What defenses do I have if a bankruptcy trustee demands a preferential transfer back?

If your business received a payment or collateral from a customer shortly before it filed for bankruptcy, be wary. No company wants to lose payment from a customer that goes bankrupt, and it’s even more frustrating when the business has to turn over the cash to the bankruptcy estate. But it can happen, and you should be prepared. The bankruptcy code prioritizes fairness, not just for the debtor, but for all parties to the case. The bankruptcy code regulates the competition between creditors so they all have a fair shot at collecting on what they’re owed. That is why there is special provision in the bankruptcy code for when a company pays or collateralizes a creditor a short period of time before the case is filed. The trustee may get an order that entitles them to a return of payment or collateral made on a debt within 90 days before the filing of the bankruptcy petition.

Essential Requirements

There are five essential requirements for a preference claim.

• – The payment must be made to a creditor. Essentially, a creditor is a company or person that is owed money from the debtor.
• – The payment has to have been made on account of an antecedent debt obligation. An “antecedent debt obligation” is a debt obligation the debtor owes that predates the transfer.
• – The debtor was insolvent at the time it made the transfer of payment or security.
• – The transfer has to have been made within 90 days before the debtor’s filing of the bankruptcy petition. For insiders, the bankruptcy code increases the time to one year.
• – The creditor or transferee must be entitled to recover more than they would be eligible to get in a chapter 7 bankruptcy if the transfer had never happened.

So a payment on a loan fully secured by collateral is probably not a preference because the full value of the collateral for the loan is probably what the lender could have gotten in a Chapter 7 bankruptcy if the transfer never took place. For unsecured loans, an unsecured payment within 90 days easily meets all five tests. Plus, a creditor still has common defenses against a preference claim.

Four Most Common Defenses

There are more than a couple of defenses to a preference claim, and sometimes, the creditor can raise more than one. The Court may find that the same payment satisfies more than one defense. The four most common defenses to a preference action are [1] contemporaneous exchange for new value; [2] subsequent new value; [3] purchase-money security interest perfected promptly; and [4] ordinary course payments.

The first defense is the contemporaneous exchange. Basically, when a debtor pays for merchandise or services about the same time it gets them, that’s usually OK. A contemporaneous exchange is usually accepted in COD (cash on delivery) transactions. When the debtor pays the creditor and the creditor releases its collateral, that may also qualify.

The second defense to a preference action is the “subsequent new value” defense. The obvious instance is where the creditor accepts payment for a previous shipment, and then makes a subsequent shipment for the debtor on credit. That new value cuts dollar for dollar what the creditor owes the trustee.

The third defense is the purchase-money security interest defense. When a creditor has a loan on something the debtor bought, and the debt is created at the time the buyer bought the collateral, that’s generally OK. The creditor has to perfect its interest within 30 days of the debtor acquiring the collateral.

The fourth defense is the “ordinary course” defense. If the debtor is making regular loan payments, or payments to trade creditors, utility providers, the landlord and those were debts incurred “in the ordinary course of business” on usual terms, that may be another defense. Whether a creditor meets the ordinary course of business requirement is a question of fact for the bankruptcy court. The creditor has the burden of proof that the payment was ordinary for the parties’ dealings or the industry custom.

The Trustee’s Demand Letter

Don’t be surprised if you receive the trustee’s demand letter. If you do, don’t panic, and don’t just pay it. Make sure you get an experienced business debtor/creditor lawyer to review and explain the demand, the bankruptcy case and your options.