What to do when faced with a bankruptcy preference demand Featured

10:52am EDT July 1, 2011
What to do when faced with a bankruptcy preference demand

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 jgrasl@mcdonaldhopkins.com.