If a customer of your business has entered bankruptcy proceedings, and you have obtained payment from that organization recently, you may receive a letter demanding “repayment of a preference” or “repayment of an unfair preference.” This article aims to shed light on this issue and help you understand your options.
Often when a business gets into financial trouble and is either contemplating filing a Chapter 11 reorganization, or is hoping to avoid Bankruptcy altogether, the Debtor will make payments on obligations owed to the creditors it needs to continue to use to keep the business going.
If a bankruptcy case is later filed, either a Chapter 11 or Chapter 7 Trustee or a creditors’ committee in a Chapter 11 case will review the Debtor’s pre-filing business records to see who received payments within 90 days, or up to a year, before the filing of the case. They then send out a demand to every creditor who received a significant payment (depending on the size of the case, but generally not less than $2,000), demanding that the creditor return the payment which they claim was a “Preference” under bankruptcy law.
One of the primary ideals of bankruptcy proceedings is the notion that creditors in equal positions should share equally in the assets of the Debtor. A business in financial distress, that cannot afford to pay all of its debts as they fall due, has to make choices as to whom to pay and when. It is natural for the Debtor to want to pay either creditors with whom it has a connection or businesses whose goods or services he needs, at the expense of other creditors. Section 547 of the Bankruptcy Code, entitled Preferences, provides for the Debtor, a Trustee or another party in interest to recover payments made within a short period prior to the bankruptcy filing from those “preferred” creditors, bringing the money back into the business for distribution to all creditors pro-rata in accordance with the priority schemes set forth in the Bankruptcy Code.
What is a Preference?
A preferential transfer is the transfer of an interest of the debtor in property—
- to or for the benefit of a creditor;
- for or on account of an antecedent debt owed by the debtor before such transfer was made;
- made while the debtor was insolvent;
- on or within 90 days before the date of the filing of the petition; or
- between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
- that enables such creditor to receive more than such creditor would receive if—
- the case were a case under Chapter 7 of this title;
- the transfer had not been made; and
- such creditor received payment of such debt to the extent provided by the provisions of this title.
Just because a Trustee or Creditors’ Committee makes a demand on you for repayment of a preference, it doesn’t mean there actually was a preference, or that even if there were, it has to be repaid.
Maybe the payment you received from the Debtor was an advance toward the purchase price of goods they were ordering. That payment was not a payment on account of an antecedent debt, owed before the payment was made, and therefore the payment is not a preference.
Maybe the debtor wasn’t really insolvent when the transfer was made. There is a presumption that the debtor is insolvent for the 90 days prior to the filing, but that presumption can be rebutted. The test for insolvency will depend on whether the debtor is a going concern or on the brink of liquidation. If the debtor remained in business for some time after the bankruptcy case was filed, then the test would be whether the debtor was generally able to pay its debts as they fell due. If the debtor was on the brink of liquidation, the test would be a balance sheet test.
Maybe the payment came from some source other than the Debtor. If the Debtor receives money earmarked to pay specific antecedent debts (such as a contractor receiving funds specifically earmarked for certain subcontractors), then those payments would not be considered a transfer of an interest of the debtor in property, and would not be a recoverable preference.
Even if a payment does fall within the definition of a preference, the payment may come within the exceptions to recoverable preferences, such as:
- The payment was a contemporaneous exchange for new value – this generally applies to payments by check for goods or services, where the check is given at the time the goods are transferred to the Debtor or the services are rendered, but may not be deposited until a little later. So long as the check clears the debtor’s bank when it is deposited, the payment is not recoverable. If a check “bounces” and is either then re-deposited or replaced, then that payment may be recoverable.
- The payment was made in the ordinary course of business. This is the area that is most litigated. If a payment is made in the ordinary course of the debtor’s and the creditor’s business, then the payment is not recoverable. Until 2005, a creditor was required to show that the payment was made according to normal business dealings not only between the creditor and the Debtor, but also according to industry standards. In 2005, the law was changed so that now the creditor only has to show that the payment was made either according to industry standards OR within the normal course of dealing between the Debtor and the Creditor. So, if a debtor habitually pays invoices 45-60 days after receipt, even if the invoice requires payment within 15 days, any payments made within that 45-60 day period would be excepted from recovery by the Trustee.
- After the payment was received, the Creditor advanced new value to the Debtor. This exception is to protect creditors who continue to do business with the Debtor after receipt of a payment. For example, assume a Debtor owes the Creditor $40,000. The Debtor pays $20,000 within 90 days of the bankruptcy filing. Prior to the bankruptcy filing, but after the payment, the creditor advances $15,000 of new goods. Only $5,000 would be recoverable as a preference. If more than $20,000 is given in new value, then none of the payment would be recoverable.
- The payment is too small. A Trustee cannot recover a preferential transfer that is less than $600 in the case of a debtor whose debts are primarily consumer debts, or $6,225 in the case of a debtor whose debts are not primarily consumer debts.
There are other exceptions that are more technical, but these are the ones that come up most often. If you receive a demand for return of a payment, you should check with a bankruptcy professional to see whether you have a defense. Very often you can negotiate with a Trustee to repay an amount that is less than the full amount due in order to save the Trustee the costs of litigation.