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Bankruptcy Preferences – Hooray — You Got Paid; Now Give It Back!

February 20, 2003

In the seemingly strange world of bankruptcy proceedings, being deemed a preferential creditor is not a good thing.

Because of the unsettled nature of our troubled economy, your company may be doing business with a customer about to go into a bankruptcy proceeding. Due to the eventual filing, you may find your company to be a creditor for amounts that were owed to you at the date of the bankruptcy filing. However bad that is, it may be about to get worse.

Under Section 547 of the Bankruptcy Code, payments made to creditors, even though rightfully owed to them, may be recaptured by the Debtor (bankruptcy entity) if paid within 90 days of the date that the bankruptcy was actually filed. If your company has a closer relationship with the Debtor than the average company, you may be deemed an “insider,” and that preference period may be extended to one year, rather than the 90 days. The funds that are taken back are eventually put into the “distribution pot” to be shared equally with all creditors, not just those that the Debtor decided to prefer during the “preference period.”

What to Do?
In the typical situation, your company receives a legal demand letter in the mail, notifying you that you received payments which have been identified by someone as having been preferential. Usually this is done by the Trustee in Bankruptcy, some fiduciary employed by the Bankruptcy Court, or lately, by private companies that actually purchased the Preference Complaint from the bankruptcy proceeding and have made a business out of trying to recover these assets. You are often given a short period of time to respond and refund the money, or you are told that legal action will be instituted against your company, and you will additionally be liable for legal fees, costs and expenses. Further bad news is that the location of the legal proceedings is often in some distant venue, making it more difficult for you to defend your company’s position that the payment that you received was non-preferential.

The first thing that you should do is immediately contact your legal counsel, as there are sometimes valid defenses that can be raised to possibly eliminate or substantially reduce the claim, if you file a timely response. A defense that is filed in time prevents the default judgment from entering against you and may give your legal counsel ammunition to at least try to settle the case for a lesser amount on your behalf.

If your payment was in fact an exchange for your delivery of services to the Debtor or delivery of new merchandise to the Debtor, you may have a valid legal defense under the doctrine of “a contemporaneous exchange”, i.e., new value was given in exchange for the payment.

Another defense, harder to prove, is that the timing of the payment was in “the debtor’s ordinary course of repayment.” For example, if your company and the Debtor had a history of allowing the Debtor 60 day terms for normal payments, and a review of past payments will show that this was what took place over a lengthy period of time, that may be a valid defense.

Another additional defense is one of industry standards. For example, in the toy industry it is not unusual to have manufacturers ship all year long in order to even out their own internal production schedules, but to allow their customers to make payment for the received goods several months later, closer to the traditional holiday seasons. Thus the payment made by a toy store to a manufacturer in November for goods that were shipped in July may not be preferential, based on the industry standards. This defense would need to be raised and proven to the Bankruptcy Trustee or Judge.

Lastly, there are some true legal defenses, for example that the payment that you received was beyond the actual 90 days. In reviewing your business records, you may find that although the Complaint raised by the Trustee says that all payments that you received were preferential, you may find that some of the actual payments received were obtained by you 91 days or 100 days before the bankruptcy filing, and thus beyond the 90 day preference period and not subject to recapture. Also the Preference Complaint must be filed with the Bankruptcy Court within two years after the payment or the Statute of Limitations has expired and that is also an important defense to raise. Note that in regard to consumer bankruptcies, preferences of $600.00 or less are exempt from recapture.

Seeking advice from knowledgeable legal counsel is always a good choice, but with a Preference Complaint it is critical to do so immediately upon receipt of the demand letter. Reviewing your invoices and payment history will be necessary for you to assist your legal counsel to see if you have any valid defenses. If not, negotiation is still an advisable strategy, as there are legal expenses to all parties if they are forced to litigate these cases. Furthermore, knowledgeable legal counsel can often negotiate a settlement of the claim which would be more advantageous to you than just writing a check and making payment to the Trustee in Bankruptcy.

Remember that the burden of proof is on the bankruptcy estate, and not on your company, and thus you need to be proactive to protect your company, in order not to be a loser twice in the bankruptcy proceeding.

Michael B. Katz, Esquire, is a Senior Partner with the law firm of Bacon & Wilson, P.C. and specializes in business, insolvency and healthcare legal matters.
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by: Michael B. Katz, Esquire

February 2003