Preference Claims in Bankruptcy
Doing business with an individual or company with financial problems may have unintended consequences. If they file for bankruptcy, you could be required to return money they legitimately paid to you months earlier, even if you were not aware of their difficulties at the time. This is because bankruptcy law may treat you as having received an impermissible preference as a creditor.
What Is a Preference Claim?
Section 547 of the Bankruptcy Code sets forth rules regarding the payment and discharge of debts of a debtor. An important public policy underlying bankruptcy law is the equal treatment of similarly situated creditors in bankruptcy. One creditor should not be given a “preference” over others in the same class of creditors. If the debtor paid some bills but not others before filing for bankruptcy, those paid creditors may have received a preference. They did not have to wait for payment or risk having their debt reduced or eliminated because there was not enough money to pay all creditors. To avoid unfairness, bankruptcy law allows a preference claim, which seeks to recover moneys paid to a creditor before a bankruptcy was filed to become part of the pool of money used to pay all creditors. Only certain payments need to be refunded. Bankruptcy law sets forth requirements as well as defenses.
Who Can Bring a Preference Claim?
A preference claim is brought by the bankruptcy trustee against creditors paid within a certain period prior to the debtor filing for bankruptcy. These claims are sometimes colloquially referred to as “claw-back” claims.
How Is a Claim Initiated?
Before the claim is filed, a creditor will typically receive a “demand letter” stating how much is owed and demanding immediate payment. If the funds are not repaid, the trustee may commence a lawsuit in Bankruptcy Court. However, creditors may be able to negotiate a settlement or convince the trustee to drop the claim, either because the money is not a preference payment or the creditor has a defense. In these instances, the money does not have to be refunded. Even if the trustee is unwilling to accept the creditor’s defense, it may help in encouraging settlement for a lesser amount.
What Happens If the Payment Is Deemed to Be a Preference?
If a payment is determined to be a preference payment, it must be repaid. Such funds become part of the pool of available assets that will be distributed to creditors in accordance with bankruptcy law. Creditors in bankruptcy may receive only a portion of what they are owed.
What Are the Requirements of a Preference Claim?
Only certain payments are considered preferential. The transaction must meet the following requirements:
- A transfer of an interest of the debtor in property. The creditor must have received something of value from the debtor, such as the payment of money, a security interest, or a guaranty.
- To or for the benefit of a creditor. This goes one step further than the first requirement in that the debtor did not have to give the creditor the payment; it could have been made to another party for the creditor’s benefit.
- For or on account of an antecedent debt. The payment to the creditor must have been for a debt that was already due. It does not include a current debt, prepayments, or advance payments for goods or services.
- Made within 90 days of the bankruptcy filing (or within 1-year if the transfer was to an insider). This requirement limits the lookback period for transactions. The payment to the creditor must have been made in the 90 days prior to the bankruptcy filing for ordinary creditors, and 1 year for “insiders” such as family members or general partners of the debtor, or, in the case of corporations, officers, directors or other persons, in control of the company.
- Made while the debtor was insolvent. An insolvent debtor is one who has more liabilities than assets. Notably, under the Bankruptcy Code, a debtor is presumed to have been insolvent during the 90 days prior to the filing of the bankruptcy.
- Which allows the creditor to receive more than it would have received if the payment had not been made, and the claim was paid through the bankruptcy process. Essentially, the transaction meets the requirement if the payment was more than the creditor would get in bankruptcy.
The trustee has the burden of proving all the above requirements by a preponderance of the evidence.
What Defenses Are Available in a Preference Claim?
If the payment meets the requirements for a preference payment, a creditor may still be able to avoid refunding the money. There are several affirmative defenses to a preference claim. The burden of proof is on the creditor to show the requirements of the defense have been met.
Ordinary Course of Business Defense
Payments made in the “ordinary course of business” between the creditor and debtor need not be refunded as preferences. In order to take advantage of this defense, the creditor must show that (1) the payment was on account of a debt incurred in the ordinary course of business or financial affairs of the debtor and the creditor; (2) payment was made in the ordinary course of dealings between the debtor and the creditor; or (3) payment was made according to ordinary business terms. Essentially, the creditor will need to demonstrate that the payments were made under similar terms and conditions as previous, non-preference period payments, or, if there is no course of dealing between the creditor and the debtor, then that the transfer is ordinary in the industry.
Evidence of the parties’ account history and collection activities and industry practices may be relevant in proving the defense.
New Value Defense
Where a creditor provides additional goods or services after a preference payment is made, the value of new goods may be used to offset the preference payment. The creditor must prove: (1) the new value was given to the debtor after the preferential payment was received; and (2) the creditor did not receive any other payment for that new value.
This defense applies when the debtor and creditor intend for a transaction to be a contemporaneous exchange of payment for goods or services. For example, cash-on-delivery (“COD”) payments would fall into this category. However, if payment was intended to pay for a previous invoice, this defense would not apply. Immediate payment is not required but should be made relatively quickly after the sale.
Where a creditor has a security interest in loaned funds or the debtor’s assets, a defense of Purchase Money Security Interests or Floating Lien may be available. In addition, de minimis transfers that are deemed too small also need not be returned.
What Is the Statute of Limitations for a Preference Claim?
A preference action must be commenced within the Statute of Limitations, otherwise, it can be dismissed as untimely. The limitations period for preference claims is the later of (1) two years from the date the bankruptcy case was commenced, or (2) one year from the date the trustee was appointed if the court-appointed a trustee. Sometimes, there are other grounds to extend the limitation periods of a claim. Accordingly, always consult an attorney when determining whether a claim is time-barred.
Anyone considering whether to do business with an individual or company that may be filing for bankruptcy should consider the law regarding preference payments. The limited definition of preference payments and available defenses can protect moneys paid in many instances, but each situation is unique.
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