What You Need to Know about Preferences: Practical Considerations for Lessors

One of the most difficult conversations a bankruptcy lawyer can have with a client is explaining why it has been sued for the recovery of money received pre-petition from a debtor for services rendered or goods supplied. We often hear the same incredulous mantras: “But the [debtor] owed me the money … for a long time.” “We helped stave off bankruptcy because we extended the payment terms.” Often these comments are made to the trustee or debtor who commenced the preference suit, before the creditor consults its attorney. The client believes the suit is a big misunderstanding because the payments it received were on account of a real debt and does not understand the admissions contained in its statements.

The pain of a preference action is much easier to accept in those situations where a creditor knowingly accepted a preferential transfer, but did so in the hope that a bankruptcy would not be filed or the preference suit would never be commenced. This occurs when a lawyer was consulted before the collection efforts were made, and the creditor was advised that the collection process might actually result in the recovery of funds that may have to be repaid if the obligor files for bankruptcy 90 days hence. We have seen a glint in the eye of many a client when deciding whether to accept a payment, or additional collateral from a financially strapped customer when we use the old adage: “Real men take preferences, wimps file proofs of claim.” Of course, the advice to knowingly accept a preferential transfer should only be given after consideration of the cost of obtaining the potentially preferential transfer. If legal action has to be taken to obtain a judgment or the leverage necessary to get payment, the cost may not be justified if a bankruptcy filing is inevitable. Often the creditor has very little information that will allow it to predict with any amount of accuracy the likelihood of a customer filing a bankruptcy petition in the succeeding 90 days.

The policy behind Section 547 makes some sense to most bankruptcy lawyers while leaving the typical preference defendant feeling like it is the victim of a grave injustice. Section 547 was intended to redistribute assets of the debtor to creditors to alleviate the unfairness resulting from payments made by debtors to favored creditors prior to the initiation of the bankruptcy case. It was intended to prevent creditors who had increased their collection efforts and pressured or sued the debtor for payments prior to the petition date to profit from such pressure or lawsuit to the disadvantage of other creditors who had failed to take such measures. Section 547 empowers the trustee or the debtor in possession to recovery money or property that the debtor owned prior to the bankruptcy and to redistribute that money more equitably to creditors. The idea was that money and property recovered from preference actions would be redistributed to creditors more fairly than what occurred pre-petition when only the most vocal, litigious or important creditors were paid.

The ideal is rarely met since a large portion of the preference recoveries pays administrative claims in most estates rather than being redistributed to unsecured creditors. The reality of preference actions is that the cost of analyzing preference claims and the expense of defending and prosecuting such claims rarely results in a redistribution of significant funds to the unsecured creditors who are a large source of the recovered funds. Trustees, creditors committees and debtors rarely do an analysis more thorough than looking at the payments made in the 90 days prior to the bankruptcy. Suits are filed against anyone who received a payment during the 90 days without consideration of possible defenses. This often can result in significant fees in defending an action, which often leads the attorney for the defendant in small preference actions to suggest settlement even if valid defenses exist. Furthermore, it is difficult and time consuming for many clients to reconstruct their relationship with the debtor to prove a history, industry standards or other facts that would support a defense to the preference action.

An analysis of one's client's position should begin with consideration of whether the transaction at issue satisfies the elements of a preference; a critical undertaking at the outset. The lack of due diligence performed by trustees and debtors in possession often leads to the commencement of suits for transfers that do not qualify as preferences in the first place. Accordingly, a review of the transaction and the claim should start with consideration of whether a preferential transfer actually occurred before one considers whether a defense to the transfer exists.

Elements of a Preference

Section 547(g) provides that the trustee has the burden of proof as to the elements of a preference. Often the defendant assumes the existence of the elements. It is important that one not make that assumption.

A preference is defined in 11 U.S.C. '547(b) as: any transfer of the debtor's property or the transfer of an interest of the debtor in property; made to or for the benefit of a creditor; for or on account of an antecedent debt; made while the debtor is insolvent; within 90 days prior to the date the bankruptcy petition was filed (or 1 year in the case of a transfer to an insider); that enables such creditor to receive more than it would have received in a Chapter 7 liquidation.

