Creditor Beware – Preferences in Bankruptcy

Bankruptcy not only stops collection efforts against the bankrupt party, but it can effectively “avoid” payments made in the past.  An “avoidance” of a payment essentially orders the creditor to repay the debtor.  The Bankruptcy Code gives the debtor and/or the bankruptcy trustee several devices to avoid payments.  Probably the most frequently used of these devices is the bankruptcy preference.

Generally, under the Bankruptcy Code a “transfer of property” (a preference) can be set aside if it is:

  •  made to or for the benefit of a creditor;
  • on account of a prior debt;
  • made while the debtor is insolvent;
  • made on or within 90 days of the bankruptcy filing; and
  • the transfer would provide the creditor more than the creditor would have received had the debtor not made the payment and had liquidated in a Chapter 7 bankruptcy.

If a payment is received in the 90 days prior to a bankruptcy a creditor can usually expect that the above elements are satisfied.  The date of payment is usually easy to prove and it is often self-evident that a payment is made for the creditor’s benefit, on behalf of a prior debt, and that the creditor would have received less in a Chapter 7.  The one factual issue that might at times help a creditor is whether the debtor was insolvent at the time of transfer.  Even with this question, however, the deck is stacked in favor of the debtor because insolvency is “presumed” during the ninety days prior to the bankruptcy.  Under most circumstances, the initial case for a preference is a fairly easy one for the debtor to make.

What this means is that if a creditor received a payment from a bankrupt party or obtained a lien or judgment against a bankrupt party 90 or fewer days prior to the bankruptcy (i.e., a preference), the creditor may receive an “adversary complaint” from the debtor’s attorney or from the bankruptcy trustee.  Note that the adversary complaint may never be filed; the debtor or the trustee might overlook the transfer or might deem the transfer too small to warrant pursuing.  In that instance, the creditor has nothing to worry about.  However, if the creditor does receive a complaint, it needs to make the decision that any defendant must make: fight it or try to settle it.

In terms of fighting the preference, the creditor has potential defenses.  If the transfer is less than certain amounts ($600.00 for bankruptcies that are primarily consumer, or non-commercial, and $5,475.00 for bankruptcies that are primarily commercial), the creditor has a complete defense.  (One would hope that a debtor’s attorney would not view a transfer of this size as something to pursue, but we have seen at least one case where this has happened.)  Additionally, as just two examples, transfers made in the ordinary course of a creditor’s business according to ordinary business terms can be exempt from avoidance as a preference, as are transfers made as part of a “contemporaneous exchange” for “new value” (e.g. a store owner purchases new stock).  These are only some of the defenses provided by the Code.  For creditors facing a larger preference claim it is important to scour the Code and the facts surrounding the transfer to identify potential defenses.

Especially in unfavorable cases, settlement should not be overlooked by the creditor.  An adversary proceeding can be time consuming and expensive for both the creditor and the debtor’s lawyer.  Add to this cost consideration the fact that the creditor is entitled to a pro rata share (along with the other creditors) of what is paid back to the estate and possibilities of settlement are often welcome by the debtor or trustee.

“Preference law” can become quite involved, there are different rules if the creditor is an “insider”, different rules for indirect transfers, and preferences can apply to transfers other than payments (e.g., voluntary liens, involuntary liens and judgments).   If you or your business is served with an adversary complaint, we are happy to help you review your options.

— Rod Fluck

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