Avoiding Preference Risk

The following is an article reprinted with permission from the upcoming Winter 2010 edition of trendline (WWR’s bankruptcy newsletter): 

Avoiding Preference Risk

By: Kevin C. Susman, Associate

Creditors doing business with entities they suspect are on the verge of filing for bankruptcy protection need to be aware that they may be required to return the payments received from that entity within the 90 days preceding a bankruptcy filing. Whether you are a party to litigation entering into a settlement agreement, a trade creditor contemplating a compromise of a delinquent account, a lender negotiating a workout, or simply conducting business as usual, all dealings with financially troubled parties should be approached with an eye on avoiding preference risk.

Section 547 of the Bankruptcy Code permits a debtor-in-possession in a Chapter 11 (reorganization) case, or a bankruptcy trustee in a Chapter 7 (liquidation) case, to recover certain payments made to the debtor’s general creditors within 90 days (or one year if the payments went to “’insiders’ of the debtors”) prior to the petition filing date for the bankruptcy. Such payments are considered “preference” payments, or just “preferences”.

The purpose of this portion of the Code is to discourage creditors from taking extraordinary collection measures against a potential debtor in the immediate, pre-bankruptcy period. In at least some cases, if creditors do not panic, the debtor can successfully work through the financial issues that trouble it and resume ordinary payment of its bills. But if creditors push, there is a perceived rush on the debtor to collect everything possible.

For example, preferential payments to the debtor’s “favorite” creditor who holds a personal guarantee by the debtor’s principal or to the creditor who can hurt the debtor the most do not reflect the bankruptcy policy of equality of treatment for all creditors. So bankruptcy law can compel a creditor to disgorge monies received in excess of its fair share of the debtor’s assets.

If a creditor receives a letter or call from debtor’s bankruptcy counsel about a potential preference claim the creditor should not automatically refund the payment(s). There are potential defenses against repayment and, in any event, it’s a negotiation game, particularly if the demand is for a relatively small sum. If negotiation does not settle the claim, the debtor or the trustee can file suit against you in the bankruptcy court. Even if suit is filed, the claim can probably still be settled by negotiation.

The Bankruptcy Code provides several defenses to preference liability in order to encourage creditors to continue conducting business with a financially troubled debtor in the hope of avoiding a bankruptcy filing. The three most common defenses are:

 (i) The contemporaneous exchange for new value,
 (ii) The subsequent new value, and
 (iii) The ordinary course of business defenses.

The first of these three defenses prevents recovery of a payment when the transfer was intended by the debtor and creditor to be a contemporaneous exchange for new value given to the debtor and when such exchange was in fact substantially contemporaneous. New value is defined by the bankruptcy code as money or money’s worth in goods, services, or new credit, or a release by a transferee of property previously transferred, but does not include an obligation substituted for an existing obligation.

The “new value” rule requires that you demonstrate an essentially contemporaneous exchange of value between you and the creditor. After learning of a debtor’s bankruptcy filing, a creditor should account for all payments received within the 90 days preceding the filing and match those payments to goods shipped or services provided after the date of the oldest payment received within the preference period. This will allow the creditor to analyze the extent of its new value defense and potential liability to a preference attack, aiding in a cost-effective resolution of any preference demand.

The “ordinary course” defense protects recurring, customary credit transactions that are incurred and paid in the ordinary course of the debtor’s business and the creditor’s business. To successfully employ this defense, it is imperative a creditor maintain detailed records of the dates that payments are received in relation to the dates invoices are generated in order to show that the pattern of payments received within the 90-day preference period is comparable to either industry statistics or the prior payment history between the parties. This defense highlights another common mistake of creditors, which is to restrict credit terms upon discovering a debtor is experiencing financial difficulty. Several courts have found that payments received after a creditor began restricting credit terms were not made within the ordinary course of business between the creditor and debtor. Rather than tighten or more strictly enforce credit terms, creditors should require prepayment in order to avail themselves of the new value defenses discussed above.

Although it may be impossible to completely eliminate all preference risk when dealing with a distressed entity, especially when drafting a settlement or workout agreement, there are strategies that can help reduce such risk. Further, given the available statutory defenses, if a payment received within the preference period is attacked as a preference, a compromise can likely be reached with the trustee that would prove more favorable to the creditor than the recovery that could be expected through the bankruptcy claims process.

Kevin C. Susman is an Associate in the Legal Action Recovery department of the Cleveland office. He can be reached at (216) 685-4298 or ksusman@weltman.com.

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