by Russell Mills and Kent Love
How can this be? It does not seem fair! A party who owes your client money files for bankruptcy to discharge the debt and, adding insult to injury, the party now demands that your client return money the party previously paid toward its obligation. Despite the apparent inequity, Section 547 of the Bankruptcy Code authorizes just that, allowing a trustee or debtor-in-possession to recover certain payments, or “preferential transfers,” made to creditors by the debtor during the 90-day period preceding the bankruptcy filing. But which ones are recoverable?
This article will provide non-bankruptcy practitioners with a primer on how to assess these preference claims. Because preference demands are regularly asserted whenever any business files bankruptcy, it is important for all practitioners to have a basic understanding of the elements and defenses available for these claims.
In order to recover a transfer under Section 547, a trustee must establish five elements by a preponderance of the evidence.
First, the transfer must be of a debtor’s interest in property to or for the benefit of your creditor client. For example, the transfer can be a monetary payment or the granting of a lien in favor of your client.
Second, the transfer must be on account of an “antecedent debt.” In other words, the debt must have arisen before the payment was made.
Third, the transfer must have been made while the debtor was insolvent. The Bankruptcy Code uses the typical “balance sheet” test for insolvency and there is a rebuttable presumption that the debtor was insolvent during the 90 days preceding the debtor’s bankruptcy filing.
Fourth, the transfer must have been made within 90 days of the bankruptcy filing, or within one year if your client is an “insider.”
Finally, the transfer must have enabled your client to receive a greater share of the debtor’s assets than it would have otherwise received in a hypothetical Chapter 7 liquidation. This element is typically satisfied unless your client is fully secured (i.e., the value of your client’s collateral is greater than the debt). A fully secured creditor cannot be forced to return a transfer because it is entitled to realize the full value of its collateral in bankruptcy.
Even if all of the above elements are satisfied, your client can still retain the transfer by proving that one or more affirmative defenses apply. While there are many defenses to preference claims, three are most commonly asserted.
First, a trustee cannot recover a transfer if your client provided goods or services contemporaneously with the debtor’s payment for those goods or services. Thus, cash-on-delivery transactions are generally exempt from preference liability.
Second, a trustee cannot avoid a transfer made in the ordinary course of business. To prove this defense, your client must show that the transfer was consistent with either (1) the parties’ prior course of dealing, or (2) common industry practice. It is important to note that the term “ordinary” does not refer to the type of expense, but instead refers to whether the payment was made within a similar amount of time and under similar terms as payments made prior to the preference period.
Third, if your client subsequently provides new value (i.e., new goods or services) after a preferential transfer, the value of those goods or services can be used as a dollar-for-dollar offset against the preferential payment. However, new value can only be used to offset the immediately preceding payment; there is no netting of all new value against all payments made during the preference period.
Practice and Procedure
Trustees commonly send demand letters to creditors who received payments during the preference period with little or no analysis into the elements or available defenses. Many of these creditors will simply return the money while overlooking even the most obvious defenses to preference liability.
For those who do not return the money, the trustee will file a lawsuit, or an “adversary complaint,” in the bankruptcy court. These “adversary proceedings” can involve substantial discovery and pre-trial motion practice just as any other lawsuit and, as a result, preference litigation can become extravagantly expensive.
To avoid this, it is usually best to respond to a trustee early, asserting all viable defenses and providing supporting documentation. Fortunately, trustees are typically willing to entertain settlement offers at a significant discount before a lawsuit is filed.
Engaging a skilled bankruptcy professional early in the process to undertake a thorough analysis and initiate settlement discussions can often significantly reduce or even eliminate preference liability, thereby avoiding expensive litigation.
Russell Mills is a partner at Bell Nunnally & Martin LLP. Kent Love is an associate attorney at Hiersche, Hayward, Drakeley & Urbach, P.C. They can be reached at email@example.com and firstname.lastname@example.org, respectively.