• Debtor's property is not defined in the Bankruptcy Code, but has been interpreted to include all property that would have been property of the estate under Section 541 had it not been transferred prior to the commencement of the bankruptcy case. For example, funds held in trust by the debtor for a third party are not property of the estate.
• Transfer is defined in Section 101(54) very broadly. The most significant disputes involving this element arise out of the date the transfer occurred or became effective. A transfer by check is clearly a transfer under Section 101(54) but the transfer for Section 547(b) purposes occurs not when the check is delivered, but when the check is honored by the bank. Barnhill v. Johnson, 503 U.S. 393 (1992).
• Antecedent: This element also is not defined by the Code. It means any debt incurred prior to the debtor's transfer; the debt is incurred as soon as a creditor would have a claim against the debtor's estate (any past obligations); accordingly, a trade creditor who insists on receipt of payment before delivery of the goods or services does not receive preferential payments ' the payments are made prior to the incurrence of the debt.
• Insolvent: Section 101(32) defines insolvency, as to debtors other than partnerships and municipalities, as a financial condition wherein the sum of the debtor's debts is greater than the fair value of the debtor's property; as to partnership debtors, insolvency exists when the partnership's debts exceed the partnership's property plus the equity in each general partner's assets. The key is that the debtor had to be insolvent when the transfer occurred. The debtor is presumed to be insolvent 90 days before filing or 1 year if the creditor is an insider. A debtor that has cash flow problems that result in the necessity of filing for bankruptcy relief because it cannot pay its debts as they become due may not be insolvent for Section 547(b) purposes. The balance sheet analysis is based upon the fair market value of the assets [as of the transfer date] when the debtor is a going concern.
• More than it would have received in a Chapter 7 liquidation: The trustee must prove that the creditor received a greater percentage of his debt than such creditor would have received if the case were a liquidation and he shared in the distribution to similarly situated creditors. Unlike the other elements of Section 547(b), this element is determined by the effect the transfer made to distributions to creditors once a bankruptcy is filed rather than the effect at the time the transfer was made.
• 90 days prior (or in the case of an insider 1 year prior): There remains some confusion over whether the 90 days is calculated by counting forward from the date of the transfer or backward from the date of the petition. Clever, bankruptcy lawyers have tried, in some cases successfully, to invoke Rule 9006 to extend the preference period when the 90th day falls on a weekend day.

Defenses to a Preference

Even if a preferential transfer has been made, the Code provides defenses to the return of the transferred property. A trade creditor may be able to invoke any one or more of the following defenses to protect itself from the recovery of property received by the debtor. While the burden of proof as to the Section 547(b) elements of a preference rests on the trustee or debtor in possession, the burden of proof as to the 547(c) affirmative defenses is on the defending creditor.

• The transfer was a contemporary exchange for new value. The creditor's burden is to prove that the new value was exchanged specifically for the transfer from the debtor; that both parties intended the exchange to be contemporaneous; and that the transfer and new value, in fact, were exchanged contemporaneously. The typical situation involves a check issued by the debtor, but presentment of the check was delayed. The delay in presentment may extinguish the contemporaneous exchange defense if the delay is unreasonable lengthy. Although the new value must be roughly equivalent to the property or property interest transferred by the debtor, it can be given by a third party.
• The transfer was a payment in the ordinary course of business. The creditor has the burden of proving three elements of this defense: 1) that the payment was made on a debt that was incurred in the ordinary course of both the debtor's and the creditor's business; 2) that the payment was made according to the parties' usual business dealings; and 3) that the payment was made consistent with industry practices. The third element is the most difficult because it often involves confidential information and is difficult to obtain. A lengthy relationship between the debtor and the creditor may reduce the weight afforded to this element of the defense.
• The creditor gave subsequent new value to the debtor. The defense is clearly not the “net result” rule that previously existed in which all transactions between the parties during the 90 days pre-bankruptcy were included to determine the amount by which a creditor received preferential treatment. Under Section 547(c)(4) only new value received after the alleged preferential transfers can be consideration against such transfers. Unlike Section 547(b), when determining whether new value was extended after the transfer from the debtor for Section 547(c)(4) purposes, a check is deemed to have been given when the check was delivered.
• Improvement of position. The defense set forth in Section 547(c)(5) can be invoked by holders of liens on after-acquired property. The liens that attach to the collateral acquired during the 90 days preceding bankruptcy are not preferences for over-secured creditors. Under-secured creditors who have liens on inventory and accounts receivable are susceptible to preference claims. If a loan is repaid and the collateral remains steady or if the aggregate collateral increases during the 90 days preceding bankruptcy, the under-secured creditor's position has improved; a preferential transfer may have occurred.

