Diserio Martin O'Connor & Castiglioni LLP

Avoiding the Avoidable Preference Claim

October 28, 2011

In the current economic climate, manufacturers and service providers are often faced with difficult situations involving customers and clients experiencing financial difficulties, or worse – who have already filed for bankruptcy protection.  Once a bankruptcy case is filed, the creditor’s primary concern is if, when and how will he be paid for any unpaid invoices.  Unfortunately, that is only half of the concern.  Once a bankruptcy case is filed, not only can a creditor be left with little or no payment on his unpaid invoices, but later on in the case the creditor may actually be requested to return any payments received during the 90 days prior to the bankruptcy filing.  The Bankruptcy Code actually permits a bankrupt company, or its trustee, to recover these payments, known as “preferences” under the Code.

While the concept seems patently unfair, the rationale for the statute, 11 U.S.C. Section 547, actually makes some sense.  What the Code is trying to avoid is a situation where a debtor, when he is insolvent and likely aware he is about to file for bankruptcy, pays some creditors while ignoring others during the three months prior to filing.  By permitting a debtor or trustee to recover, or “avoid,” those preferential payments by returning that money to the bankruptcy estate of the debtor, unsecured creditors will share in the debtor’s assets on an equal footing.  Of course, this policy rationale is of little solace to a creditor – already faced with writing off thousands of dollars in debt due to the bankruptcy filing – is actually asked to pay back money to that same debtor. 

The first thing to determine when faced with a preference claim is if the alleged payment was, in fact, a “preference” under the statute.  Typically, a preference is any transfer of money or property, made to or for the benefit of a creditor, on account of an antecedent debt, made while the debtor was insolvent and within 90 days of the bankruptcy filing, and which allows the creditor to receive more than he would have received in a Chapter 7 liquidation proceeding of the debtor.   Essentially, any payment of an old debt made within 90 days of the bankruptcy filing eventually will be challenged by the debtor or trustee as a preference.

The debtor or trustee usually starts the process by sending a letter requesting the immediate repayment of the alleged preferential payment.  If the request to repay a preferential payment is ignored, typically the debtor or trustee will commence a lawsuit to avoid the preference.  Those actions are commenced as adversary proceedings in the same Bankruptcy Court where the bankruptcy case is pending.  Since any creditor who files a proof of claim against a debtor in a bankruptcy case has actually consented to the jurisdiction of the Bankruptcy Court, often the creditor will find that he has to defend the preference action in a court far away from his place of business.

While the preference statute is harsh, fortunately there are some defenses.  If a payment made within the 90-day preference period is intended by both the debtor and creditor to be a contemporaneous exchange for new value – such as a C.O.D. payment accompanied by delivery of new goods – that payment typically cannot be avoided as a preference.  A payment of a debt incurred by the debtor in the ordinary course of the business of the debtor and the creditor, and made in the ordinary course of the business dealings of the debtor and creditor or according to ordinary business terms, likewise can escape avoidance as a preference.  Typically, however, those ordinary course payments must be paid within 30 days of their due date, or meet the exact credit and payment terms between the debtor and creditor, to be considered ordinary course payments.  Maintaining good records of the normal payment history between the debtor and creditor is essential to successful assertion of the ordinary course defense.  Finally, when a creditor has transferred new value to a debtor – such as by shipping new goods – after the alleged preferential payment, the payment may be protected from a preference avoidance action.  

In the event that your company is presented with a demand for repayment of an alleged preferential payment received by a bankrupt debtor – or if you have received a summons and complaint seeking to avoid the preference -- it is important to act quickly and seek appropriate legal representation to evaluate the claim, determine any available defenses, and negotiate or litigate a resolution. For more information, or if you have a question about a preference avoidance claim or any bankruptcy issue, call (203) 358-0800 and ask for Scott Harrington, or e-mail Scott at sharrington@dmoc.com.