Creditors face any number of perils when an account debtor files for bankruptcy – loss of sales, likely risk of collection of amounts owed, legal fees and more. One more challenge a creditor might encounter is a possibility the now-bankrupt debtor or a bankruptcy trustee will demand the return of prepetition debt payments made by the debtor to the creditor. Repayment might be required even if the debtor received and used (or sold) the underlying goods and services, and even if the creditor arguably did nothing wrong in collecting the debt. Defending one’s interests under these circumstances is a useful art for the credit professional.
How can they do this to me?
Bankruptcy Code section 547(b) authorizes a debtor or trustee to seek to recover payments made by the debtor to a creditor during the 90 days prior to the debtor’s bankruptcy filing (or a one-year recovery period if the creditor is an “insider” of the debtor). The 90-day period is typically referred to as the “preference period,” and payments made during the preference period are called “preferences” or “preferential transfers.” 11 U.S.C. § 547(b) (2013).
The policy behind the preference statute is twofold. First, by permitting the trustee to recover pre-bankruptcy payments that occur within a short period before bankruptcy, creditors are discouraged from taking collection actions that might hasten the debtor’s slide into bankruptcy. Second, and more important, the preference provisions facilitate the prime bankruptcy policy of equality of distribution among creditors of the debtor. Any creditor that received a greater payment than others of his class (i.e., a “preferential” payment) may be required to give it back, so that all creditors may share equally in a debtor’s remaining assets.
What constitutes a “preferential” transfer?
Bankruptcy Code section 547(b) lists specific requirements that must be established by the debtor or trustee in order for a transfer to be considered “preferential.” More specifically the transfer must be:
- A transfer of an interest of the debtor in property
- Made to or for the benefit of a creditor
- Made on account of an antecedent debt of the debtor
- Made while the debtor is insolvent
- Made within 90 days before bankruptcy; and
- That enables the creditor to receive more than she would in a Chapter 7 liquidation case
How can I keep my money?
The debtor or trustee bears the burden of proving the basic elements of a preferential transfer. Proving these elements also represents a first line of defense for the preference defendant, as each requirement must be established before a debtor or trustee can recover an alleged preferential transfer.
Specific considerations that might undermine each of these individual, essential elements are discussed below.
Was the transfer “of an interest of the debtor in property?”
Did the payment come from a source other than the debtor (i.e., a guarantor or a principal of the debtor)? If so, this is not an “interest of the debtor in property,” and not recoverable.
Was the transfer “made to or for the benefit of a creditor?”
This element is rarely in dispute.
Was the transfer “made on account of an antecedent debt of the debtor?”
Was the payment made for an existing debt owed by the debtor (i.e., on account of antecedent debt)? Cash in advance (CIA) and cash on delivery (COD) payments are not made on account of prior (antecedent) debt, so they are not considered preferential transfers.
Was the transfer “made while the debtor is insolvent?”
Insolvency is presumed in the 90 days before bankruptcy. However, the presumption of insolvency can be defeated by showing the debtor was solvent on a balance sheet basis during some or all of the preference period, or if the debtor made such a representation prior to the debtor’s bankruptcy.
Was the transfer “made within 90 days before bankruptcy?”
Confirm the payment cleared the debtor’s bank on days 1 to 90 before the day of the bankruptcy filing. One day can make a big difference in whether a payment must be returned.
Did the transfer “enable the creditor to receive more than she would in a Chapter 7 liquidation case?”
Would the creditor have received just as much if the debtor liquidated its assets in a Chapter 7 case? (Transfers to a fully-secured creditor are not avoidable, so holders of a purchase money security interest may have protection.)
If each of these factors can be established to the satisfaction of the Court, it next falls upon the creditor to establish one or more of the designated defenses to recovery of the respective payments. The art of defending preference actions will be the subject of future editions of the KRCL bankruptcy blog.