Defending Preference Actions On The Cheap

Litigation actions based on Section 547 of the Bankruptcy Code, typically called “preference actions,” are one of the most counter-intuitive powers a bankruptcy trustee possesses. Companies that received a payment from a debtor in the 90 days prior to the commencement of its bankruptcy case can expect a letter demanding the return of that payment. There are several ways to respond.

Trustees have two years from the commencement of a bankruptcy case to bring a preference action. Demand letters are often sent out far in advance of that deadline. How one should respond to the demand letter usually is guided by the amount of the demand, since trustees may ultimately decide to file complaints only against companies receiving total payments above a certain threshold. A letter recipient may fall under that threshold without knowing it. Responding with an articulation of defenses likely will not result in the trustee agreeing to not pursue the action. However, if a company possesses unusual defenses (discussed below), a simple letter in response to the trustee’s demand letter might end the potential preference action before it starts.

One “defense” is that the action is too small for a trustee to bring. The Bankruptcy Code states that a trustee cannot bring a preference action unless at least $5,850 was paid to the company in the 90 day period. Additionally, 28 U.S.C. §1409(b) states that if the total amount sought is less than $11,725 (or $17,575 against an “insider”), the trustee has to file the complaint in the company’s home district—something few trustees are likely to do if the company is in a different district.

Another defense is that the company received payment when payment was not required—such as a deposit, advance payment of rent, or payment on COD terms. To be a preference, a payment has to be on account of an “antecedent” debt. If a company can make the argument that it received payments first and provided goods or services later, it should do so.

There are several additional defenses which are not immediately obvious from a review of Section 547. If the company had an executory contract or lease with the debtor, which was assumed by the debtor post-petition (meaning, the debtor agreed to continue the contract and cure all defaults under it), the trustee cannot avoid any potentially preferential payments, as the trustee already agreed that the debtor must pay those pre-petition amounts. The same scenario may apply to insurance carriers or even critical vendors who are the beneficiaries of a critical vendor motion. If a company would have possessed a lien in a chapter 7 case had the payments had not been made, or if the company is a secured creditor for some other reason, the company should make that argument as well, as a preference action cannot survive against a company that received payment in an amount it would have received in a liquidation.

The strongest defense for most companies is usually going to be the “new value” defense. If after receiving a “preference payment”, a company delivered goods or services to a debtor, then the value of those services offsets the preference “exposure” dollar for dollar. This is a complete defense, and any trustee should have an interest in fully understanding it. The company may also be able to assert that it delivered goods or services “contemporaneously” with payment from the debtor.

Finally, there is the ordinary course of business defense. The trustee may not avoid transfers that were made in the ordinary course of business between the parties, or were ordinary for the industry. A company, to successfully assert this defense, need only meet one of those requirements.

To successfully assert this defense, the company should pull its records relating to the debtor’s payment history and check to determine if the debtor appeared to be paying invoices later than normal the preference period, compared to before that period. If the difference is stark, for instance if a debtor normally paid invoices 30 to 45 days after invoice but in the preference period paid invoices 60 to 75 days after invoice, that could be evidence that a trustee will use to assert that the payments were not ordinary. If the pattern of payments falls within a normal range that existed prior to the petition date, consider sending that information to the trustee.

If certain payments in the preference period stand out as being potentially late-paid, check to determine if those are payments that are protected by subsequent new value delivered by the company. If some payments still appear anomalous, and there are no other defenses that apply, it may be difficult to get a trustee to dismiss a case without a payment of some portion of those anomalous transfers. Trustees may be willing to accept claim waivers in lieu of payment, and companies should ask about potential creditor recoveries early in the case to determine if a claim waiver will provide value to the trustee.