It’s your worst nightmare: you provided goods and services to a financially struggling company, only to find out that it filed for bankruptcy, leaving your company with a large unpaid balance. Worst yet, after the debtor filed for bankruptcy, you receive a demand letter in the mail threatening a lawsuit if you do not return payments that you received from the debtor, even though you earned that money by providing goods or services to that entity. What sense does that make?
Unfortunately, this is the reality that many companies face when transacting business with an entity in the months prior to its bankruptcy filing. Section 547 of the Bankruptcy Code allows a debtor to avoid and recover transfers that it made in the 90 days prior to its bankruptcy filing, regardless of whether it received anything in return. This section was enacted to preclude a debtor from paying off its favorite creditor(s), while leaving nothing for the rest of the debtor’s creditors. Hence the term preference payment.
Where does this leave your company after receiving a demand letter or complaint in the mail for the return of such alleged preferential transfers? Rest assured, the Bankruptcy Code also provides numerous defenses that you can raise in response to such a demand. This post provides a brief summary of the elements of, and common defenses to, preference claims.
Elements of a Preference Claim
To establish that a defendant received a preferential transfer under Section 547 of the Bankruptcy Code, plaintiff must prove the elements of 11 U.S.C. §547(b). These elements include that payments were received by a creditor on account of an “antecedent debt”, and that the preferential payments must be made (i) while the debtor was “insolvent”, (ii) made within 90 days before the debtor filed for bankruptcy, and (iii) the payments provide the creditor with more payments than it would receive if the debtor had liquidated under a chapter 7 liquidation. 11 U.S.C. § 547(b).
An antecedent debt arises when a party receives a right to payment from the debtor for goods or services provided to the debtor. This means that transfers which were “prepayments” do not qualify as preferential transfers under Section 547. To determine whether a payment falls within the 90 day preference period, count back ninety days from the date the debtor filed for bankruptcy (the petition date). For preference claims against “insiders” of the debtor, the preference period extends back one year prior to the petition date.
Finally, the plaintiff must show that the creditor received more than it would have received had it not received the payment, but instead received a distribution in a chapter 7 liquidation. This means that in order to show that a creditor received “preferential” treatment by the debtor, the plaintiff must prove that the creditor’s payment was greater than what the creditor would have received had the debtor liquidated its assets under chapter 7 of the Bankruptcy Code.
Affirmative Defenses to Preference Litigation: Ordinary Course of Business, New Value and Contemporaneous Exchange
Even if the plaintiff can establish that the debtor made a preferential transfer as defined under the Bankruptcy Code, there are several affirmative defenses available to creditors under Section 547(c). The more common defenses include the subsequent new value defense, ordinary course of business defense, and the contemporaneous exchange of new value defense, which are discussed below.
- Ordinary Course of Business Defense – Section 547(c)(2)
The party receiving the payment may still avoid returning the money by proving the payment was made in the “ordinary course of business.” The ordinary course of business defense is the most widely used defense to a preference claim. Congress created the ordinary course defense in order to protect recurring, customary credit transactions that are incurred and paid in the ordinary course of business of the debtor and the debtor’s customers.
Under the 2005 amendments to the Bankruptcy Code, it is now easier for creditors to prove payments were made in the ordinary course of business. Under the amended provisions of the Code, a creditor that receives preferential payments must prove that payment was received in the ordinary of business of the debtor and creditor (the “subjective test”). Alternatively, if the creditor cannot prove that the payments were made according to ordinary business terms between the parties, it can still prevail by showing that the payments were made according to ordinary business terms (the “objective test”). Prior to the 2005 amendments, the creditor had to satisfy both the subjective and objective tests in order to satisfy the ordinary course of business defense.
- Subsequent New Value Defense – Section 547(c)(4)
Exposure to a preference action can be reduced by the amount of “new value” provided by the defendant to the debtor subsequent to receipt of the preferential payment. To establish a new value defense, the creditor must show that it received a preference payment, the creditor then provided the debtor with new value in the form of subsequent goods or services.
- Contemporaneous Exchange of New Value Defense – Section 547(c)(1)
Creditors can also defend against a preference claim by showing that the payment(s) received from the debtor were contemporaneous exchanges for subsequent new value. The contemporaneous exchange defense requires the creditor who received the payments from the debtor provide the debtor with “new value” after receiving payment, which can include the value of goods or services. Additionally, the creditor and debtor must intend for the payments to be a contemporaneous exchange. Finally, the payments received by the creditor and the exchange of new value must actually be substantially contemporaneous.
The above is a brief introduction to the elements and core defenses of Section 547 preference actions. Subsequent posts will explore in greater detail the various components of preference claims. Besides looking at substantive legal issues, however, it is also important to understand the Local Rules and General Orders that govern the procedural flow of these cases from beginning to end.
Carl D. Neff is a bankruptcy attorney with the law firm of Fox Rothschild LLP. Carl is admitted in Delaware and regularly practices before the United States Bankruptcy Court for the District of Delaware. You can reach Carl at (302) 622-4272 or at firstname.lastname@example.org.