Publication - Preference Payments

Publication

Preference Payments

For a business it can be quite disheartening to diligently pursue and collect its accounts receivable, only to have a customer go bankrupt and have the customer’s last couple of payments become the subject of a preference payment action. To make matters worse, frequently the customer still has an outstanding balance which will most likely never be fully recovered by the business as an unsecured creditor in a bankruptcy proceeding.

Under the United States Bankruptcy Code, a business that files for bankruptcy is assumed to have been insolvent for 90 days prior to the filing. Consequently, any payments made during that period are assumed to be preference payments as those creditors were “preferred” over other creditors who were not paid. The money is to be repaid and, in theory, pooled with other funds of the debtor to be redistributed equitably among creditors. In reality, unsecured creditors that repay a “preference payment” rarely, if ever, receive that amount back through the bankruptcy process.

While there are defenses to a preference claim, many initial demand letters, typically from a trustee, are generated using the debtor’s check register with no analysis of whether or not the creditor has valid defenses. Thus, if a business has received a payment within 90 days of a customer’s bankruptcy, it should not be surprised to receive a demand letter. Another disadvantage to the business creditor is that preference claims of $10,000 or more may be filed in the debtor’s jurisdiction and not the creditor’s jurisdiction. Unless the debtor happens to be a local business, the business creditor will most likely have to address a claim of $10,000 or more in a distant court location. In many cases, these economic pressures lead to the business creditor settling for a lesser amount rather than fully defending the preference claim. Consequently, most preference cases are resolved through negotiation.

If a business creditor does decide to contest a preference action, there are a number of defenses that will need to be analyzed. The most common defense is the “ordinary course of business” defense. Under this defense, the debt for which payment was received must have been incurred in the ordinary course of business. The business creditor must then also show that the payment received was in the ordinary course as between the parties or that such payment was ordinary in the relevant industry. The “ordinary course of business” defense is very fact intensive and is the subject of much litigation.

Another common defense is the “contemporaneous exchange for new value” defense. In this defense, the business creditor must prove that the debtor and creditor intended the transfer to be a contemporaneous exchange for new value. As a general rule, courts have construed this to mean that payment must be made within 1 to 14 days of the transfer of new value (e.g. goods) to the debtor. In order to attempt to preserve this defense, the business creditor may want to set up a separate account ledger for any such contemporaneous exchange and apply the payment specifically to the most recent transaction. This defense is commonly lost when business creditors apply payments to past due invoices and not to the contemporaneous exchange transaction.

Another way a business creditor can protect itself is through the “subsequent new value” defense. Assume that you have received a payment which would normally be considered a preference payment for $45,000, and further assume that you thereafter have made another shipment for $25,000 which has not been paid. Under this defense, the creditor receives a dollar for dollar credit against the amount of the preference claim for each dollar of unpaid credit extended to the debtor after the debtor received a payment that would constitute a preference payment. Under the foregoing example, the maximum amount that could be recovered in a preference action would be $20,000.

If you have any questions, please contact Ron Pretekin at (937) 449-5765.

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