Fending Off the Trustee

A preference occurs when the debtor favors a particular creditor by paying it shortly before bankruptcy filing, thereby reducing the value of the total bankruptcy estate and the amount payable to other creditors. Allowing preferential transfers to remain undisturbed would undermine the bankruptcy goal of equal distribution.

There are seven elements that must all be present in order for a trustee to set aside a preferential transfer. See 11 USCA ' 547(b). Those elements are: 1) a transfer, 2) of an interest in the debtor's property, 3) to or for the benefit of a creditor, 4) for or on account of an antecedent debt owed by the debtor before such transfer was made, 5) made while the debtor was insolvent, 6) made on or within 90 days before the date of the filing of the petition (or between 90 days and one year before the date of the filing of the petition if the creditor was an insider), and 7) the transfer enabled the creditor to receive more than would have been received if the case were a liquidation case, if the transfer had not been made, and if the transferee's claim were allowed or disallowed to the extent permitted by Title 11. It is important to note that the intent of the parties is irrelevant in a preference action, and even though the creditor has received payment on a legitimate debt it may be recovered by the trustee if a preference is established.

Once a preference has been identified and the bankruptcy trustee initiates an action to avoid or recover the preferential transfer, there are several potential defenses a creditor may raise. As an initial matter, when faced with a preferences action it is important for the creditor to make sure the transfer (measured, where applicable, on the date the payment check cleared the payor's bank) was in fact made within the 90 days before the bankruptcy filing. In most cases the trustee will have accurately computed the preference period, but if the transfer was made outside the 90-day window, a preferential transfer has not occurred. 'Transfer' is broadly defined and includes essentially any transaction that would diminish the estate of the debtor. Payments made by a third party, or payments from funds received from a third party that were especially earmarked for a particular creditor, will usually not constitute preferences if the debtor's estate did not thereby diminish in value.

Nine Statutory Defenses

There are nine statutory defenses available to a creditor in a preference action that will not allow the trustee to avoid the transfer. See, 11 USCA ' 547(c).

First, ' 547(c)(1) states that if the parties at the time of the transaction intended a contemporaneous exchange for new value given to a debtor, and a substantially contemporaneous exchange occurs, the transfer is not a preference. For example, if the creditor receives payment for the title to real property conveyed to the debtor at the time of payment, there is no preference because the debtor's estate has not been diminished. The same would be true of a security interest given and perfected at the time the creditor makes a loan, or a C.O.D. payment for shipment of goods.

Second, ' 547(c)(2) exempts transfers that constitute payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, if the transfer was either: 1) made in the ordinary course of business or financial affairs of the debtor and the transferee; or 2) made according to ordinary business terms. Prior to the 2005 amendments to the Bankruptcy Code, the creditor was required to prove both prongs of the test ' ordinary course of dealing between the parties and according to ordinary business terms. The 2005 amendments only apply to bankruptcy cases filed after their effective date, but they greatly increase the ability of a creditor to defend against preference actions. Under the current statute, a creditor need only prove that the timing of the payment was consistent with the past practice of the particular debtor, or that it was consistent with industry practice.

Third, ' 547(c)(3) contains an exception for the grant of certain security interests in property of the debtor. To come within this exception, the security interest must secure new value, such as a loan, that was given at or after the signing of a security agreement that contains a description of the property as collateral, and that the debtor used to acquire the property. The creditor must also complete perfection of the security interest within 30 days after the debtor's receipt of the property. For bankruptcy cases filed prior to the 2005 amendments, the creditor was required to perfect within 20 days.

Fourth, ' 547(c)(4) is the subsequent new value defense. This defense is available to the extent the creditor extended new credit to the debtor after the receipt of an otherwise preferential transfer. The new credit must have been unsecured (or rendered unsecured through avoidance of the security interest), and the creditor must not have received payment by an unavoidable transfer. The subsequent new value defense, where available, is usually easier to establish factually than the ordinary course of business defense, and it provides a dollar-for-dollar defense to otherwise preferential transfers.

Fifth, ' 547(c)(5) provides the 'two points test' for creditors secured by inventory, receivables, or their proceeds. This defense is available if the position of a creditor secured by accounts receivable or inventory did not improve at the time of bankruptcy filing relative to what it was 90 days before bankruptcy. The defense requires that the security interest of the creditor has been properly perfected, and it upholds the concept that there will be no preference if the debtor's estate has not been decreased and the creditor has not been compensated more than it would receive as a secured creditor after the bankruptcy filing.

