at some point, a business that provides trade credit to other businesses and customers is likely to encounter a lawsuit seeking return of payments as a “preferential” transfer. This type of lawsuit typically seeks recovery of the amounts paid for goods or services by a customer that has subsequently filed for bankruptcy protection.

On the surface, the idea of ever having to return an undisputed payment for a legitimate obligation is a difficult concept for creditors to comprehend. After all, the payment received was on account of a legal debt and, in most instances, was made without knowledge that it would later be challenged, or that the payor would subsequently file a bankruptcy case. The lawsuit also often “rubs salt in the wound” of a creditor because the creditor being sued to return what it was paid may still have amounts that are owed by the bankrupt customer, and the debtor is now seeking to increase its obligation by demanding that the creditor return a payment on the previously-paid debt. To make matters worse, although the creditor is entitled to a claim in the debtor’s bankruptcy case for the money that it has to return, the claim will almost certainly be paid to the creditor, if at all, in a “pennies on the dollar” scenario.

Although on its face the preference law seems unfair, there are legitimate reasons why Congress enacted the preferential transfer statute in the Bankruptcy Code. The primary policy underlying a debtor’s ability to seek a return of preferential payments is the fair and equal treatment of all creditors. As such, “preferential” treatment of certain or “selective” creditors should not be permitted.

By way of example, Company A may have received full payment on its outstanding invoices within ninety (90) days of the date on which its customer filed a bankruptcy case. On the other hand, Company B may not have received anything as a result of the debtor’s limited financial resources. Assuming there are no valid defenses available to Company A, the debtor (or trustee) may avoid the transfers to Company A and bring them back into the estate so they can be redistributed and divided between Company A, Company B, and any other creditors on a pro rata basis.

A second policy reason for allowing a debtor to recover preferential transfers is to dissuade creditors from engaging in coercive collection practices and racing to the courthouse to secure a judgment against a debtor and forcing a bankruptcy filing. The theory of this policy is that without the coercion and collection practices, a debtor may be able to work out its debts with its creditors in a consensual manner and avoid filing for bankruptcy protection.

To recover a preference payment, the debtor (or trustee) must establish that each of the elements for recovery under the Bankruptcy Code exists. First, to recover a transfer, an interest in the debtor must have been transferred to or for the benefit of a creditor (i.e., payment of money). Next, the transfer must have been made within ninety (90) days of the date on which the debtor filed its bankruptcy case (or within one year if the recipient is an “insider”, i.e., an owner, officer or affiliated business) and made on account of a debt that pre-existed the transfer. Next, the plaintiff must show that the debtor was insolvent when the transfer was made, which requires an analysis of the financial condition of the debtor. Lastly, it is the plaintiff’s burden to show that the creditor’s position was improved by receiving the challenged transfer. In other words, if the creditor is no better off having received the transfer, then the avoidability of the transfer becomes moot. The analysis of this element focuses on the assets in the debtor’s estate and whether the creditor would have received the same amount under a liquidation of the debtor’s property.

It is important to note that there is no requirement that the creditor being sued did anything wrong or intended to receive a preference, or even that the debtor intended to prefer the creditor. Because the primary policy is an equal distribution to all creditors, intent and/or notice are irrelevant to the analysis. If all of the above elements are satisfied, the debtor (trustee) may avoid the transfer.

There are, however, certain defenses that are available to a creditor to avoid liability. The primary statutory defenses, typically referred to as subsequent new value, contemporaneous exchange of new value, and ordinary course of business, were enacted to avoid penalizing a company for continuing to do business with another company on the brink of bankruptcy. For instance, if value is provided to the debtor subsequent to, or contemporaneous with, the receipt of the transfer, the defendant may be entitled to a “credit” or elimination of liability, assuming certain other factors exist.

Liability of a defendant may also be reduced or negated by application of the ordinary course of business defense. This defense is intended to insulate ordinary, recurring business transactions from exposure to avoidance, thereby encouraging continued transactions between parties. There are several other defenses that may be available to negate liability. Therefore, a thorough analysis of the nuances of the above defenses, the availability of other defenses, and the plaintiff’s satisfaction of its affirmative case is necessary to determine a defendant’s ultimate liability.

This article is for general information only and does not constitute legal advice.