Understanding the Bankruptcy Code Featured

5:28am EDT October 29, 2004
The Bankruptcy Code was designed to protect two distinct interests -- that of the debtor to obtain a fresh start and that of the creditor to be treated fairly along with other creditors. Since its enactment in 1978, although many interest groups have tried to obtain better treatment for themselves, the two basic tenets upon which the Bankruptcy Code is premised remain in place.

One way Congress attempted to provide equal treatment for creditors was through section 547 of the code, which allows the trustee or the debtor in possession to avoid or recover payments made to creditors during the 90 days prior to filing a bankruptcy petition. Payments are recoverable only if the trustee can prove certain items and the recipient cannot prevail on any of the defenses available.

Here is an overview of the proof the trustee must make and the more common defenses that the creditor may assert.


Protection in the face of preference demand

The trustee must file a preference case within two years from the date the bankruptcy petition is filed. At the time that you, as a creditor, receive the letter or before, analyze your preference risk. Has the trustee met the burden of proof as to whether a preference exists? What defenses do you have? What is your potential risk? What will it cost to defend your case?

After determining the answers, you should, with the help of your attorney, respond with a letter outlining your defenses and attempting to settle. A carefully drafted response may eliminate a lawsuit and reduce your legal costs.


Trustee's burden of proof

The trustee must prove the following if he or she is to recover the alleged preferential payment.


* The payment was to or for the benefit of a creditor.


* The payment was for or on account of a past due debt owed by the debtor before the payment was made.


* The payment was made while the debtor was insolvent


* The payment was made within 90 days before the date of the bankruptcy petition or within one year before the date of the bankruptcy petition, if the recipient is an insider of the debtor.


* The payment enables the creditor to receive more than it would receive if the case were a Chapter 7 case, the transfer had not been made and the creditor received payment of its claim through the Chapter 7 distribution.


If the trustee cannot prove each of the above elements, the case should go no farther.


Your defenses

The Bankruptcy Code provides certain defenses to a preference action. The defending creditor has the burden to prove each defense is valid.


* Contemporaneous exchange. To the extent the transfer was intended by the debtor and the creditor to be contemporaneous for a new shipment of inventory or provision of services and in fact was contemporaneous. COD payments should be considered contemporaneous and subject to this defense.


* Ordinary course. To the extent the transfer is payment of a debt incurred in the ordinary course of business of the debtor and the recipient; the payment is made in the ordinary course of business of the debtor and the recipient; and is made according to ordinary business terms, the defendant creditor can assert this defense to protect the payment or transfer. The bottom line for ordinary course is that this is a fact-intensive defense and generally subjective.


* New value. To the extent that after each transfer is made, the creditor supplied "new value" to the debtor, the creditor is able to assert the value of the new inventory or services supplied as a credit against the transfer. Only value provided after the transfer is available to be used as a credit.

Depending on which bankruptcy court the case is brought in, the defending creditor may be able to assert this defense whether or not the "new value" is paid. Check with your attorney to see what the case law is in the circuit in which your case is brought.


Deborah L. Thorne is a partner in the Chicago office of Barnes & Thornburg LLP. She concentrates her practice in the areas of creditors' rights, bankruptcy, financial restructurings and commercial transactions. Reach her at (312) 214-8307 or dthorne@btlaw.com.