A “preference action” is a lawsuit by or on behalf of a debtor seeking to recover certain payments made by the debtor prior to filing for bankruptcy. Preference actions are unfamiliar to many business owners and often seem illogical and unfair.
“Clients often receive a letter demanding the return of a payment that the debtor made to them before filing for bankruptcy. They call and say, ‘What does this mean? Do I have to return this money? We sold them products and they paid us, are they entitled to get their money back?’” says Stephen C. Goldblum, member at Semanoff Ormsby Greenberg & Torchia, LLC. “The answer is yes, you may have to return the money — unless the payment falls within one of the statutory defenses.”
Smart Business spoke with Goldblum about how preferences work.
What should you know about preferences?
Typically, a preference action is often preceded by a ‘demand letter’ from the debtor demanding the return of payments made in the 90 days prior to the debtor filing for bankruptcy. This seems patently unfair to the recipient of the payment. The business provided products or services and was paid for them, and it seems unjust to have to return the money, often many months after the payment was received. The policy behind the bankruptcy code, however, takes a broader view. The policy is to prevent debtors from treating creditors unequally and paying preferred creditors before filing bankruptcy, and to prevent aggressive collection activities that could actually force a debtor into bankruptcy. Such policies have been determined to be of greater importance than the rights of an individual creditor.
There are four elements needed to prove a preferential payment; if the payment was:
- For an antecedent (previously incurred) debt.
- Made while the debtor was insolvent.
- Made to a non-insider creditor in the 90 days prior to the bankruptcy filing.
- Allows the creditor to receive more than it would have if the payment had not been made and the claim paid through the bankruptcy proceeding.
Where do many businesses make mistakes regarding preferences?
A business’ biggest mistake is to ignore a demand letter received by or on behalf of a debtor. Often the debtor is willing to settle the preference claim for a significantly reduced amount before a lawsuit is filed. A business that ignores a demand letter or fails to timely retain counsel familiar with bankruptcy law often misses its best opportunity for a favorable resolution.
Do you receive the repayment back?
Usually not. The preferential payments recovered by the debtor are added to the bankruptcy estate. To the extent there are funds available, secured, priority and certain other creditors are paid first. To the extent there are funds remaining, they are distributed to the unsecured creditors, which often results in little or no payment.
What are the defenses when a payment is alleged to be preferential?
The three primary defenses to an alleged preferential payment are the following:
- New value defense, which provides an offset against the preferential payment if the creditor subsequently gives new value to the debtor after the alleged preferential transfer.
- Ordinary course of business defense, which protects transfers consistent with the debtor and creditor’s prior business history.
- Contemporaneous exchange defense, which includes certain concurrent transactions such as a cash-on-delivery.
How are insider creditors treated differently?
With insiders — corporate officers or directors, relatives and related entities — a debtor may recover payments for up to 12 months prior to the bankruptcy.
How can you protect your company?
It’s difficult for a company to pre-emptively protect itself from a payment later being deemed preferential. When you receive a letter demanding return of an alleged preferential payment, contact an attorney experienced with creditors’ rights. He or she will analyze the potential defenses and prepare a response to the letter. Often, a timely, well-reasoned response to a demand for the return of a preferential payment leads to a prompt and cost-effective resolution.
Stephen C. Goldblum is a member at Semanoff Ormsby Greenberg & Torchia, LLC. Reach him at (215) 887-5961 or email@example.com.
Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC
Whether your company is large or small, sooner or later you will experience the pain and apprehension that come from receiving notice that one of your customers has filed bankruptcy.
The first thing that many companies do after receiving notice is run to the accounts receivable ledger to see how much money just became uncollectible. However, that may not be the end of the pain, says Jeffrey S. Grasl, member, McDonald Hopkins PLC.
“Many companies don’t realize that the real knife in the gut may come 18 to 24 months later when they receive a letter demanding that they pay back some of the money the bankrupt company previously paid to them,” says Grasl. “In bankruptcy parlance, this is referred to as a ‘preference.’”
Smart Business spoke with Grasl about what to do when faced with a bankruptcy preference demand.
What is a preference?
