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Jerry Cohen

Bankruptcy Preferences: Insult to Injury or Fair Redistribution? How to Protect Yourself

It’s inevitable dear readers that the recent spate of high profile bankruptcies will result in many of you receiving the dreaded letter demanding that you return payments made by the debtor for delivered goods. We’ll discuss a recent change in the law that favors creditors and some suggested safeguards.

What it is. Most of us are aware that the Bankruptcy Code allows a debtor to recover “preference” payments made by the debtor (1) on account of antecedent debt (rather than current debt), (2) while the debtor is insolvent, (3) within 90 days of the filing of bankruptcy (and within one year if the creditor is an insider), and (4) that allows the creditor to receive more than it would have received if the payment was made in a bankruptcy proceeding (i.e., where all unsecured creditors receive a pro rata distribution of assets after payment of priority claims). A trustee, debtor in possession or creditors’ committee has up to two years from the bankruptcy petition to file a preference claim. At that point the creditor can pay the amount demanded, negotiate a settlement, or seek protection under one of the preference defenses.

Defenses. In a favorable development for creditors (you don’t read that often, do you), a three pronged preference defense was scrapped in favor of a two pronged defense. Now a creditor will win a preference action if it can show that (1) the transfer was in payment of a debt incurred in the ordinary course of business between the creditor and debtor and (2) the transfer was made consistent with past practice between the creditor and debtor OR was made consistent with general business practice in the industry.

                Other familiar defenses are mostly unchanged. A creditor can show (1) that the payment received and the goods delivered were a contemporaneous exchange. Therefore COD or CBD payments are generally immune to preference claims, or (2) that new value (goods or services) were delivered after the creditor received a preferential payment. Therefore a supplier that ships merchandise after it actually received payment can reduce its preference exposure (as opposed to shipping goods after it receives a promise of payment), or (3) that the creditor has a security interest in the goods delivered (such as a purchase money security interest) or in the assets of the debtor in excess of the payment received. Sometimes creditors get in trouble with this defense if they don’t properly perfect the security interest (e.g., properly filing UCC financing statements, delivering proper written notices, etc.) or if the security interest is granted by the debtor to the creditor within the preference period.

Conclusion. The current trend seems to be for trustees and creditors to shoot first and ask questions later, thus they generally demand repayment from all creditors that were paid within the preference period and sort out the merits later if necessary. The actions the creditor takes upon receiving a demand will depend on the amount of funds in question and the safeguards in place to reduce its exposure. It can’t hurt to accept a preference payment if offered, but don’t spend the money just yet.