Additional Considerations. The defense of a preference action can be analyzed in a number of ways, but the first considerations should include the following:

• Know the law of the jurisdiction where the preference action is pending. There remain many aspects of preference claims and defenses that are given different treatment or weight in different jurisdictions. For instance, the weight afforded to the “industry standard” in determining whether a valid ordinary course defense exists varies among the circuits.
• Was suit commenced prior to the expiration of the statute of limitations? 11 U.S.C. '546 provides that suit must be commenced prior to the earlier of (a) the later of (i) 2 years after the entry of an order for relief or (ii) 1 year after the appointment of any trustee during the foregoing 2-year period or (b) closure or dismissal of the case.
• Consider settlement. The plaintiff does not want to try the case. The overwhelming majority of the cases will be settled or dismissed. In many large cases today, the courts have elaborate procedures for handling preference litigation to reduce the cost of such litigation. The trustee or debtor may be given the right to settle preferences under a certain dollar amount without court approval. Also, courts have approved preference procedures that permit the settling of claims of any amount at various stages of the litigation (typically prior to the filing of an answer) without court approval. It may behoove the defendant to reach a settlement early in the process to avoid the cost associated with seeking court approval. Even if the plaintiff takes the laboring oar, there is inevitably expense associated with overseeing action taken by one's opponent to ensure that the settlement approved by the court is the settlement agreed to.
• Consider whether your client received other potentially preferential transfers that the trustee or debtor in possession has not identified or raised in the complaint. A quick settlement with a general release may be the best approach.
• Check the accuracy of the amounts of the transfers alleged in the complaint. Often the complaint may allege transfers that exceed the amount actually received by the creditor as a result of discounts or credits.
• Consider seeking a jury trial. If no proof of claim was filed or other entry of appearance by the defendant, the defendant may want to request a jury trial. Although a jury trial will result in greater costs, it may have a favorable impact on the trustee's appetite for settlement.
• If settlement is the objective, take the initiative. Defer the answer date to minimize the cost of defense. Many trustees and debtors will agree to postpone the answer date if they believe that the creditor will engage in serious settlement discussions.
• Ask the plaintiff to make a settlement proposal. In many of the larger cases, settlement proposals are often made for smaller preference actions shortly after the complaints are filed. Because the cost of defending an action can be significant and the acceptable settlement amount may increase the more time spent in prosecuting the case, your client should be apprised of the need to consider settlement offers seriously.
• Determine whether there will be a dividend paid to unsecured creditors. If the trustee is able to prove each of the elements of a preference, the bankruptcy code requires the creditor to return the transferred property, if no defenses exist, and, in exchange the creditor can file a proof of claim for the amount returned. 11 U.S.C. '502(h). The trustee may be willing to consider the projected payments to unsecured creditors in establishing a settlement demand. The claim can be waived by the defendant as part of the settlement.
• Watch the docket and educate yourself on how the trustee or creditors committee is handling other preference litigation. Insights into the settlement philosophy of the plaintiff can be gained by reviewing settlement terms reached with other preference defendants.
• The issue of whether the debtor was insolvent at the time of the transfer is a critical element of the plaintiff's case. Insolvency should not be treated as a given. Although overcoming the presumption of insolvency can be expensive, it may be a worthy pursuit. You may consider joining with other preference defendants to share the cost of investigating the debtor's financial records or other information pertaining to the insolvency issue.

Conclusion

At the outset of a preference action there are a number of variables that are difficult to quantify. Nevertheless, knowledge of the statutory underpinnings and an understanding of the practical considerations should assist one in making the process less painful and the result more palatable to one's client.

