Remember that customer who was always late paying? The one that got really far behind until you sent threatening notices and maybe had your attorneys threaten to sue? Maybe they paid up their account and you breathed a sigh of relief. Maybe you were even happier when you found out the customer went into bankruptcy. Today you got a letter from a law firm demanding that you pay back the money your customer paid as a "preference". This article outlines some basic steps you should take, after your initial shock and outrage wears off. In the space available, we can only provide a simplified overview of this situation, to give you a general idea of the issues and areas in this complex area of bankruptcy law. There is no substitute for competent individual advice from a bankruptcy specialist.

What is a preference?

In simplest terms, a preference is a payment or transfer of property to pay an existing debt that results in one unsecured creditor receiving more on their debt than the percentage payment they would have received in the debtor’s bankruptcy case had they not been paid. Because "equality of treatment among creditors" is a well established principle of the bankruptcy system, the Bankruptcy Code gives trustees, certain debtors and creditors committees the right to sue to recover preferential payments or property transfers to increase the "pot" of value to be distributed to all the creditors according the priorities and rules the Code and bankruptcy law specify. (How this distribution works is more complicated and beyond the scope of this article).

In defending a preference action, you should pay attention to some other requirements. The payment or transfer must have been made on or within 90 days before the bankruptcy petition filing date, [the period is one year when the creditor qualifies as an "insider" (e.g. relative, shareholder, officer or person in control of the debtor)]. If the payment was made by check, the check must have cleared within that time. The Debtor must have been "insolvent" when the payment was made. (This is presumed to be so during the 90 days just before the bankruptcy filing. You have to prove otherwise). The payment or transfer must have come from the Debtor or the Debtor’s property, and not from somewhere else.

What defenses against a preference claim do I have?

There are several defenses that you may use to defeat a preference action if you, the creditor, can prove them. Simplified, some of the more common of these defenses are:

This payment was in the "ordinary course of business". What this term means is complex and specific to each set of facts. If the bankruptcy was filed before October 17, 2005, a payment may qualify if (A) it is consistent with the payment terms agreed upon (i.e. on time) or consistent with the pattern of payment that had developed between you and the Debtor AND (B) You can prove that the payments were consistent with "ordinary business terms." (Before those amendments become effective you have to prove A AND B). On the other hand, if the payment was the result of collection efforts, a lawsuit or a threat of lawsuit, proving "ordinary course of business" may become more difficult.

If the bankruptcy case was filed on or after October 17, 2005, proving ordinary course of business becomes easier. Instead of having to prove both A and B above, you need only prove one or the other. Thus, even if a particular payment was out of line with the pattern and practice you had developed with this particular customer, you can still have a good defense if you can prove that it is consistent with what is done in the industry. This will usually require expert testimony.

After this payment, you gave the Debtor "new value". This means that after the payment, you provided goods, services or something else of value to the Debtor for which you didn’t receive payment and are still owed money, OR you were paid but the payment itself is a voidable preference. For example, if you received $5000.00 on account 89 days pre-bankruptcy, then later furnished another $3000.00 worth of goods, the "net preference" on the $5000.00 payment would be only $2000.00 if (a) you never got paid for the second shipment, or (b) you got paid for the second shipment but that payment is itself a preferential transfer you will have to refund.

You had a legally perfected security interest in the Debtor’s property and the money or value you received came out of the collateral. A judgment usually will not qualify. Also, if your security interest became legally perfected within the 90 days pre-bankruptcy, that may be a preference that is itself subject to attack.

The money or property didn’t come from the Debtor. Examples include money paid by another person or another company that is not in bankruptcy. In some cases, money that is "earmarked" for payment of your debt (e.g a payoff as part of new financing) will also fit into this exception.

It’s too late. A lawsuit to recover a preference must be filed within specific time, measured from different starting points, depending on your case. If the suit was filed more than two years after the bankruptcy started, it may be time barred. See a bankruptcy specialist. Also, if the payment or transfer was made more than 90 days before the bankruptcy started, you may not have to pay it back. This depends on whether you qualify as an "insider".

