As a creditor, just when you thought nothing can be worse than receiving little to nothing on your unsecured claim, you receive a letter, sometimes years later, demanding that you return payments received prior to the bankruptcy. How can this be?
It’s simple: The Bankruptcy Code permits a trustee (or a debtor in possession) to demand that a creditor return to a debtor certain payments made before the debtor filed for bankruptcy. The objective in recovering these payments— known as preferential payments— is to ensure that all similarly situated creditors receive equal treatment when a bankruptcy is filed. This may require repayment of monies received in situations where the payment resulted in an advantage to one creditor over other similarly situated creditors.
Definition of a preference
Bankruptcy Code section 547 defines a transaction to be a preference when satisfying all of the following requirements:
- The debtor transferred its property to or for the benefit of a creditor.
- Payment was for or on account of an antecedent debt, owed by the debtor before the transfer was made.
- The transfer was made within 90 days of the bankruptcy filing to a non-insider creditor.
- The transfer was made while the debtor was insolvent.
- The transfer enables the creditor to receive more than such creditor would have received if the case were a Chapter 7 liquidation proceeding.
Fortunately, there are several defenses to preference claims. The three most common, which will be discussed below, are as follows:
- Ordinary course of business
- Subsequent new value
- Contemporaneous exchange for new value
Ordinary course of business
To establish an ordinary course of business defense, the creditor must show that the transfers were payments for a debt incurred by the debtor in the ordinary course of business or were related to the financial affairs of the debtor and the transferee. In addition, there must be some proof that the transfers were made according to ordinary business terms.
In evaluating an ordinary course of business defense, several factors will be considered, including the length of history between the parties, whether there were any changes in terms or unusual collection practices and the timing and circumstances of the payments in question. “Ordinary course” can also be defined as ordinary business terms within the industry.
New value defense
A creditor has a new value defense when it can be shown that the creditor gave unsecured new value to the debtor by selling goods and/or providing services on credit terms after an alleged preference payment was received.
A simple example would be if a creditor received a potential preference payment of $1,000 on day one of the preference period. On day two the creditor delivers $500 in new goods. The creditor would have a $500 new value defense.
Contemporaneous exchange for new value
Contemporaneous exchange for new value refers to payments that were intended to be exactly that—part of a contemporaneous exchange for new value given to the debtor. An example would be COD payments, as long as payment was made at the time of delivery.
The above examples represent simplified illustrations of what can be a complicated situation. With each of these defenses, it is important to consider the complex nuances of the particular case and to keep in mind that the precedents for deciding these matters are constantly evolving.
Karl Knechtel is a director in the corporate recovery group at Friedman LLP, a New York-based firm that’s been serving the accounting, tax and business consulting needs of public and private companies since 1924. He can be reached at firstname.lastname@example.org.