In this troubled economy, no one wants to give up hard-earned cash.  Unfortunately, many companies are forced to do exactly that as the number of corporate bankruptcy filings increases.  When a company in financial turmoil files for bankruptcy, important changes take place that alter the relationship between the bankrupt company and the collecting creditor.  One of those changes allows the bankrupt debtor, or an appointed trustee,[1] to review all payments made by the debtor during the 90 days before the debtor filed bankruptcy (the so-called "preference period"), and to prosecute a lawsuit in bankruptcy court to recover those "preferential" payments.

From a creditor's perspective, preference lawsuits do not make sense, and appear unfair, because the creditor is simply receiving money that is due and owing.  However, one of the fundamental tenets of bankruptcy is to achieve equality of distributions to creditors.  A debtor that pays only the creditors of its own choosing just before filing bankruptcy generally will not have enough assets left to pay the other creditors.  As the name suggests, preference recovery actions are intended to deter a debtor from giving preferential treatment to only certain creditors, at the expense of others, while enabling the Trustee to recover those payments for distribution to all creditors on a pro rata basis according to the Bankruptcy Code.

An avoidable preferential transfer is defined in Section 547 of the Bankruptcy Code as a transfer of property of the debtor: (i) to or for the benefit of a creditor; (ii) for a debt existing at the time of transfer; (iii) at a time the debtor is insolvent (the debtor is presumed insolvent during the 90-day period prior to filing bankruptcy); (iv) made within 90 days before the debtor filed for bankruptcy;[2] and (v) that enables the creditor to get more money than it would have received in a Chapter 7 liquidation (the "Chapter 7 Test").  It is the Trustee's (usually easy) burden to prove a given transfer is "preferential." 

Fortunately, Congress also provided creditors a number of defenses to preference actions under the Bankruptcy Code.  The four most commonly used defenses are:  (i) the ordinary course of business defense; (ii) the ordinary business terms defense; (iii) the new value defense, and (iv) the contemporaneous exchange defense.  Each is briefly discussed below.

Ordinary Course of Business Defense:  The ordinary course of business defense is often the most controversial defense, as it involves a subjective examination of the course of dealing between debtor and creditor.  The purpose of the defense is to leave undisturbed, normal debtor - creditor relationships.  A court evaluating a creditor's ordinary course of business defense will look at not only the credit terms between debtor and creditor, but also how the parties actually conducted business with one another in the months prior to the bankruptcy.  Consistency is key, and the court will evaluate whether changes took place during the preference period that made transfers during that period less than ordinary.

Generally, when determining whether a particular payment satisfies the ordinary course of business defense, courts will consider (i) the timing of shipments and payments (lag between invoice date to payment date), (ii) the size of the average transaction, (iii) the usual manner of payment (check, wire transfer), and (iv) any other circumstances surrounding the shipments and payments (particularly any unusual collection efforts on the creditor's part). 

Ordinary Business Terms Defense:  The ordinary business terms defense complements the ordinary course of business defense, and was intended by Congress to provide a defense when the parties' ordinary course of business was limited (as in a first-time or one-time transaction).  Unfortunately, the application of the ordinary business terms defense can be considerably more complicated than the ordinary course of business defense.

To determine whether a transaction or set of transactions was performed pursuant to ordinary business terms, courts will look at transactions in the relevant industry involving similarly-situated debtors and creditors.  If the preference period transactions between creditor and debtor were generally consistent with what took place in the relevant industry at the relevant time, the creditor may prevail under the ordinary business terms defense, or at least gain settlement leverage.  Many courts also hold that long-standing (and consistent) business practices between a creditor and debtor are inherently "ordinary business terms." 

New Value Defense:  The new value defense allows a creditor to prevent the Trustee's avoidance of an alleged preferential payment to the extent the creditor subsequently extended "new value" to the debtor in the form of additional goods or services.  The purpose of the new value defense is to encourage a creditor to continue to provide goods and services to a financially troubled debtor.  The new value defense gives a creditor a one dollar reduction in preference exposure for each dollar's worth in new goods or services provided. 

Contemporaneous Exchange Defense:  To establish this defense, a creditor must establish the creditor and the debtor intended the debtor to pay for a creditor's goods or services in a contemporaneous exchange, and that the actual exchange was, in fact, substantially contemporaneous.  Generally, if a creditor ships goods, and is paid for those goods prior to the creditor's next shipment to the debtor, the transaction constitutes a "contemporaneous exchange." 

Basic Tips to Defend Bankruptcy Preference Actions:  As with other things, the best defense of a preference action may be a good offense.  In other words, one can take early steps to avoid the characterization of a transfer as "preferential."  For example, payments you receive from a third, non-debtor party would not diminish the bankruptcy estate, and are therefore not considered preferential transfers.  Similarly, secured transactions (such as those involving a purchase money security interest) would serve to defeat the Chapter 7 Test, and prevent the avoidance of payments received by the secured creditor.  A number of steps can also be taken to shore up an ordinary course of business defense, such as establishing a clear collections policy and sticking to that policy at all times, with all creditors.

Finally, should your company receive a demand letter or an actual complaint demanding the return of alleged preferential transfers, do not simply give in.  Rather, consult counsel experienced in defending preferential transfers, and fight back.  At a minimum, the defenses discussed above can serve as a foundation for negotiating a better result that simply returning the payment in full.

[1] For the purposes of this article, the entity suing for recovery of alleged preferential payments will be referred to as the "Trustee."

[2] The Bankruptcy code extends the preferential payment period from 90 days to 1 full year if the creditor receiving payment was an "insider."  Insiders include close relatives, officers and directors, etc.