Preference Defenses Available to Creditors

March 14, 2012

Most non-lawyers have a vague understanding that certain payments they may have received in the days before a bankruptcy filing are subject to demands that the payments be turned over to a bankruptcy trustee or returned to the debtor that made the payment. These payments are referred to in bankruptcy parlance as a “preference.” The term preference implies that the recipient may have engaged is some conduct that resulted in that creditor being preferred over others. Actually, a preference requires no action on the part of the creditor receiving the payment, and there is no requirement of undue pressure by the creditor. A preference is simply the receipt of a payment by a creditor within a prescribed time period before the filing of a petition in bankruptcy. The creditor need do nothing wrong or out of the ordinary for a payment to be considered preferential. What you may not know is that the bankruptcy code provides a number of defenses to preference claims, and you should never simply hand over money received because you have been threatened with a preference lawsuit without first weighing available defenses. The truth is, most preference actions settle. If the facts permit, you can significantly strengthen your settlement position by claiming that the payment is subject to one of the exceptions discussed in this article.

What Is a Preference?

The Bankruptcy Code defines a preferential payment as including the following:

  1. Any transfer of an interest of the debtor in property;
  2. Made to or for the benefit of a creditor;
  3. For on account of a debt which was owed by the debtor before the transfer was made;
  4. Made while the debtor is insolvent;
  5. Within 90 days prior to the date the bankruptcy case was filed, or within 1 year for “insiders”;
  6. That enables the creditor to receive more than it would have received in a Chapter 7 liquidation.

The debtor in this scenario is your customer/client that has paid you money (or given you something of value), and has now declared bankruptcy. The first element, that the debtor transfer something of value, is satisfied by a broad array of transfers, including (1) the payment of money; (2) giving a guaranty of certain obligations; (2) granting a security interest in the debtor’s property; or (2) transfer of a right the debtor may have to collect from another. When the payment received is in the form of a check, the transfer occurs for purposes of a preference action when the check is honored by the bank.

The second element provides that preferences include not only payments made directly to creditors, but also payments made to another for the benefit of a creditor. The third requirement – that the payment be made on account of past debts – means that the alleged preference must have been a payment or transfer in payment for a debt that was already due. What is not included in this definition, however, are prepayments or advance payments for goods or services. The fourth element requires that the alleged preference must have been made while the debtor is insolvent. The deck is stacked against the creditor on this element, as the Bankruptcy Code provides that the debtor is presumed to have been insolvent during the 90 days prior to the filing of the bankruptcy.

The fifth element requires that the challenged payment have been made in the 90 days prior to the bankruptcy filing for typical creditors, and one year for “insiders.” The 90 day period excludes the date the bankruptcy petition was filed, and begins on the prior day counting backwards 90 days. Insiders are defined in the code to includes relatives of the debtor, a general partner of the debtor, or, if the debtor is a corporation, payments to officers, directors or person in control of the company.

As with other parts of the preference test, the deck is stacked against the creditor with regards to the final element too. The sixth element attempts to ascertain whether the creditor received more from the alleged preference than it would have had the debtors assets been liquidated as of the date the debtor filed for bankruptcy. In reality, bankruptcy estates almost never are sufficient to pay the entire amount of the claims owed to creditors.

The trustee or the debtor has the burden of proving the above elements. If any one these elements cannot be proven, then there is no preference and you do not need to rely on a preference defense to escape payment.

What Defenses Are Available?

Most creditors will first learn of a potential preference claim against them by receiving a letter from the bankruptcy trustee or from an attorney for the debtor. These demand letters typically set forth alleged preference amounts, and demand that the funds be paid in full. If the funds are not paid, or if there is no settlement reached by the parties, the trustee or the debtor then must commence a lawsuit, in bankruptcy court, seeking return of the alleged preference.

The following defenses should be used as a sword by creditors at the very threat of a preference action. If the defenses are strong given the facts of your case, asserting the defenses in response to a demand letter may help you avoid having to pay any money back. Even if the application of the defenses is uncertain, asserting these defenses may allow you to settle the alleged preference for an amount you can justify. While it may be hard to stomach paying back any portion of the money that was owed to you in the first place, given the costs of defending the preference action, and the uncertainty of the outcome of a trial in front of the bankruptcy judge, settlement may be your best option. The following list of available defenses is not complete, but it does include the most common and widely used defenses to preference claims.

1.  Substantially Contemporaneous Exchange

If the payment or other transfer you received from the debtor was intended by both you and the debtor to occur at the same time as the sale or transfer of something of value to the debtor, the preferential payment may be completely exempt from turnover. Prime examples of contemporaneous exchanges involve cash-on-delivery (“COD”) payments. Indeed, companies doing business with distressed companies or individuals should consider entering into a COD arrangement, to insure payment and to defend against possible preference claims. To strengthen the application of this defense, you should document your intention that the exchange (sale of goods for example) is intended to occur contemporaneously with payment. The Bankruptcy Code does not necessarily require immediate payment, but payment should be made relatively quickly after sale.

