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 has already taken a loss on the debtor’s accounts. Your initial response is anger at the unfairness of being sued.
Fortunately, under Bankruptcy Code § 547(b), Congress included defenses against preference actions so debtors’ ordinary transactions would remain undisturbed. Vendors could be encouraged to continue providing goods and services to companies on the verge of bankruptcy.
So, as Douglas Adams famously recommended, “Don’t panic.” While they have complexities, principal preference action defense options are not hard to analyze, and you can readily estimate your company’s potential liability to the debtor using a handful of business records.
[Editors’ Note: If you are interested in learning more about what problems a vendor should be aware of in a bankruptcy case, read 3 Issues for Vendors to Consider When Their Customer Files Bankruptcy]
Bankruptcy Code § 547 permits a trustee to avoid and recover certain transfers made to or for the benefit of a creditor during the “preference period.” That period is 90 days or, for debtor “insiders,” 1 year preceding the day the debtor filed its bankruptcy petition.
The transfers must have been:
If these conditions are met, 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 the debtor makes to an unsecured creditor.
Accordingly, this article avoids various definitions of preference claim elements but focuses on analyzing preference action defense options for the most common complaint — recovery of payments to a supplier for goods or services.
[Editors’ Note: You may also be interested in reading What Distressed Businesses and Their Counsel Should Know About the Consolidated Appropriations Act 2021 and Its Effect on the Bankruptcy Code]
3 primary ways businesses defend against preference action are1:
A few documents are key to assessing these preference action defense options.
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:
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, the 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 before the preference period, e.g., changing from payment by check to payment by electronic funds transfer. Gather any existing correspondence your company had with the debtor, particularly communications about payment of overdue invoices made before 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 gathered the necessary documents, analyze them to find trends. The documents will either show support of a consistent and long-standing tradition in the business relationship or indicate deviations that open the door to preference actions. The strength of your defense depends on the timing of payments/exchanges, the normality of the interaction, and whether or not both parties were satisfied. But what are these preference action defense options?
Consider whether the transfer was made in a manner other than on credit. That is, determine whether your company received the transfer before the debtor received goods or services or whether there was a contemporaneous exchange. If there was a prepayment arrangement, a preference claim would fail.
The Bankruptcy Code requires a debtor to have made a preferential transfer on account of an antecedent debt, meaning a debt “owed by the debtor before such transfer was made.”2 If the debtor paid for the goods or services in advance, there was no antecedent debt, and a preference claim is not substantiated.3
Similarly, where the debtor received new value for a transfer and where the transfer was intended and made substantially contemporaneously with the delivery of new value, the Bankruptcy Code provides a defense against a preference claim for that transfer.4
“New value” means money or money’s worth of goods, services, new credit, or a non-void and non-voidable release of a claim or lien.5 “Substantially contemporaneous” may encompass a period of several days or more.6
For example, the following transaction would be protected by the contemporaneous exchange defense.
A supplier agreed to provide a debtor with goods if the debtor provided immediate payment. The debtor agreed, took delivery of goods, and immediately paid.7
Review the number of days that invoices to the debtor were outstanding prior to and during the preference period. Courts will consider payment timing as a principal attribute of the parties’ relationship.8 However, additional factors may affect their assessment of whether the preference period transfers were “ordinary.” Factors include whether the creditor increased collection efforts or the debtor changed the usual payment method.
Next, calculate the number of days from invoice to receipt of the check.9
From there, calculate the days to payment for all invoices in the year prior to the debtor’s petition date, or longer if sufficient payment history is available. Note the following:
Payment history, related range, and average provide the basis for comparison against the timing of preference period payments.10
Calculate the days to payment for invoices paid during the preference period. Compare the payment time for each transaction made during the preference period against the pre-petition days-to-payment range and against the pre-petition average days-to-payment range. The pre-petition average days-to-payment range can be calculated by finding the pre-petition average less 1 standard deviation and the pre-petition average plus 1 standard deviation.
Next, compare the payment time for each transaction made during the preference period against the prepetition days to payment range and against the prepetition average days to payment range. (The range is the prepetition average less the standard deviation to the prepetition average plus standard deviation.)11
Payments that fall outside either range may not be protected by the ordinary course defense. Consideration should be given to whether the debtor changed the payment method during the preference period (e.g., check to electronic transfer) and whether your company increased attempts to collect unpaid invoices during the period. The court may consider these two additional factors in assessing whether a transfer was “ordinary.”
Arrange invoices for “new value” that your company provided to the debtor during the preference period.
The subsequent advance of a new value defense is timing-dependent. Your company will only receive credit for the new value provided the receipt of an otherwise preferential payment. In some jurisdictions, the new value must also remain unpaid on the petition date.12
These are the proper steps to take in assessing this preference action defense:
Repeat this process through the debtor’s petition date.13
The remaining potential preference amount represents a reasonable estimate of the number of transfers from the debtor that may not be protected by the ordinary course or subsequent new value preference defenses.
When considering potential preference action defense options, do not forget to review the obvious. For example:
Preference actions normally occur later in the life cycle of a bankruptcy proceeding and are often handled by outside law firms that don’t have direct experience with the debtor’s business. Because of this, the debtor’s records may not be as readily accessible or as understood as they were at the beginning of the bankruptcy case, and many or all of the debtor’s employees may be gone.
Accordingly, preference actions sometimes include transfers not made “to or for the benefit” of the defendant. Thus, it is important to confirm whether the specific entity that is named in the complaint actually received the transfers or benefits from the transfers.
The steps outlined above should provide a reasonable assessment of potential preferential transfers your company received and defenses your company may have in a preference action. There are a couple of additional things to note.
First, while there may be reasons not to do so, filing a proof of claim preserves your claim against the debtor and may help resolve any preference action brought against you. This is particularly true if your company provided goods or services to the debtor after the petition date that would entitle it to an administrative claim.
Second, if the debtor assumed or assigned your company’s contract during the bankruptcy, that will provide a complete defense against any preference action, at least in some circuits.
Finally, a rough assessment of your company’s defenses is helpful but cannot replace the value of good counsel. After your initial assessment, access competent legal counsel. Use the documents you gathered and your assessment of defenses as a starting point for evaluating preference action defense options. Mount a robust defense.
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on April 23, 2018, and previously updated on January 27, 2021. It has been edited by Nora Willi]
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
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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