One of the most difficult conversations a bankruptcy lawyer can have with a client is explaining why it has been sued for the recovery of money received pre-petition from a debtor for services rendered or goods supplied. We often hear the same incredulous mantras: “But the [debtor] owed me the money … for a long time.” “We helped stave off bankruptcy because we extended the payment terms.” Often these comments are made to the trustee or debtor who commenced the preference suit, before the creditor consults its attorney. The client believes the suit is a big misunderstanding because the payments it received were on account of a real debt and does not understand the admissions contained in its statements.

The pain of a preference action is much easier to accept in those situations where a creditor knowingly accepted a preferential transfer, but did so in the hope that a bankruptcy would not be filed or the preference suit would never be commenced. This occurs when a lawyer was consulted before the collection efforts were made, and the creditor was advised that the collection process might actually result in the recovery of funds that may have to be repaid if the obligor files for bankruptcy 90 days hence. We have seen a glint in the eye of many a client when deciding whether to accept a payment, or additional collateral from a financially strapped customer when we use the old adage: “Real men take preferences, wimps file proofs of claim.” Of course, the advice to knowingly accept a preferential transfer should only be given after consideration of the cost of obtaining the potentially preferential transfer. If legal action has to be taken to obtain a judgment or the leverage necessary to get payment, the cost may not be justified if a bankruptcy filing is inevitable. Often the creditor has very little information that will allow it to predict with any amount of accuracy the likelihood of a customer filing a bankruptcy petition in the succeeding 90 days.

The policy behind Section 547 makes some sense to most bankruptcy lawyers while leaving the typical preference defendant feeling like it is the victim of a grave injustice. Section 547 was intended to redistribute assets of the debtor to creditors to alleviate the unfairness resulting from payments made by debtors to favored creditors prior to the initiation of the bankruptcy case. It was intended to prevent creditors who had increased their collection efforts and pressured or sued the debtor for payments prior to the petition date to profit from such pressure or lawsuit to the disadvantage of other creditors who had failed to take such measures. Section 547 empowers the trustee or the debtor in possession to recovery money or property that the debtor owned prior to the bankruptcy and to redistribute that money more equitably to creditors. The idea was that money and property recovered from preference actions would be redistributed to creditors more fairly than what occurred pre-petition when only the most vocal, litigious or important creditors were paid.

The ideal is rarely met since a large portion of the preference recoveries pays administrative claims in most estates rather than being redistributed to unsecured creditors. The reality of preference actions is that the cost of analyzing preference claims and the expense of defending and prosecuting such claims rarely results in a redistribution of significant funds to the unsecured creditors who are a large source of the recovered funds. Trustees, creditors committees and debtors rarely do an analysis more thorough than looking at the payments made in the 90 days prior to the bankruptcy. Suits are filed against anyone who received a payment during the 90 days without consideration of possible defenses. This often can result in significant fees in defending an action, which often leads the attorney for the defendant in small preference actions to suggest settlement even if valid defenses exist. Furthermore, it is difficult and time consuming for many clients to reconstruct their relationship with the debtor to prove a history, industry standards or other facts that would support a defense to the preference action.

An analysis of one's client's position should begin with consideration of whether the transaction at issue satisfies the elements of a preference; a critical undertaking at the outset. The lack of due diligence performed by trustees and debtors in possession often leads to the commencement of suits for transfers that do not qualify as preferences in the first place. Accordingly, a review of the transaction and the claim should start with consideration of whether a preferential transfer actually occurred before one considers whether a defense to the transfer exists.

Elements of a Preference

Section 547(g) provides that the trustee has the burden of proof as to the elements of a preference. Often the defendant assumes the existence of the elements. It is important that one not make that assumption.

A preference is defined in 11 U.S.C. '547(b) as: any transfer of the debtor's property or the transfer of an interest of the debtor in property; made to or for the benefit of a creditor; for or on account of an antecedent debt; made while the debtor is insolvent; within 90 days prior to the date the bankruptcy petition was filed (or 1 year in the case of a transfer to an insider); that enables such creditor to receive more than it would have received in a Chapter 7 liquidation.

