Bankruptcy is boon to debtors in trouble, and a pain for creditors of those debtors.  You provide goods or services to a company only to find that their receivable is noncollectable once that company enters bankruptcy, and if you’re lucky if you receive cents on the dollar on the amount owed.  However, preference payments can sting even worse.  This blog entry gives an overview of preference payments and the common defenses.

Section 547 of the Bankruptcy Code allows a bankruptcy trustee (or a debtor-in-possession under Chapter 11) to “recapture,” or invalidate, payments made by the debtor for the benefit of a creditor during the 90 day period prior to the date the bankruptcy petition was filed (the “preference period”), regardless of whether the debtor received anything in return for the payment.  This is called a “preference payment,” so named because one of the goals of bankruptcy is to promote equality of distribution of assets to similarly-situated creditors, and to prevent a debtor from paying off its preferred creditors before filing for bankruptcy leaving basically nothing for the other creditors. There are certain requirements for a preference payment, e.g., that the payment was for an “antecedent” debt (the payment to the creditor followed provision of the goods and services to the debtor), and that the payment was made when the debtor was insolvent (there is a presumption of insolvency during the 90-day preference period).

Once a bankruptcy is filed, the trustee will often look at payments made by the debtor during the preference period, and will send demand letters (or complaints) seeking repayment of the alleged preference payments from creditors. These are the letters and court actions that vex many companies.  In some cases, repaying the alleged preference payment is more economical to a company than fighting it out with the trustee, resulting in attorneys’ fees and distractions for internal personnel.  However, companies can, and often do, fight back against preference payment recapture demands.  The Bankruptcy Code includes a number of defenses to a trustee’s attempted recapture of preference payments.  The three most common of these are:

• Ordinary Course of Business Defense.  Under Section 547(c)(2) of the Bankruptcy Code, if a payment was made in the “ordinary course of business,” the recipient of the payment can avoid the obligation to return the payment.  (The reasoning for this is that if a payment was made in the ordinary course, there’s nothing preferential about it.)  A payment was made in the “ordinary course of business” if the creditor can prove (it has the burden of proof here) that the alleged preference payment was made either (a) consistent with the parties general business practices, such as the parties’ course of dealing; amount, timing and circumstances of previous payments; and contractual terms (the “Subjective Test”), or (b) consistent with common industry practice (the “Objective Test”). If you don’t have a payment history, you may not be able to use this exception. A trustee will likely give greater credibility to contractual terms where there’s a long history between the parties.  If that doesn’t exist, look to the actual payment history, not just the contractual terms.  The more consistency you have in your accounts payable practices with your partners and suppliers and the less “one-off” exceptions you allow, and the farther back your history goes, the easier it will likely be for you to claim the ordinary course defense. Good record-keeping is essential here.  It’s unclear whether payments made pursuant to an installment plan would be considered made in the ordinary course of business.

• Contemporaneous New Value Defense.  Under Section 547(c)(1), if a payment by the debtor is substantially contemporaneous with the provision of “new value” by the creditor, the party receiving that payment can avoid the obligation to return the payment.  If the payment is essentially offset by new value contemporaneously provided to the debtor, the debtor’s estate is unaffected and thus there just a payment (but not a preferential payment).  A good example of this is a purchase of goods by check or cash – if the debtor paid $1,000 by check and received $1,000 in office supplies on a one-off purchase, the contemporaneous new value of office supplies received by the debtor offsets the $1,000 payment to the creditor.  To assert this defense, you must demonstrate (1) that the parties intended for the exchange of payment for value to be contemporaneous; (2) that the exchange was in fact contemporaneous; and (3) that the exchange was for new value.  If you’re concerned that a vendor may be in financial trouble, one approach is to restructure payment terms to provide for contemporaneous exchanges to better enable you to assert this defense later on.

• Subsequent New Value Defense.  Under Section 547(c)(4) of the Bankruptcy Code, if following receipt of a preference payment a company provides new value to the debtor in the form of subsequent goods or services during the preference period, the amount of that “new value” can offset the corresponding amount of a prior preference payment.   For example, if you receive a preference payment of $10,000 sixty days prior to bankruptcy, and provide new services valued at $6,000 thirty days prior to bankruptcy (for which you do not receive another payment prior to bankruptcy), the $10,000 preference payment is offset by the $6,000 in new value, leaving a remaining preference amount of $4,000.  Credit cannot be carried forward; if there is a new payment in any amount after new value is provided but before the bankruptcy filing date, the new value is extinguished for the purposes of this defense.  This defense primarily differs from the contemporaneous new value defense in that the new value is not contemporaneous with the alleged preference payment.

One other important defense to consider is that it’s only a preference payment if made in the preference period.  For any payments made close to the 90-day mark, it may be worth a careful review of when the payment was received. In a number of courts, a “date of delivery” rule is used when determining the date of a payment for preference purposes.  Also note that for insiders of the debtor, the preference period is 1 year.

Two closing thoughts.  The possibility of recapture of preference payments shouldn’t automatically preclude you from doing business with companies which may not be fully financially stable – it’s often better to have the money and have to potentially return it than to never have it at all.  Finally, there are a lot of additional nuances to dealing with preference payment claims and litigation – consider talking with bankruptcy counsel to ensure you know your rights and defenses.