No area of bankruptcy law is less understood, and causes more shock and upset, than the law pertaining to the recovery of preferential transfers, referred to as “preferences.”

The first time a business is exposed to the law of preferences is usually when it receives an unpleasant letter, or a complaint initiating a lawsuit, demanding the return of a payment the business received on a legitimate debt from a company that later filed bankruptcy. The payment demand comes from a bankruptcy trustee or a company in bankruptcy,

The inevitable response to that kind of demand is predictable: “It was a legitimate debt, not fraudulent; can they really do this? They never served us, I got the complaint in the mail; can they do that? Is there any way to fight this?” The answers are yes, yes and yes. The details follow.

The Method to the Madness

The law of preferences in bankruptcy dates back well into the 19th century. The core idea is that one of the principles of bankruptcy is that equally situated creditors should be treated equally.

It is only a short jump from there to the idea that:

  • the debtor was insolvent in the 90 days before bankruptcy;
  • fortunate creditors who were paid during that 90-day period should pay back those funds to the bankruptcy estate, so they are in the same position as the unfortunate creditors who were not paid.

The logic behind this approach is based on the collective nature of the bankruptcy process. This rejects a Darwinian, survival-of-the-diligent approach, where the first creditor to get to the debtor, or to the courthouse, during the preference period, would come out on top. Instead, the bankruptcy system favors a collective, share-and-share-alike approach.

To ensure that all creditors are treated equally, certain payments made by the debtor within 90 days of the bankruptcy filing can be brought back into the “pool,” with the creditor receiving a claim against the bankruptcy estate equal to the for the amount that it was forced to “put back.”

In a nutshell, preference law exists to even the playing field between those that were preferred by receiving payments in the 90 days prior to bankruptcy (thus the term preferences), and those who did not. The concept is that creditors, preferred and non-preferred, should be treated equally.

How It Works

A payment is a preference if it was a transfer of property of the company that filed bankruptcy that meets the following five criteria:

  • it was to or for the benefit of a creditor;
  • it was on account of a pre-existing debt;
  • it was made within 90 days of the bankruptcy filing (or 1 year if the transferee was a relative or entity closely related to the debtor);
  • it was made while the debtor was insolvent;
  • it allowed the transferee to receive more than it would have received in a chapter 7 bankruptcy case if the transfer had not been made.

Special Rules for the Service of a Preference Complaint

Congress granted jurisdiction to the Bankruptcy Courts over any person who has received a preference.

Service of process of a preference complaint can be accomplished by first class mail, anywhere in the United States. Personal service of the summons and complaint is not required.

Defenses

A company that is the target of a preference action or demand does have defenses, which are specified in the Bankruptcy Code. These are:

  • Contemporaneous exchange of new value. This applies when the transfer of money from the debtor to the transferee was accompanied by a transfer of value from the transferee to the debtor. Example: a cash sale.
  • Ordinary course of business. This is the “softest” and most difficult defense to prove. It applies when the payment meets three separate standards of “ordinariness.” Example: a payment within the terms of the invoice.
  • Subsequent advance: This defense applies when the transferee advanced value to the debtor after the original transfer. For any amount which is a preference, the transferee is given a dollar-for-dollar credit for all amounts advanced to the debtor after the initial transfer was made. Example: after receiving a payment from the debtor within 90 days of bankruptcy, the transferee ships additional merchandise to the debtor. The transferee is given a dollar-for-dollar credit for the invoiced value of the merchandise shipped.
    In the 9th Circuit, which includes California, this applies whether or not the transferee was ever paid for the subsequent advances prior to the debtor’s bankruptcy case. In many other circuits, however, the defendant must show that the new value remained unpaid at the time for the bankruptcy filing in order for the defendant to apply the new value as a credit against the amount of the preferential transfer(s).

Responding to a Preference Demand

It is common for trustees to make a demand for the repayment of alleged preferential transfers prior to filing a lawsuit. This gives the company responding to the demand an opportunity to lay out its defenses. If done properly, this can convince the trustee to simply go away.

In matters in which there is real exposure, you can engage in settlement negotiations and sometimes settle matters for pennies on the dollar prior to a lawsuit being filed. This avoids the costs, frustration, and valuable time involved in defending a lawsuit.

Here is how it works in real life. The following preference matters were successfully resolved by the Valensi Rose Bankruptcy, Restructuring, and Creditors' Rights practice group:

Case 1:  A bankruptcy trustee demanded the return of over $60,000 in payments that had been made to our client during the 90 days before the bankruptcy filing. We had the client supply us with all of the invoices, and the invoice and payment ledgers. After reviewing them, and preparing a detailed analysis, we were able to show the trustee that all of the preferential payments received were covered by defenses. A lawsuit was never filed, and the trustee was not heard from again.

Case 2:    The trustee sued our client to recover alleged preferences totaling over $850,000. After we set out, in a detailed presentation, all of our client's defenses, the trustee settled for $40,000, which was less than five cents on the dollar.

The strategy you should not take when receiving a preference demand letter is to ignore it, or to solemnly tell yourself you have no liability and toss the letter. It will surely be followed by a complaint initiating a preference lawsuit. Better to engage the matter sooner than later.

Valensi Rose's Bankruptcy, Restructuring and Creditors' Rights practice group represents clients who have been targeted for the recovery of preferential transfers.

In our next issue, we will be discussing the "evil twin" of preferences:  fraudulent transfers. Such transfers to not even have to be "fraudulent" to create liability. Stay tuned.

By David M. Reeder