A Primer on Preferences
by Judge Harlin DeWayne Hale and Andrew Edson
Your client receives a demand from a bankruptcy trustee that certain otherwise valid payments made for goods or services have to be returned. Affectionately known as “preferences,” such claims are troublesome to creditors, for a good faith and innocent recipient may have to refund payments received from a bankrupt debtor before the bankruptcy filing. Understanding basic preference law should aid you in your conversation with your client.
The Basics
Preference law is strict. A trustee must prove six elements to recover under 11 U.S.C. Section 547(b): (1) a transfer of an interest of the debtor in property; (2) to or for the benefit of a creditor; (3) for or on account of antecedent debt; (4) made while the debtor was insolvent; (5) made on or within 90 days before the date of the filing of the bankruptcy petition; and (6) that enabled the creditor to receive more than it would otherwise have received if the transfer had not been made and the case had proceeded under Chapter 7. A preferential transfer may include money, property, or lien rights.
Creditor Defenses
Thankfully, for the creditor in the goods and services situation, some defenses exist. If the trustee is able to prove all the preference elements, the Bankruptcy Code provides three primary defenses under 11 U.S.C. Section 547(c): the contemporaneous exchange, the subsequent new value, and the ordinary course of business defenses.
The contemporaneous exchange defense protects from avoidance the simultaneous payment by the debtor for goods or services provided at the same time. A cash on delivery transaction, where payment was received about the same time as goods were delivered, is an example.
The subsequent new value defense reduces the creditor’s potential preference liability by the amount of goods or services provided to the debtor after the preferential transfer. Thus, if the debtor made a preferential payment, and the creditor subsequently provided additional goods or services, the creditor can reduce the overall preference liability by the amount of those additional goods or services provided. This defense encourages creditors to continue doing business with the debtor prior to bankruptcy.
The ordinary course of business defense may protect creditors who received payments that are either consistent with the historical business relationship or conform to the typical industry standard. Courts consider, among other factors, the length of time of the business relationship, whether the payment at issue conformed to past payment practices, and if the creditor engaged in unusual collection activities. This defense is often met if the preferential payments fall within the typical range of payments from invoice date or according to industry standards.
Practical Advice
When bankruptcy seems imminent, questions may arise for a creditor worried about preferences. Consider:
- Take the Money: Your client should always accept payment, even when worried it is about to receive a possible preference. Preferential transfers are only voidable under the Bankruptcy Code, not per se void. To be voidable, the transfer must meet all six Section 547 requirements, which is a difficult standard to meet. Finally, the penalty is only to give the money back.
- Start With a Deposit: A deposit permits a creditor receiving payment to claim that it was partially secured, perhaps avoiding, the requirement that the payment allowed the creditor to receive more than it would have in a Chapter 7 case.
- Go COD: Cash on delivery turns a credit transaction into a substantially contemporaneous exchange so long as the debtor pays at the time the creditor provides the goods or services.
- Use Broad Contract Terms: Use broad contract terms that permit different types of payment so that any continued payment by the debtor before bankruptcy will be considered in the ordinary course of business.
- But, Don’t Change Things Too Close to Bankruptcy: The debtor’s payment method close to bankruptcy should not change, because this is arguably outside the normal course of business. The mode of payment should be consistent with past forms of payment.
- Consider Settling: If the trustee makes a demand for return of the alleged preferential payments, it is often cheaper to respond with defenses and offer a smaller amount to settle instead of saying, “see you in court.”
Summary
The foregoing should provide you and your client with the basic information regarding preferential payments and, with just a little precaution, a defense or two.
Judge Hale has been a bankruptcy judge since 2002. Andrew Edson is an associate with Strasburger & Price, LLP, and can be reached at andrew.edson@strasburger.com.This article was written in part and edited by Justin Light and Conrad Steele, law students at Southern Methodist University.