• Debtor's property is not defined in the Bankruptcy Code, but has been interpreted to include all property that would have been property of the estate under Section 541 had it not been transferred prior to the commencement of the bankruptcy case. For example, funds held in trust by the debtor for a third party are not property of the estate.
• Transfer is defined in Section 101(54) very broadly. The most significant disputes involving this element arise out of the date the transfer occurred or became effective. A transfer by check is clearly a transfer under Section 101(54) but the transfer for Section 547(b) purposes occurs not when the check is delivered, but when the check is honored by the bank. Barnhill v. Johnson , 503 U.S. 393 (1992).
• Antecedent: This element also is not defined by the Code. It means any debt incurred prior to the debtor's transfer; the debt is incurred as soon as a creditor would have a claim against the debtor's estate (any past obligations); accordingly, a trade creditor who insists on receipt of payment before delivery of the goods or services does not receive preferential payments ' the payments are made prior to the incurrence of the debt.
• Insolvent: Section 101(32) defines insolvency, as to debtors other than partnerships and municipalities, as a financial condition wherein the sum of the debtor's debts is greater than the fair value of the debtor's property; as to partnership debtors, insolvency exists when the partnership's debts exceed the partnership's property plus the equity in each general partner's assets. The key is that the debtor had to be insolvent when the transfer occurred. The debtor is presumed to be insolvent 90 days before filing or 1 year if the creditor is an insider. A debtor that has cash flow problems that result in the necessity of filing for bankruptcy relief because it cannot pay its debts as they become due may not be insolvent for Section 547(b) purposes. The balance sheet analysis is based upon the fair market value of the assets [as of the transfer date] when the debtor is a going concern.
• More than it would have received in a Chapter 7 liquidation: The trustee must prove that the creditor received a greater percentage of his debt than such creditor would have received if the case were a liquidation and he shared in the distribution to similarly situated creditors. Unlike the other elements of Section 547(b), this element is determined by the effect the transfer made to distributions to creditors once a bankruptcy is filed rather than the effect at the time the transfer was made.
• 90 days prior (or in the case of an insider 1 year prior): There remains some confusion over whether the 90 days is calculated by counting forward from the date of the transfer or backward from the date of the petition. Clever, bankruptcy lawyers have tried, in some cases successfully, to invoke Rule 9006 to extend the preference period when the 90th day falls on a weekend day.

Defenses to a Preference

Even if a preferential transfer has been made, the Code provides defenses to the return of the transferred property. A trade creditor may be able to invoke any one or more of the following defenses to protect itself from the recovery of property received by the debtor. While the burden of proof as to the Section 547(b) elements of a preference rests on the trustee or debtor in possession, the burden of proof as to the 547(c) affirmative defenses is on the defending creditor.

• The transfer was a contemporary exchange for new value. The creditor's burden is to prove that the new value was exchanged specifically for the transfer from the debtor; that both parties intended the exchange to be contemporaneous; and that the transfer and new value, in fact, were exchanged contemporaneously. The typical situation involves a check issued by the debtor, but presentment of the check was delayed. The delay in presentment may extinguish the contemporaneous exchange defense if the delay is unreasonable lengthy. Although the new value must be roughly equivalent to the property or property interest transferred by the debtor, it can be given by a third party.
• The transfer was a payment in the ordinary course of business. The creditor has the burden of proving three elements of this defense: 1) that the payment was made on a debt that was incurred in the ordinary course of both the debtor's and the creditor's business; 2) that the payment was made according to the parties' usual business dealings; and 3) that the payment was made consistent with industry practices. The third element is the most difficult because it often involves confidential information and is difficult to obtain. A lengthy relationship between the debtor and the creditor may reduce the weight afforded to this element of the defense.
• The creditor gave subsequent new value to the debtor. The defense is clearly not the “net result” rule that previously existed in which all transactions between the parties during the 90 days pre-bankruptcy were included to determine the amount by which a creditor received preferential treatment. Under Section 547(c)(4) only new value received after the alleged preferential transfers can be consideration against such transfers. Unlike Section 547(b), when determining whether new value was extended after the transfer from the debtor for Section 547(c)(4) purposes, a check is deemed to have been given when the check was delivered.
• Improvement of position. The defense set forth in Section 547(c)(5) can be invoked by holders of liens on after-acquired property. The liens that attach to the collateral acquired during the 90 days preceding bankruptcy are not preferences for over-secured creditors. Under-secured creditors who have liens on inventory and accounts receivable are susceptible to preference claims. If a loan is repaid and the collateral remains steady or if the aggregate collateral increases during the 90 days preceding bankruptcy, the under-secured creditor's position has improved; a preferential transfer may have occurred.