The sixth through ninth statutory defenses are fact-specific and only apply in limited situations. ' 547(c)(6) states that most statutory liens will not be considered a preference (subject to ' 545 of the Bankruptcy Code). Section 547(c)(7) provides that a payment within the preferential period that was made on account of spousal or child support will not be considered a preference and is not subject to recovery by the trustee. Under ' 547(c)(8) a preference will not be avoidable if the debtor is a consumer debtor and the transfer is less than $600. Last, in non-consumer bankruptcies there is an exception for transfers of less than $5,000.

Conclusion

The vast majority of preference actions settle before trial. Bankruptcy trustees often file preference complaints against virtually anyone who received a payment of over $5,000 within 90 days of the bankruptcy. In large bankruptcy cases this can result in hundreds of separate actions, which would clog the court system if even a large percentage went to trial. Often the amount at issue will be less than the combined cost to prosecute and defend the action. This creates a powerful incentive to settle. In most cases, a reasonable compromise based on a principled application of the facts to the statutory defenses is the most cost effective solution.

Thus there are numerous options available to you as in-house counsel if you are faced with a preference action. Knowing how to act, and how quickly, might make the difference between hanging onto the funds you received prior to your clients' bankruptcy, and having to hand them all over to the trustee to be redistributed among all the creditors.

Robert Lochhead is a shareholder with Salt-Lake City, UT-based Parr Waddoups Brown Gee & Loveless. He concentrates on bankruptcy reorganizations and commercial and intellectual property litigation and bankruptcy reorganizations. He can be reached at 801-532-7840 or [email protected].

It could be called a nightmare scenario within a nightmare scenario. A client or customer of your company has filed for bankruptcy protection. That's bad enough: a major source of future revenue may have just gone up in smoke. You also have to calculate what's owed to you, and worry that you'll get any of it back. However, looking at the report from accounts receivable, the customer settled its debts with you 30 days ago. They're paid up. You relax, thinking you've dodged a bullet. Until you receive notice of a preference action from the company's bankruptcy trustee, demanding that you give back the money you were paid. Now you need to know your legal options and how to respond, as the decisions you make in handling this could impact whether or not you can hang on to those funds.

What It Means

A primary goal of bankruptcy law is to provide for equal treatment of creditors owed money by a debtor that has filed for bankruptcy. In order to accomplish this goal, the law attempts to eliminate the incentive for a creditor to pressure a distressed debtor and recover payments ahead of others shortly before bankruptcy is filed. This is accomplished through the law of preferences.

A preference occurs when the debtor favors a particular creditor by paying it shortly before bankruptcy filing, thereby reducing the value of the total bankruptcy estate and the amount payable to other creditors. Allowing preferential transfers to remain undisturbed would undermine the bankruptcy goal of equal distribution.

There are seven elements that must all be present in order for a trustee to set aside a preferential transfer. See 11 USCA ' 547(b). Those elements are: 1) a transfer, 2) of an interest in the debtor's property, 3) to or for the benefit of a creditor, 4) for or on account of an antecedent debt owed by the debtor before such transfer was made, 5) made while the debtor was insolvent, 6) made on or within 90 days before the date of the filing of the petition (or between 90 days and one year before the date of the filing of the petition if the creditor was an insider), and 7) the transfer enabled the creditor to receive more than would have been received if the case were a liquidation case, if the transfer had not been made, and if the transferee's claim were allowed or disallowed to the extent permitted by Title 11. It is important to note that the intent of the parties is irrelevant in a preference action, and even though the creditor has received payment on a legitimate debt it may be recovered by the trustee if a preference is established.

Once a preference has been identified and the bankruptcy trustee initiates an action to avoid or recover the preferential transfer, there are several potential defenses a creditor may raise. As an initial matter, when faced with a preferences action it is important for the creditor to make sure the transfer (measured, where applicable, on the date the payment check cleared the payor's bank) was in fact made within the 90 days before the bankruptcy filing. In most cases the trustee will have accurately computed the preference period, but if the transfer was made outside the 90-day window, a preferential transfer has not occurred. 'Transfer' is broadly defined and includes essentially any transaction that would diminish the estate of the debtor. Payments made by a third party, or payments from funds received from a third party that were especially earmarked for a particular creditor, will usually not constitute preferences if the debtor's estate did not thereby diminish in value.

