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The Customer Finally Pays, But the Bankruptcy Trustee Demands the Payment Be Returned; What to do When Faced with a Preference Action

By Joseph A. Carita / Jul 14, 2016

Many businesses have been there - a customer who is always slow to pay or, worse yet, has stopped all payments. You diligently press them for payment and after many promises, you finally receive payment. The receivable finally has been collected and you can get back to your actual work. Soon after, you receive word the customer has filed bankruptcy and since you were already paid, you breathe a sigh of relief and perhaps make it a point to go to C.O.D. with the customer going forward. Problem avoided? Maybe - until you receive a demand letter or even a complaint from the bankruptcy trustee, demanding you return the pre-bankruptcy payment.

What? Why? The payment was made before any bankruptcy filing.  Is this some kind of mistake? Hardly. The payment may be what is known as a preference payment and under bankruptcy law, you may have to return it.

Now it is important to note it is neither wrong for a debtor to make a preferential payment nor wrong for a creditor to accept such a payment. However, Section 547(b) of the Bankruptcy Code permits a trustee or debtor in possession to recapture payments made by a debtor prior to the filing of bankruptcy. The goal is to achieve equal treatment of a debtor's creditors, that is, to recapture payments to some creditors for the benefit of other creditors whose debts remain unpaid.

Preference actions seem to be counter-intuitive. If the goal of bankruptcy is, to the extent possible, to have the debtor pay the debts they are able to, why should the trustee be able to lay claim to what appears to be a properly paid debt made before the debtor even filed?

The elements of a preference action are defined in Section 547 of the Bankruptcy Code. Generally, a trustee may avoid, i.e. recapture, any transfer of an interest (money) of the debtor in property when:

  • The transfer was made to or for the benefit of a creditor (example, a creditor receives a check from a debtor; the goods are returned by the debtor to the creditor or an obligation of the creditor is reduced by the debtor);
  • The transfer was made for or on account of  an antecedent debt owed by the debtor before the transfer was made (meaning payment or transfer made on an old debt, i.e. not a "cash on delivery" or "cash in advance" type of payment);
  • The transfer was made while the debtor was insolvent (the Bankruptcy Code provides the Debtor is presumed to have been insolvent during the 90 days prior to the bankruptcy filing);
  • The transfer was made ninety (90) days before the date of the filing of a bankruptcy petition (the deadline is extended to one year if the transfer was made to or for the benefit of an insider);
  • The transfer enables the creditor to receive more than it would have received if the case were Chapter 7 liquidation. A payment received within 90 days of the bankruptcy filing almost always enables a creditor to receive more than it would have received in a Chapter 7 case. 

Under Section 546 (a), a preference action may not be commenced after the earlier of (i) the later of (a) two (2) years after entry for the order of relief or (b) one (1) year after the appointment or election of the first trustee or (ii) the time the case is closed or dismissed. Demand letters are often sent out far in advance of any actual filing, to see if creditors will voluntarily return preference payments. Such letters usually only go out to creditors who received larger payments.

Whether you receive a demand letter or your first notice is the preference action itself, there are a number of defenses available.  The most common are listed below.

New value. This is perhaps the strongest defense to a preference action. If, after receiving an alleged preferential payment, a creditor delivers additional goods, services or credit to a debtor, the value of those goods, services or credit off-set the alleged preference amount, dollar for dollar. 

The payment was too small. Under the Bankruptcy Code, the trustee cannot bring a preference action unless at least $6,225 was paid to the creditor within the 90 day period. Also, if the total amount sought from a non-insider is less than $12,475, the trustee must file the preference action in the creditor's home bankruptcy district. Many trustees are unwilling to go beyond their or the debtor's district. 

Payments made in the ordinary course. The code also provides the defense for transfers (payments) made in the "ordinary course of business." In determining if a transaction was ordinary, the court will examine (1)  the prior course of dealing between the parties; (2) the amount of payments; (3) the timing of the payments; and (4) the circumstances surrounding the payments. Essentially, if the prior history of payments looks similar to the alleged preferential payment in terms of timing, amount, etc., the creditor has a stronger defense.

Contemporaneous exchange. Another defense is available when the parties intended and in fact conducted a contemporaneous exchange, for example a C.O.D. transaction. Clear terms in the related documentation stating the parties intention that the exchange is to be contemporaneous is helpful. Also, payments in advance or deposits are not recoverable as preferences because they do not meet the definition of a payment on an antecedent debt. 

This is just a brief overview of preference actions and the most common defenses. Every case is different and will turn upon the specific facts of your situation and your course of dealing with the debtor. There are also other defenses for more involved transactions. Your attorney can work with you to fully understand your situation, negotiate with the trustee, and if necessary, answer the preference action on your behalf and press your defenses. 

If you have any questions about the subject matter of this e-alert, please contact Joseph A. Carita at jcarita@clarkhill.com | 609.785.2923.