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Timing Is Everything: How to Make a Rough Assessment of Potential Preference Action Defenses (PART 1)

Your company has just been served with a preference complaint. The complaint seeks to recover tens or hundreds of thousands of dollars even though your company already has taken a loss on the debtor’s accounts.

Your initial response is anger at the unfairness of being sued. Fortunately, Congress included defenses to preference actions so that the debtor’s ordinary transactions would remain undisturbed, and vendors would be encouraged to continue providing goods and services to companies on the precipice of bankruptcy.

So, as Douglas Adams famously recommended, “don’t panic.” While they have some complexities, the principal preference action defenses are reasonably easy to analyze, and you can readily estimate your company’s potential liability to the debtor using a handful of business records.

Preference Requirements

First, let’s discuss what a preference complaint requires.

Section 547 of the Bankruptcy Code permits a trustee to avoid and recover certain transfers that were made to or for the benefit of a creditor during the “preference period”—the 90 days or, for debtor “insiders,” the one year—preceding the day the debtor filed its bankruptcy petition.

The transfers must have been “of an interest of the debtor in property,” made when the debtor was insolvent, on account of an antecedent debt, and must have allowed the creditor to receive more than it would have in a chapter 7 liquidation of the debtor.

You may also be interested in, “Common Bankruptcy Litigation Scenarios — Venue Fights.”

If these conditions are met, then the transfers are preferential and the trustee can recover the value of those transfers for the benefit of its bankruptcy estate unless one of the defenses described below is established. While transactions sometimes implicate more esoteric issues, in most cases a preference complaint seeks to avoid simple payments by the debtor to an unsecured creditor.

Accordingly, this article does not delve into the various definitions and interpretations of the elements of a preference claim, but instead focuses on analyzing the potential defenses to the most common type of preference complaint—the recovery of payments made to a supplier for goods or services.

Preference Defenses

Three primary defenses that businesses raise to a preference action are the so-called contemporaneous exchange, ordinary course of business, and subsequent new value defenses.

  • As its name implies, the contemporaneous exchange defense relates to transactions in which the debtor and creditor intended and made a substantially contemporaneous exchange for new value, normally money for goods or services.
  • The ordinary course of business defense looks at the historical relationship between the parties and compares it to the preference period relationship.
  • Generally, the subsequent new value defense looks at the provision of goods or services by the defendant to the debtor during the preference period.

(See 11 U.S.C. § 547(c)(1), (2), (4))

Building a Preference Defense

A few documents are key to assessing these defenses.

First, compile the payment history of the debtor for the year preceding the preference period, and more if it is available. The payment history should include (as available) invoice numbers, invoice dates, check numbers, check issue dates, check receipt dates, and check clearing dates. You should also compile a separate payment history for the preference period.

Next, pull invoices for “new value” provided to the debtor during the preference period. This includes goods, services, extension of new credit, or the release of a claim or lien. Check the payment history to determine whether any change in payment method occurred during or prior to the preference period, such as changing from payment by check to payment by electronic funds transfer. Gather any correspondence that your company had with the debtor, particularly communications that inquire about or demand payment of overdue invoices that were made both before (if they exist) and during the preference period.

Finally, confirm whether your company provided the debtor with any goods or services post-bankruptcy, whether the debtor assumed or assigned your company’s contract, and whether your company filed a claim in the debtor’s bankruptcy proceeding.

Now that you have the base group of documents, what is the next step?

Read the Part 2 Conclusion of this article here.

About Robert C. Maddox

Robert C. Maddox is an associate at Richards, Layton & Finger, P.A., in Wilmington, Delaware. The views expressed in this article are those of the author and not necessarily those of Richards, Layton & Finger or its clients.

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Robert C. Maddox