What is a Preference in Bankruptcy and Why It Matters to Your Business?

What is a Preference in Bankruptcy and Why It Matters to Your Business?

What is a Preference in Bankruptcy and Why It Matters to Your Business?

There are perhaps few things more frustrating than when one of your customers files for bankruptcy leaving you with the tab. However, is this really the worst thing that can happen? Unfortunately, it is not. Even though your customer has filed bankruptcy and perhaps even paid you, Section 547(b) of the Bankruptcy Code permits the debtor-in-possession or a trustee to recapture those payments from you. These payments made by a customer right before filing bankruptcy are known as preference payments. Put simply, the customer preferred to pay you rather than someone else. Although it is not always achieved in practice, the policy goal underlying the preference statute is to further the goal of equality of treatment of creditors of the debtor. Accordingly, the Bankruptcy Code authorizes the recapture of these payments for the benefit of the bankruptcy estate.

What are the elements of a preference?

The elements of a preference payment set forth in Section 547(b) of the Bankruptcy Code are as follows:

  • The transfer was made to or for the benefit of a creditor (i.e., creditor receives a check from the debtor, goods are returned by the debtor to the creditor or an obligation of the creditor is reduced by the debtor);
  • The transfer was made for or on account of an antecedent debt owed by the debtor before the transfer was made (this is merely a payment or transfer made on an old debt, i.e., not a cash on delivery or cash in advance payment);
  • The transfer was made while the debtor was insolvent;
  • The transfer was made 90 days before the date of the filing of the bankruptcy petition (extended to one year if the transfer was made to an insider); and
  • The transfer enables the creditor to receive more than it would have received if the case were a Chapter 7 liquidation. A payment received within 90 days of the bankruptcy filing almost always enables a creditor to receive more than it would have received in a Chapter 7 case. Indeed, the only time this would not be true would be in the unusual case where creditors were receiving 100% on their claims pursuant to a plan of liquidation.

Keep in mind that there is no value judgment linked to a creditor receiving a preferential payment. It is neither wrong of the debtor to make a preferential payment nor wrong of the creditor to accept it. It is almost always better to get paid and deal with efforts by a trustee to recover the payment.

What happens when the customer files bankruptcy and I received a payment?

Typically, a preference action is often preceded by a “demand letter” from the debtor or the trustee. The demand letter sets forth the trustee’s claims and demands payment. More often than not, the trustee is willing to settle the preference action for a reduced amount if the settlement is reached before the lawsuit is filed. As a result, depending on the amount of the payment, when the creditor receives a “preference demand letter,” the creditor should have an experienced bankruptcy attorney review the case to determine whether the creditor has valid defenses. Often times a favorable settlement can be negotiated which will allow the creditor to avoid having to expend large sums of money in litigation.
However, if the parties cannot reach a settlement, the preference action is initiated with a complaint filed with the bankruptcy court. The preference complaint is similar to any other lawsuit with the exception that it is filed in bankruptcy court instead of federal district or state court.

Are there defenses to a preference action?

Yes, there are several affirmative defenses to a preference action. Three of the major affirmative defenses which can be asserted by the creditor/defendant are:

  1. the new value defense;
  2. the ordinary course of business defense; and
  3. the contemporaneous exchange defense.

Each of these affirmative defenses will be discussed in detail in upcoming blog posts so stay tuned!