Additional Considerations. The defense of a preference action can be analyzed in a number of ways, but the first considerations should include the following:

• Know the law of the jurisdiction where the preference action is pending. There remain many aspects of preference claims and defenses that are given different treatment or weight in different jurisdictions. For instance, the weight afforded to the “industry standard” in determining whether a valid ordinary course defense exists varies among the circuits.
• Was suit commenced prior to the expiration of the statute of limitations? 11 U.S.C. '546 provides that suit must be commenced prior to the earlier of (a) the later of (i) 2 years after the entry of an order for relief or (ii) 1 year after the appointment of any trustee during the foregoing 2-year period or (b) closure or dismissal of the case.
• Consider settlement. The plaintiff does not want to try the case. The overwhelming majority of the cases will be settled or dismissed. In many large cases today, the courts have elaborate procedures for handling preference litigation to reduce the cost of such litigation. The trustee or debtor may be given the right to settle preferences under a certain dollar amount without court approval. Also, courts have approved preference procedures that permit the settling of claims of any amount at various stages of the litigation (typically prior to the filing of an answer) without court approval. It may behoove the defendant to reach a settlement early in the process to avoid the cost associated with seeking court approval. Even if the plaintiff takes the laboring oar, there is inevitably expense associated with overseeing action taken by one's opponent to ensure that the settlement approved by the court is the settlement agreed to.
• Consider whether your client received other potentially preferential transfers that the trustee or debtor in possession has not identified or raised in the complaint. A quick settlement with a general release may be the best approach.
• Check the accuracy of the amounts of the transfers alleged in the complaint. Often the complaint may allege transfers that exceed the amount actually received by the creditor as a result of discounts or credits.
• Consider seeking a jury trial. If no proof of claim was filed or other entry of appearance by the defendant, the defendant may want to request a jury trial. Although a jury trial will result in greater costs, it may have a favorable impact on the trustee's appetite for settlement.
• If settlement is the objective, take the initiative. Defer the answer date to minimize the cost of defense. Many trustees and debtors will agree to postpone the answer date if they believe that the creditor will engage in serious settlement discussions.
• Ask the plaintiff to make a settlement proposal. In many of the larger cases, settlement proposals are often made for smaller preference actions shortly after the complaints are filed. Because the cost of defending an action can be significant and the acceptable settlement amount may increase the more time spent in prosecuting the case, your client should be apprised of the need to consider settlement offers seriously.
• Determine whether there will be a dividend paid to unsecured creditors. If the trustee is able to prove each of the elements of a preference, the bankruptcy code requires the creditor to return the transferred property, if no defenses exist, and, in exchange the creditor can file a proof of claim for the amount returned. 11 U.S.C. '502(h). The trustee may be willing to consider the projected payments to unsecured creditors in establishing a settlement demand. The claim can be waived by the defendant as part of the settlement.
• Watch the docket and educate yourself on how the trustee or creditors committee is handling other preference litigation. Insights into the settlement philosophy of the plaintiff can be gained by reviewing settlement terms reached with other preference defendants.
• The issue of whether the debtor was insolvent at the time of the transfer is a critical element of the plaintiff's case. Insolvency should not be treated as a given. Although overcoming the presumption of insolvency can be expensive, it may be a worthy pursuit. You may consider joining with other preference defendants to share the cost of investigating the debtor's financial records or other information pertaining to the insolvency issue.

Conclusion

At the outset of a preference action there are a number of variables that are difficult to quantify. Nevertheless, knowledge of the statutory underpinnings and an understanding of the practical considerations should assist one in making the process less painful and the result more palatable to one's client.