In its most common form, a preference is a payment by a bankrupt company to a person or entity made on or before 90 days from the date of the bankruptcy filing and on account of a past debt. For example, ABC Corp. files bankruptcy on June 1, 2011. Prior to the filing, on March 15, 2011, it paid to XYZ Co. $10,000 on account of an old invoice. Because the payment was made less than 90 days prior to the bankruptcy, the $10,000 is potentially recoverable from XYZ Co. as a preference.
A preference is not limited to payments of cash. While less common, the statutory definition includes all transfers of interests in property of the bankrupt entity. Therefore, if a bankrupt company satisfies a past debt by conveying a piece of property to a creditor in lieu of cash, the value of the property is potentially recoverable by the bankruptcy estate as a preference.
Also, you do not actually have to be ‘preferred’ by the bankrupt to be subject to a preference. The Bankruptcy Code does not require that a bankrupt have the actual intent to ‘prefer’ one creditor over another at the time of payment. For purposes of the statute, it is enough that you were simply paid.
What should you do if your company receives a preference demand?
The first thing you should do is contact competent legal counsel experienced in bankruptcy practice. Do not think that you will save time and money by responding without legal counsel, as you can damage your position by disclosing information that is detrimental to you. If your company has valid defenses, an experienced bankruptcy attorney will discern them quickly and assist in formulating an appropriate response to expedite the process and, in the long run, save you money.
That being said, there are some simple steps you can take before you contact an attorney.
First, the preference recovery demand will list a schedule of payments allegedly made by the bankrupt entity to you within the 90 days prior to bankruptcy filing. The bankrupt’s records may be inaccurate, so verify that all payments the bankrupt asserts it made were actually received. It is often the case that the records list checks that were either issued but not delivered, or were received but failed to clear the bank due to lack of sufficient funds.
Second, the Bankruptcy Code prohibits action to recover a preference if the value of the payments received in the 90 days prior to the bankruptcy filing aggregate less than $5,850. However, the bankrupt may send preference recovery demands to parties paid less than the statutory minimum hoping to take advantage of the unwary.
What defenses does a company have to a preference demand?
There are several defenses a party can raise, but the most common are the new value and ordinary course of business defenses.
Subsequent to verifying receipt of the preference payments and that the aggregate value exceeds the statutory minimum, the next step in analyzing your exposure is to determine if you gave the bankrupt ‘new value.’ Under the statute, a party is allowed to set off against the value of the preference the value of goods provided to the bankrupt subsequent to each preference payment and for which goods the party was not paid. For example, after receiving a $10,000 payment on March 14, XYZ Co. delivered another $5,000 worth of goods to ABC Corp. But the new shipment of goods was never paid by ABC Corp.
XYZ Co. is allowed to set off against the $10,000 preference asserted by ABC Corp. the $5,000 worth of unpaid goods delivered after receiving the payment. Therefore, XYZ Co.’s preference exposure is reduced from $10,000 to $5,000. Accordingly, it is important to maintain sound business records in order to verify the dates of shipments to, and payments made by, the bankrupt.
After determining if you have provided new value to the bankrupt, the next step is to determine if the remaining preference exposure can be reduced based upon the ‘ordinary course of business’ defense. The Bankruptcy Code prohibits the recovery as a preference those payments made to you by the bankrupt that were made in the ordinary course of business between you and the bankrupt, or under ordinary business terms within the industry.
The ordinary course analysis is a comparison of the bankrupt’s historical payment history with your company prior to the 90-day preference period, to each payment made within the 90-day preference period. The general rule is that each payment made during the preference period must fall within the same range of payment pattern as those made during the pre-preference period.
What if a company fails to respond to a preference?
No matter what the circumstance, do not ignore it. Failure to respond will result in further legal action, or the entry of a judgment against you from the Bankruptcy Court ordering you to pay back the preference. Once this occurs, it is more difficult, time consuming and costly to deal with the matter.
Responding to it rationally and with competent legal counsel can be the key to minimizing, if not eliminating, your exposure.
Jeffrey S. Grasl is a member at McDonald Hopkins PLC. Reach him at (248) 646-5070 or firstname.lastname@example.org.