Someone you do business with just filed for bankruptcy. You immediately check your records to make sure they don’t owe you any money. To your relief, you discover that they paid off all their debts almost two months ago, Pheww!
So why did you later receive a notice in the mail demanding that you return ALL the money that they paid to you within the past 90 days?
What gall! Can this really be fair ? What right do they have to do this?
Welcome to Preference Claims
Bankruptcy law is designed to gather up all the resources of a bankrupt entity (called a “debtor”) and divide them fairly among all the creditors. Inherent in the Bankruptcy Code is an assumption that entities are typically financially bankrupt before they actually file a formal bankruptcy petition with the court.
In order to capture the true period of bankruptcy, the law provides a mechanism to clawback payments made in the time period before the bankruptcy filing itself. These pre-bankruptcy payments are sometimes called Preferences because they can be caused by a debtor preferring one creditor over another.
Under bankruptcy law, a debtor can file a lawsuit to void (sometimes called “avoid”) a preferential pre-bankruptcy payment, which might include a recent payment to a supplier prior to filing for bankruptcy. The goal of this legal action is to equalize the playing field for all creditors who have a stake in the debtor. Without this law, the debtor could “prefer” certain creditors over others by paying them and not the other creditors immediately prior to filing for bankruptcy.
Don’t panic just yet! Not all payments made prior to a bankruptcy qualify as a Preference. For a payment to be classified as a Preference, it must meet all the following requirements:
- Made in interest of the debtor in property;
- The payment made must have diminished the debtor’s estate. For example, if a debtor uses someone else’s assets to make a payment to a creditor, that would not count as a Preference.
- Made to or for the benefit of a creditor;
- This means that the payment does not have to be made directly to creditors, but can include indirect payments that benefit the creditor. For example, when you pay the pizza delivery person, although she is the recipient, the payment is not intended for her benefit. As a result, you would sue the company she works for, not the delivery person.
- Made for or on account of an antecedent debt owed by the debtor before such transfer was made;
- The payment must have been made for debt acquired prior to the payment taking place. For example, if a payment is made at the same time as the delivery of the goods or services, that would not be considered to be made on account of an antecedent debt as the exchange is taking place at the same time.
- Made while the debtor was insolvent;
- on or within ninety days before the date of the filing of the petition; or
- between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
- An amount greater than what the creditor would have received if the case had been filed under Chapter 7, if the transfer had not been made, or if such creditor received payment of such debt to the extent provided by the provisions of this title.
If the payment doesn’t fulfill all of the above requirements, then you are under no legal obligation to return the money back to your debtor.
If it turns out that the payment does in fact qualify as a Preference Claim in regard to the six points above, there are three common methods you can use to defend yourself and keep your hard-earned money.
The Ordinary Course Defense: An ordinary course defense can be applied to payments that are made without any unusual traits. For example, if the debtor always makes their payments within the same time frame, with the same method of payment, under the same terms and conditions, then it will be hard to prove that the debtor was showing preferential treatment with the payment in question. To plan for this kind of defense in case one of your debtors files for bankruptcy, it’s helpful to try to be as consistent as possible with how you typically receive your payments from companies that are in financial distress.
Subsequent New Value Defense: A subsequent new value defense comes into play when creditors continue to give “new value” to the debtor, even after receiving what would be considered as a Preference payment. Let’s say your customer is close to filing for bankruptcy and they suddenly pay off all of their debts to you. Later it may be argued that this pre-bankruptcy payment to you was a Preference payment. However, if you continue to provide goods or services to the company after they file for bankruptcy, the cost of the subsequent goods and services would be deducted from any Preference Claim they have against you. For example, if you provide $15,000 worth of goods to your debtor after the bankruptcy filing and you have $20,000 worth of Preference Claims against you, the $15,000 would be deducted and you would only have to return $5,000. The reasoning behind this defense is that it incentivizes creditors to continue to do business with companies that may be close to filing for bankruptcy.
Contemporaneous Exchange for New Value Defense: A contemporaneous exchange for new value defense is a very straightforward concept: you provide goods or services to a soon-to-be bankrupt company at the exact same time they pay you. Having events occur at roughly the same time is called “contemporaneous.” An example of this would be a COD (cash on delivery) transaction.