By: Joseph Briggett
Any business that provides goods or services and receives payment from its customers in arrears runs the risk of receiving a bankruptcy preference complaint. This is true even if the collection procedures of the business are sound. If a customer of the business files bankruptcy, the bankruptcy trustee will eventually seek to claw back one or more of the payments that the business received from the debtor prior to the bankruptcy case.
Strategies for Dealing with Preference Claims
Preference claims are unique because the defendant often did not do anything wrong, yet they are haled into bankruptcy court and asked to pay back money into the bankruptcy estate. Usually, all the defendant did was charge its customer for goods or services, and then received a payment. The defendant may have had no idea that its customer was on the verge of bankruptcy or even insolvent. Unfortunately, the lack of culpability on the part of the party who received the payment often does not matter.
Nevertheless, there are some strategies that businesses can implement to minimize preference liability, or at least to ensure that they will have defenses to liability when a preference case is filed.
To understand these strategies, it is first necessary to understand the basics of the preference statute, 11 U.S.C. § 547. The elements that a bankruptcy trustee has to prove to win a preference claim are simple. The trustee must show that the debtor transferred money or property to a party within 90 days prior to the date the debtor filed bankruptcy.1 This can usually be shown in black and white on the debtor’s bank ledger. The trustee must show that the payment was on account of an “antecedent debt” which essentially means a debt that was due and owing before the payment was made. The trustee must also show that the debtor was insolvent at the time of the transfer, which is often not difficult to prove in the case of a debtor on the verge of filing bankruptcy.
Considering these elements, one way a business can implement procedures to avoid preference liability is seeking payment in advance. Because the showing of an “antecedent debt” is an element of the claim, insisting upon payment in advance would avoid the issue in many cases. Of course, payment in advance is not always practical as a business matter.
The final element that a trustee must show is that the transfer enabled the creditor to receive more than it would have otherwise received if the transfer had not been received, and the debtor went through a liquidation. This requires the court to examine a hypothetical Chapter 7 liquidation, and to determine what the creditor would have likely received in that process. The question here is whether the payment gave the creditor an advantage over what it would otherwise have received in an orderly liquidation.
For creditors, this final element of the trustee’s case highlights the importance of preserving any lien rights. A creditor that has a claim secured by a lien would, at least hypothetically, still be able to collect in a Chapter 7 liquidation. Therefore, the creditor can argue that the final element is not satisfied. This makes it critical for creditors to observe and perfect applicable lien rights when their customer is in difficult financial times. These include maritime liens, materialmen’s liens, oil well liens and Uniform Commercial Code security interests, among others. Of course, each of these have their own regimes and particular filing requirements, including appropriate notices of liens, lien affidavits, financing statements and other instruments which must be properly filed and perfected in county and parish records and other official public registries.
In addition to the elements that the debtor or trustee must prove, there are several statutory defenses to preference liability. The one that is most important to recognize and prepare for in advance for purposes of collection procedures is the ordinary course of business defense. The ordinary course of business defense allows the party that received the payment to defeat the trustee’s preference claim by showing that the goods or services provided, and the payment made for them, were in the ordinary course of business.
Prior to the 2005 amendments to the Bankruptcy Code, the ordinary course defense was more difficult to prove. The creditor had to show not only that the payment was received in the ordinary course of business between the parties, but also in the ordinary course considering terms for the particular industry. Following the 2005 amendments to the Bankruptcy Code, however, the creditor may prove this element by showing the transaction terms were ordinary either by reference to the parties, or the industry at issue.
Ultimately, the ordinary course of business defense often hinges upon the bankruptcy court’s review of the historical payments between the creditor and debtor. The critical issue is whether the timing and method of the allegedly preferential payment was consistent with the historical payments prior to the period when the debtor was nearing bankruptcy.
When the ordinary course defense is at issue, it is important to have documented and routine collection procedures. If the business accused of receiving a preference payment can show that every month it sent an invoice to the debtor, followed up on overdue accounts according to a regular procedure, and then received payment in a regular and repetitious manner, that will go a long way in proving an ordinary course of business defense. If the alleged preference payment was invoiced and received in a manner consistent with the history, the bankruptcy judge is more likely to find that the trustee cannot recover that payment. For this reason, a business that has a coherent and consistent billing and collection policy should ultimately have less exposure to preference liability.
Another important statutory defense is the contemporaneous exchange for new value. This defense applies to any payment received in exchange for new value given to the debtor, when such exchange was in fact substantially contemporaneous. The Bankruptcy Code defines new value as money or money’s worth in goods, services, or new credit, or a release by a transferee of property previously transferred, however, it does not include an obligation substituted for an existing obligation.
Just as a creditor may mitigate the risk of preference liability by demanding payment in advance from its customers, the creditor may also have a defense to preference liability when it insists upon payment at the same time as the provision of goods or services. Again, in many cases this is not practical, and a customer in dire financial straits is probably even less likely to pay on delivery. Moreover, demanding contemporaneous payment may be a double edged sword, because if the customer is nearing bankruptcy, demanding up-front payment from a customer might undermine any ordinary course defense that would otherwise be available to the creditor. It could go to show that the creditor was departing from the ordinary course of business.
The Bankruptcy Code also provides a defense for creditors who provide new value subsequent to an allegedly preferential payment. This defense makes sense from a bankruptcy equity standpoint, because although the creditor may have received an advantage as a result of the payment, it also provided value to the estate by rendering more goods and services to the debtor, and likely was induced to do so by the payment it received.
How does the new value defense affect a creditor’s calculus for dealing with a customer that may be nearing bankruptcy?
It may actually be a good reason to keep working for, and providing goods and services to, a company that is on the verge of filing bankruptcy, at least to a certain point. Even if the creditor never gets paid for the last goods and services provided, it will at least form the basis of a defense to preference liability.
Courts have historically limited the new value defense to instances where the creditor provided new value and where the creditor did not receive compensation for that new value. The Bankruptcy Code states that the new value defense is limited to instances where the debtor did not thereafter “make an otherwise unavoidable transfer to or for the benefit of such creditor” on account of such new value. Courts have interpreted this language to mean that if the debtor paid the creditor for the supposed new value, it cannot be used as a defense.
Recent decisions, however have marked a change in this interpretation. In In re BFW Liquidation, LLC, 899 F.3d 1178 (11th Cir. 2018), the Eleventh Circuit Court of Appeals broke with prior decisions and held that a creditor may assert a new value defense even though it received payment for the supposed new value. It reasoned that the payment received from the debtor was not “otherwise unavoidable” within the meaning of the Bankruptcy Code. This is an open question of statutory interpretation among the circuits, and will likely continue to be a point of dispute in preference litigation.
1 In the case of recipients who are “insiders” of the debtor, the trustee can reach back to a longer period, up to one year.
Lugenbuhl’s bankruptcy team represents a wide array of constituencies, including acting as counsel for numerous corporate and partnership Chapter 11 debtors, as well as committees, trustees, secured and unsecured creditors, bondholders and equity holders. More information about Lugenbuhl’s bankruptcy practice is available here.
The content of this article is not intended to serve as an exhaustive review of the laws, statutes or issues related to bankruptcy, creditor/debtor rights and preference liability cases and is not intended to provide legal advice. The opinions expressed through this article may not reflect the opinions of the firm, individual attorneys or clients.
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