Nine Statutory Defenses

There are nine statutory defenses available to a creditor in a preference action that will not allow the trustee to avoid the transfer. See, 11 USCA ' 547(c).

First, ' 547(c)(1) states that if the parties at the time of the transaction intended a contemporaneous exchange for new value given to a debtor, and a substantially contemporaneous exchange occurs, the transfer is not a preference. For example, if the creditor receives payment for the title to real property conveyed to the debtor at the time of payment, there is no preference because the debtor's estate has not been diminished. The same would be true of a security interest given and perfected at the time the creditor makes a loan, or a C.O.D. payment for shipment of goods.

Second, ' 547(c)(2) exempts transfers that constitute payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, if the transfer was either: 1) made in the ordinary course of business or financial affairs of the debtor and the transferee; or 2) made according to ordinary business terms. Prior to the 2005 amendments to the Bankruptcy Code, the creditor was required to prove both prongs of the test ' ordinary course of dealing between the parties and according to ordinary business terms. The 2005 amendments only apply to bankruptcy cases filed after their effective date, but they greatly increase the ability of a creditor to defend against preference actions. Under the current statute, a creditor need only prove that the timing of the payment was consistent with the past practice of the particular debtor, or that it was consistent with industry practice.

Third, ' 547(c)(3) contains an exception for the grant of certain security interests in property of the debtor. To come within this exception, the security interest must secure new value, such as a loan, that was given at or after the signing of a security agreement that contains a description of the property as collateral, and that the debtor used to acquire the property. The creditor must also complete perfection of the security interest within 30 days after the debtor's receipt of the property. For bankruptcy cases filed prior to the 2005 amendments, the creditor was required to perfect within 20 days.

Fourth, ' 547(c)(4) is the subsequent new value defense. This defense is available to the extent the creditor extended new credit to the debtor after the receipt of an otherwise preferential transfer. The new credit must have been unsecured (or rendered unsecured through avoidance of the security interest), and the creditor must not have received payment by an unavoidable transfer. The subsequent new value defense, where available, is usually easier to establish factually than the ordinary course of business defense, and it provides a dollar-for-dollar defense to otherwise preferential transfers.

Fifth, ' 547(c)(5) provides the 'two points test' for creditors secured by inventory, receivables, or their proceeds. This defense is available if the position of a creditor secured by accounts receivable or inventory did not improve at the time of bankruptcy filing relative to what it was 90 days before bankruptcy. The defense requires that the security interest of the creditor has been properly perfected, and it upholds the concept that there will be no preference if the debtor's estate has not been decreased and the creditor has not been compensated more than it would receive as a secured creditor after the bankruptcy filing.

The sixth through ninth statutory defenses are fact-specific and only apply in limited situations. ' 547(c)(6) states that most statutory liens will not be considered a preference (subject to ' 545 of the Bankruptcy Code). Section 547(c)(7) provides that a payment within the preferential period that was made on account of spousal or child support will not be considered a preference and is not subject to recovery by the trustee. Under ' 547(c)(8) a preference will not be avoidable if the debtor is a consumer debtor and the transfer is less than $600. Last, in non-consumer bankruptcies there is an exception for transfers of less than $5,000.

Conclusion

The vast majority of preference actions settle before trial. Bankruptcy trustees often file preference complaints against virtually anyone who received a payment of over $5,000 within 90 days of the bankruptcy. In large bankruptcy cases this can result in hundreds of separate actions, which would clog the court system if even a large percentage went to trial. Often the amount at issue will be less than the combined cost to prosecute and defend the action. This creates a powerful incentive to settle. In most cases, a reasonable compromise based on a principled application of the facts to the statutory defenses is the most cost effective solution.

Thus there are numerous options available to you as in-house counsel if you are faced with a preference action. Knowing how to act, and how quickly, might make the difference between hanging onto the funds you received prior to your clients' bankruptcy, and having to hand them all over to the trustee to be redistributed among all the creditors.

Robert Lochhead is a shareholder with Salt-Lake City, UT-based Parr Waddoups Brown Gee & Loveless. He concentrates on bankruptcy reorganizations and commercial and intellectual property litigation and bankruptcy reorganizations. He can be reached at 801-532-7840 or [email protected].