Section 547 of the Bankruptcy Code provides the power to claw back “preference” payments made to creditors within the 90 days before a debtor files for bankruptcy. In many instances, during the few months just before a bankruptcy filing, creditors are not treated equally, with a debtor choosing to pay certain creditors and not others. The Congressional intent behind Section 547 is to level the playing field by requiring all creditors to return payments made by the debtor immediately preceding the bankruptcy filing and then redistribute that money equally (pro-rata) to the creditor body.
Picture this scenario: Your business has been working with a regular customer for years. That client has historically paid your business mostly on time based on Net 30 terms. Over the past year, however, that client began to slow pay, and make promises of catching up but continuing to fall short on its obligations to your business, often spending months without dedicating a single dime toward paying its ever-increasing unpaid balance. To make matters worse, a global pandemic hits, and your customer (“ABC Co.”) asks for concessions to continue to defer their payments. You agree for a few months, before eventually cutting ABC Co. off completely and you are left with a balance owing. Just when you think things are starting to stabilize, you receive a demand letter demanding you return any payments you received from ABC Co. within the 90 days prior to the bankruptcy filing. You didn’t even know your customer filed for bankruptcy.
“This is horribly unjust!” you exclaim upon receiving the demand letter. “ABC Co. still owes me a lot of money, why should I have to give back any of the money I actually received? I performed the work/provided the goods like I was supposed to!”
“What do I do now?!?!” Well, first you should understand the basics of what a preference is, what possible defenses you may have to this demand, and what information you will need to provide to your bankruptcy attorney so that he/she can best defend you against the claim.
A. WHAT IS A PREFERENCE?
A preference is a transfer of a bankrupt debtor’s interest in property (e.g. money) that is:
(1) Made within 90 days before the bankruptcy is filed (or within 1 year if the payment was made to an insider);
(2) To/for the benefit of a creditor;
(3) Made on account of an antecedent debt (e.g. made in response to a debt that was already on the books);
(4) Made while the debtor was insolvent (the Bankruptcy Code presumes a debtor to be insolvent in the 90 days prior to the bankruptcy filing); and
(5) That enables a creditor to receive more than it would in a Chapter 7 bankruptcy.
Sometimes the trustee will not be able to fulfill all of these elements for a preference. Explaining your business relationship to your attorney will assist him/her in evaluating this threshold issue. If your bankruptcy attorney determines that the amounts claimed by the trustee are, in fact, preferences, then the next step is to evaluate the strength of your potential defenses.
B. WHAT ARE MY DEFENSES?
Section 547(c) sets out certain defenses you can use to combat the demand to return the claimed preference payments. The basics of these defenses are:
- 547(c)(1) Contemporaneous Exchange of Value: This defense can be used when the subject payment was intended to be a trade for new value made close in time. For example, the customer immediately pays you when he receives a good or service, like cash on delivery. It is critical that the payment be for the new good or service – not for the past due balance of the debt.
- 547(c)(2) Ordinary Course of Business: Under this defense the creditor must demonstrate that the preference paid a debt that the debtor incurred in the ordinary course of business and according to ordinary business terms. This involves satisfying either a subjective or objective test, meaning the creditor must prove what is “ordinary” in its relationship with the customer or the creditor must show that the terms of the arrangement are customary in the creditor’s industry.
- 547 (c)(4) Subsequent New Value: This defense may be available when the creditor, after receiving a payment during the preference period, gives the customer “new value” by selling further goods and/or providing additional services on credit terms. The subsequent new value given can reduce your preference liability dollar for dollar. This defense is meant to encourage creditors to continue to do business with, and extend credit terms to, companies with financial problems.
- C. WHAT DO I DO WITH THIS PREFERENCE DEMAND LETTER? If you do nothing, eventually the trustee likely will obtain a judgment against you for the entire amount claimed. Aside from the obvious advice of “don’t ignore it – do something!” here are some steps you can take to best position yourself to defend against a preference demand/claim:
- Call Your Bankruptcy Lawyer: Just because you receive a preference demand letter does not mean that the trustee’s preference claim is necessarily valid. Typically, these initial letters offer to accept only a small discount off the amount received and have a short timetable to respond. Do not delay in contacting an experienced bankruptcy attorney to assist you. For counsel to provide the best legal analysis, it is important to compile the below documents in short order for review.
- Compile a Complete Payment History with Back-Up: Compile the customer’s payment history extending as far back as three years before the customer filed for bankruptcy. This should include details regarding the date of delivery of goods/services, the date of invoice, and the date payment was received. Specifically, highlight and retrieve invoices for all payments received within the past ninety days. Even though the trustee can only collect payments from creditor for the ninety days before the bankruptcy, looking back further will be useful in proving the nature of the parties’ financial relationship for the ordinary course of business defense, as well as your contemporaneous exchange of new value defense. Additionally, gather copies of all invoices with proof of delivery and copies of checks for all claimed preference payments.
- Compile a Dossier on your Relationship: Then generate an organized file for the customer that includes all of their financial statements, credit applications, contracts and file notes, as well as all correspondence between your business and the debtor’s for the last six months of the relationship.
- Generate a List of Outstanding Amounts Due: Finally, prepare a chronological, detailed list of all goods and services provided on credit after receiving each alleged preference payment, including all amounts that still remain outstanding. This will assist your counsel in determining the feasibility of your subsequent new value defense.
These preference demands can be maddening and daunting, but you do have options to combat the claim for return of the funds. Following these steps will put you and your attorney in the best position to defend against them. Remember, the large majority of preference claims are settled out of court, often before a lawsuit is even filed.