2.  Payments in the Ordinary Course

Probably the most heavily litigated preference defense is the ordinary course of business defense. In 2005, the ordinary course defense was modified to make it easier for creditors to establish ordinariness. A creditor will need to show that the transaction at issue was incurred in the ordinary course of business or financial affairs of the debtor. This will require establishing that there is nothing out of the ordinary regarding the services or goods purchased, i.e. the debt relates to the debtor’s business. This factor is usually easily met.

A creditor asserting the ordinary business defense will also need to establish one of the following: (1) that the transfer was made in the ordinary course of business or financial affairs as between the debtor and the creditor; or (2) that the transfer was ordinary in the business or trade in which the debtor is involved in. Therefore, a creditor can show that the alleged preference fits within its own course of dealing with the debtor, or, if there is no course of dealing between the creditor and the debtor, then that the transfer is ordinary in the industry. For preference actions involving trade debt, the court will look the history of the accounts receivable between the parties, and ask whether the days to pay for the alleged preference are in line with the parties past transactions. It will be helpful in developing your defense to compile a chart setting forth all of your transactions with the debtor, identifying the invoice date and the payment date. Other factors that the court will look at the length of the parties’ relationship, whether the method of payments remained constant, and whether there were any unusual collection efforts by the creditor.

3.  Purchase Money Security Interests

This defense protects lenders that have loaned funds to a debtor to purchase a specific item, as long as there is a specific security agreement describing the property, the funds are to be used specifically to purchase the item, the debtor does purchase the item in question, and the creditor perfects its security interest in the item within 30 days of the time the debtor received the item.

4.  New Value Defense

The new value defense permits a creditor to protect payments it has received during the preference period if the creditor has given new value to the debtor that remains unpaid. By way of example, if a debtor makes a preferential payment to a creditor for $100, but the creditor subsequently – during the preference period – extends new credit to the debtor in the amount of $75, then the creditor may claim that the net preference amount is only $25. The new value must come after the preference payment was received.

5.  Floating Lien or Improvement in Position

A floating lien is a security interest in the debtor’s present and to be acquired assets, such as inventory, crops, and accounts receivable. A creditor with a floating lien facing an alleged preference, may defend such a claim by showing that its position has not improved during the preference period. If the value of the creditor’s collateral has not increased during the preference period, the creditor may avoid returning all or part of an alleged preference.

6.  De Minimus Payments

The Bankruptcy Code excepts out transfers that are deemed too small. For debtors whose debts are not primarily consumer debts, the bankruptcy trustee or the debtor may not avoid alleged preferential transfers if the aggregate value of the transfers is less than $5,850. A transfer by a debtor whose debts are primarily consumer debts may not be avoided if the aggregate value of all transfers to the creditor is less than $600.

Preferences in Wisconsin Statutes Chapter 128 Receiverships

Recent years have seen a rise in alternatives to bankruptcy, including proceedings filed pursuant to Chapter 128 of the Wisconsin Statutes. These proceedings involve the assignment of a debtor’s assets to a court-appointed receiver, for the benefit of the debtor’s creditors. Chapter 128 includes its own preference provisions. Although originally based on the bankruptcy act in place at the time (the 1898 Bankruptcy Act), the preference provisions in Chapter 128 are vague in comparison to the current Bankruptcy Code preference provisions.

A preference under Chapter 128 is defined as the transfer of the property of the debtor when “insolvent” that enables the recipient of the transfer to obtain a greater percentage of his or her debt than any other creditor of the same class. The preference period under Chapter 128 is four months, not 90 days. Preferences under Chapter 128, unlike preferences under the Bankruptcy Code, require the showing that the recipient of the transfer “has reasonable cause to believe that the enforcement of the judgment or transfer would effect a preference.” Therefore, the primary defense to a preference claim by a creditor is that the creditor had no reason to believe that it was receiving a preferential payment. By way of example, the creditor may claim that it had no basis to know that the debtor was insolvent when the preference was received. Additionally, Chapter 128 Receivers will often utilize federal bankruptcy law as part of Chapter 128 proceedings, and a creditor faced with an alleged preference claim by a Receiver should assert additional arguments that its receipt of payment fits within one of the well established bankruptcy exceptions to preference claims.

There are other available defenses not addressed in this article. You should consult an attorney if faced with a demand letter requesting the return of funds or property transferred to you by a debtor. It is important to consider whether you have any available defenses to the alleged preference, and if so, how strong those defenses are. You should never just write a check in response to a demand by a trustee, receiver or a debtor in bankruptcy. Axley Law Firm has extensive experience representing creditors faced with preference claims. We invite you to contact us to ensure that your interests are properly protected in the face of a preference claim.

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For more information about "Preference Defenses Available to Creditors," contact David M. Pelletier at dpelletier@axley.com or 608.260.2495.