The claim is too small. If the bankruptcy case in which the suit or claim against you is being pursued was filed on or after October 17, 2005, and if debtor's debts are not "primarily consumer debts", (a consumer debt is one incurred for personal, family or household purposes) no preference suit is permitted for less than $5000.00.

The suit is in the wrong place if not filed where you have your principal place of business. If suit is threatened or filed in a bankruptcy case originally filed on or after October 17, 2005 suit must be filed in the federal court district where you "reside" if one of the following is true:
1. The claim seeks to recover payments totaling less than $15,000.00 on a consumer debt or less than $10,000 on an non-consumer debt.
2. Unless you are an "insider" (ie a shareholder, relative, officer, director or someone else with a close relationship with the debtor, the trustee seeks to recover payment of less than $10,000 on a non-consumer debt. (A consumer debt is one incurred for personal, family or household purposes).

The Complaint does not have enough detail and should be dismissed..

In 2007 and 2009, the United States Supreme Court handed down two decisions that substantially increased the specificity required for a Complaint in federal court to survive a motion to dismiss. It is no longer enough that the Complaint sets forth the basic elements of a preference suit. Now, there must be enough specific facts contained in it so that the preference suit is factually plausible. It should contain the specific method, date and time of each payment or transfer of property, and identify the account or otherwise establish that the transfer was property of the debtor. It should identify each debt that was satisfied with enough detail to show that it is a pre-existing or “antecedent” debt. It should do more than just allege the debtor was insolvent; instead there should be information about the debtor’s finances, assets and liabilities to show that insolvency existed. There should be facts showing how you received more than you would have otherwise in a bankruptcy. This could well require a statement of what other debts there were and what each could receive in a bankruptcy.

How this plays out in any one case is still evolving, and reliance on experienced and knowledgeable counsel is essential.

Talk to a bankruptcy specialist about these and other ways of defending a preference claim.

What should I do to prepare to defend a preference?

Don’t ignore it. See an attorney who is a bankruptcy specialist or otherwise knowledgeable and experienced right away. If suit has been filed, carefully note the date the Complaint was mailed and the deadline for your Answer. If time is short, you may be able to get a reasonable extension of time to answer, but you must document that agreement by a letter or signed Stipulation.

Immediately collect together all your account records for this customer. Compile a payment and billing history with careful attention to the time between billing or invoicing and payment. Collect and organize all notes and correspondence, especially those concerning any collection efforts. In some industries, payment at 90 days or more is well accepted and typical. This may show "ordinary course of business".

If possible, have someone analyze the time between billing and invoicing and this customer’s actual payment, not only for the alleged preferences, but also for the 6-9 months before. You may be able to demonstrate that the payments you received fit a normal and usual pattern for this customer and/or this industry.

Talk to the accounts payable people who actually dealt with this customer. Was there an agreement to spread out payments or a payment plan? Can you show that the payments to this customer were in line with what is typical in your industry or the actual practice with this customer for some time?

Be careful about admitting facts in any response to the demand. If you respond to the demand without first consulting with an attorney, you should limit yourself to asking for more information and documents (such as copies of cancelled checks).

After consulting with an attorney, consider demonstrating that there is no basis for suit. (But see above). Attorneys pursuing preferences often have incomplete information based only on the fragmentary records of a "now-defunct" company. If your attorney can show that no preference exists, you may save considerable time and expense. Employing a bankruptcy specialist here may be the best money you can spend.

If possible and reasonable, consider an early settlement, after consulting with competent counsel. Often, preference demands are initiated to "test the waters". Also, Trustees are very aware of the cost and risks of this litigation. (As you should be also). In most cases, an early settlement at a substantial discount can be reached. Again, hiring a bankruptcy specialist is critical.

This article should give you a start in analyzing your situation and developing an effective plan to defend against preference demands. However, since these cases are very fact-specific and the law is complex and ever-changing, you may have issues or problems not discussed here. To be adequately represented you must seek personal advice from a bankruptcy specialist.

We are NJ bankruptcy attorneys and help consumers obtain debt relief under the Bankruptcy Code.

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