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Protection Against Preference Actions

How to Assess 3 Potential Preference Action Defenses

Businesses Have Options for Defending a Preference Action. Here’s How to Build the Right Defense.

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, 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” (90 days, or, for debtor “insiders,” 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.

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 ways that businesses defend against a preference action are1:

  • Contemporaneous exchange—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.
  • Ordinary course of business—The ordinary course of business defense looks at the historical relationship between the parties and compares it to the preference period relationship.
  • Subsequent new value defenses—Generally, the subsequent new value defense looks at the provision of goods or services by the defendant to the debtor during the preference period.

Building a Preference Defense

A few documents are key to assessing these preference action 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
  • 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, you must analyze them to find trends. The document will either support a long-standing tradition in your business relationship or show deviations that open the door to preference actions. Timing of payments/exchanges, normality of the interaction, and satisfaction for both parties will either support or hinder your defense. But what does this really mean?

Contemporaneous Exchange Defense

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 in exchange 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 “owed by the debtor before such transfer was made.”2 If the debtor paid for the goods or services in advance, then there was no antecedent debt, and a preference claim cannot be substantiated.3

Similarly, where the debtor received new value for a transfer, and the transfer was intended to be and was made substantially contemporaneously with the delivery of the 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.5 “Substantially contemporaneous” may encompass a period of several days or more.6

For example, where a supplier agreed to provide a debtor with goods if the debtor provided immediate payment, and the debtor agreed, took delivery of goods, and immediately paid, the transaction was protected by the contemporaneous exchange defense.7

Ordinary Course of Business Defense

Review the number of days that invoices to the debtor were outstanding, both prior to and during the preference period. Other factors may affect the assessment of whether the preference period transfers were “ordinary,” including whether there were increased collection efforts by the creditor or changes in payment method by the debtor. However, payment timing is the principal attribute of the parties’ relationship that courts consider.8

Using the previously assembled payment records, the next step would be to calculate the number of days from invoice to receipt of the check.9 From there, calculate the days to payment for the year prior to the debtor’s petition date, or longer if sufficient payment history is available, and note the following:

  • The range comprised of the lowest and highest number of days to payment
  • The average number of days to payment
  • The standard deviation of that average

 

The payment history, related range, and average will provide the basis for comparison against the timing of preference period payments.10 Accordingly, you should also calculate the days to payment for invoices paid during the preference period.

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 of either range, which may not be protected by the ordinary course defense. In addition, consideration should be given as to whether the debtor changed its payment methods during the preference period (e.g., from check to electronic transfer) and whether your company increased its attempts to collect unpaid invoices from the debtor during the preference period.

As noted above, both of these additional factors may be considered in assessing whether a transfer was “ordinary.”

Subsequent New Value Defense

Look at the invoices for “new value” that your company provided to the debtor during the preference period and arrange these statements by date.

As noted above, new value is defined as money or money’s worth of goods, services, new credit, or a non-void and non-voidable release. The subsequent advance of new value defense is timing contingent. Your company will only receive credit for new value that is provided after receipt of an otherwise preferential payment. (Note that in some jurisdictions, the new value must also remain unpaid on the petition date.)12

Below are the proper steps to take in assessing this preference action defense:

  • Arrange the list of unprotected transfers from your ordinary course of business analysis by date. Use the earliest payment as your starting point.
  • Total the value of the payment(s) (the “potential preference amount”) on that date and for each subsequent date until the date of the first “new value” your company provided to the debtor.
  • Reduce the potential preference amount by the value of that and any subsequent new value through the date of the next payment by the debtor. (The potential preference amount cannot go below $0, so depending upon the timing of the debtor’s payments and your company’s provision of new value, it may have provided value that does not reduce your overall preference exposure.)
  • That payment—and any subsequent payments—should be added to the remaining potential preference amount and then reduced by any new value provided after the payments.

 

This process should be repeated through the debtor’s petition date.13

An example of this analysis is reflected in the chart below. The remaining potential preference amount represents a reasonable estimate of the amount of transfers from the debtor that may not be protected by the ordinary course or subsequent new value preference defenses.

Additional Considerations

When considering potential defenses to a preference complaint, you should also deal with the obvious. For example:

  • Are the parties named in the complaint correct?
  • Were the transfers listed in the complaint received by the named entity within the preference period?

 

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 understood as they were at the beginning of the bankruptcy case, and many—if not all—of the debtor’s employees may be gone.

Accordingly, preference actions sometimes include transfers that were 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 the benefit of the transfers.

Conclusion

Taking the steps outlined above should provide a reasonable assessment of the potential preferential transfers that your company received and the defenses that your company may have in a preference action. There are a couple of additional things to note, however.

First, while there may be reasons not to do so, filing a proof of claim preserves your claim against the debtor and may help in resolving any preference action that is brought against you. That 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, then that will provide a complete defense to any preference action (at least in some circuits).

Finally, while having a rough assessment of your company’s defenses is helpful, it cannot replace the value of good counsel. After you have made your initial assessment, locate competent legal counsel and use the documents that you gathered and your assessment of your company’s defenses as a starting point for mounting a fulsome defense.


[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Anatomy of a Preference; What to Expect and Do When Your Customer Becomes Insolvent; Defending Against Bankruptcy Avoidance Action. This is an updated version of an article originally published on April 23, 2018.]

©All Rights Reserved. January, 2021.  DailyDACTM, LLC

  1. See 11 U.S.C. § 547(c)(1), (2), (4)
  2. 11 U.S.C. 547(b)(2)
  3. See, e.g., Anderson News, LLC v. The News Group, Inc. (In re Anderson News, LLC), 2012 WL 3638785 at *2-3 (Bankr. D. Del. Aug. 22, 2012)
  4. See 11 U.S.C. § 547(c)(1)
  5. See 11 U.S.C. § 574(a)(2)
  6. See, e.g., Pine Top Ins. Co. v. Bank of Am. Nat’l Trust & Sav. Ass’n, 969 F.2d 321, 328 (7th Cir. 1992)
  7. See H.R. Rep. No. 95-595, U.S. Code Cong. & Admin. News, 1978, p. 6329; In re Payless Cashways, Inc., 306 B.R. 243, 251 (B.A.P. 8th Cir. 2004)
  8. See, e.g., In re Sierra Concrete Design, Inc., No. 08-12029 (CSS), 2015 WL 4381571, at *8 (Bankr. D. Del. July 16, 2015)
  9. See, e.g., In re Am. Home Mortg. Holdings, Inc., 476 B.R. 124, 138 n.17 (Bankr. D. Del. 2012)
  10. See, e.g., In re Waterford Wedgwood USA, Inc., 508 B.R. 821, 835-836 (Bankr. S.D.N.Y. 2014)
  11. See In re Sierra Concrete Design, Inc., 2015 WL 4381571, at *3
  12. See 11 U.S.C. 547(c)(4)
  13. See, e.g., In re Frey Mech. Grp., Inc., 446 B.R. 208, 219 (Bankr. E.D. Pa. 2011)

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
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