Your business provided goods or services to another company. Shortly thereafter, that company then files for bankruptcy, and owes your business substantial sums of money. After the filing of the bankruptcy action, you then receive a letter from counsel demanding that your business return all of the money the debtor paid to you in the 90 days before it filed for bankruptcy.
Can this really be true?
Unfortunately, it happens frequently. Under Section 547(b) of the Bankruptcy Code, a debtor may avoid a transfer it paid to creditors, trade vendors, etc. made in the ninety days prior to its bankruptcy filing. Under Section 550 of the Bankruptcy Code, a debtor may recover, for the benefit of the estate, the amount of the avoided transfer. Simply put, Section 547 was enacted to prevent a debtor from picking and choosing its favorite creditors, while leaving pennies on the dollar for the rest of the debtor's creditors.
Fortunately, there are several defenses that can be raised in response to a preference demand. This article provides a brief summary of the elements of a preference claim, and defenses that can be asserted in response thereto.
Elements of a Preference Claim Under Section 547(b) of the Bankruptcy Code
First, what is a preference claim?
To establish that a defendant received a preferential transfer under Section 547(b) of the Bankruptcy Code, plaintiff must prove that the transfer was received by a creditor on account of an "antecedent debt", and that the preferential payments must be made (i) while the debtor was "insolvent", (ii) within 90 days before the debtor filed for bankruptcy, and (iii) the transfer provide the creditor with more sums than it would have received if the debtor had liquidated under a chapter 7 liquidation.
An antecedent debt is created when a creditor receives a right to payment from the debtor for goods or services. In other words, a transfer that is a "prepayment" does not qualify as a preferential transfer under Section 547. Keep in mind that for preference claims against "insiders" of the debtor, the preference period extends back one year before the petition date.
Finally, the plaintiff must show that the creditor received more than it would have received had the payment not been made, but instead the defendant received a distribution in a chapter 7 liquidation on account of such claim. Stated differently, to show that a creditor received "preferential" treatment, the plaintiff must establish that the transfer was greater than the amount the defendant would have received had the debtor liquidated its assets under a bankruptcy brought under chapter 7 of the Bankruptcy Code.
Defenses to a Preference Demand
Second, what are the defenses to a preference claim?
Even if the debtor or trustee can establish that the debtor made a preferential transfer, there are several affirmative defenses available under Section 547(c). The most frequently invoked defenses are: (i) the subsequent new value defense; (ii) the ordinary course of business defense; and (iii) the contemporaneous exchange of new value defense. These defenses are briefly discussed below.
1. Subsequent New Value Defense
Under Section 547(c)(4) of the Bankruptcy Code, potential exposure to a claim seeking the recovery and avoidance of a preferential transfer can be reduced by the amount of "new value" provided by the defendant to the debtor subsequent to receipt of the preferential transfer.
To establish a new value defense, the preference defendant must show that after it received a preferential transfer, it then provided the debtor with new value in the form of additional goods or services.
For example, Company A receives a payment from Company B sixty days before Company B files for bankruptcy. Ten days later, Company A provides goods or services to Company B. The subsequent new value defense reduces the preferential exposure resulting from the preferential payment in the amount of the goods or services subsequently provided.
2. Ordinary Course of Business Defense
Another commonly invoked defense to a preference claim is the ordinary course of business defense, which is made available under Section 547(c)(2) of the Bankruptcy Code. A preference defendant may reduce its preferential exposure by establishing that the payment was made in the "ordinary course of business." The ordinary course defense was implemented by Congress to protect transactions incurred in the ordinary course of business of the parties.
Under the Bankruptcy Code, a party may establish that the payment was received in the ordinary of business of the debtor and defendant (the "subjective test"). On the other hand, if the defendant is unable to prove that the payment was made according to ordinary business terms between the parties, it can still prevail by demonstrating that the payment was made according to ordinary business terms. This is known as the "objective test."
3. Contemporaneous Exchange of New Value Defense
Finally, creditors can also defend against a preference claim by demonstrating that the transfer received from the debtor was a contemporaneous exchange for new value. 11 U.S.C. § 547(c)(1). Known as the contemporaneous exchange defense, it requires the party receiving the preferential transfer to provide the debtor with "new value", and the parties must intend for the transfer to be a contemporaneous exchange. Per its name, the transfer received and the exchange of new value provided must, in fact, be substantially contemporaneous for this defense to apply.
Wrap-Up
The above primer is a brief introduction to the elements and affirmative defenses of preferential claims asserted under Section 547 of the Bankruptcy Code. Of course, it is crucial to understand applicable developments in case law, the relevant provisions of the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure, and the local rules of the Bankruptcy Court in which the claim has been brought. As always, experienced local counsel should be retained in order to defend against a claim seeking the recovery of a preferential transfer.
Originally published October 21, 2020
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
