Strategies for Defending Preference Actions
 
October 21, 2003
 
Robert Labate - Chicago

Few letters produce as much anger and frustration as a dispatch from a bankruptcy debtor (or liquidating trustee) announcing that two years ago a creditor received a pre-petition preferential payment and demanding immediate repayment.

The unlucky creditor scrambles to determine what was paid and to decide whether it must now pay the tens of thousands of dollars the debtor demands.  To many, this process appears to be weighted heavily in the debtor’s favor, yet strategies exist that may significantly reduce or, on occasion, eliminate the creditor’s preference obligations. 

Start Early 

The best time to start defending a preference action is when you still have time to ensure that outstanding payments remain within normal business terms, both bilaterally (between you and the customer) and multilaterally (that is, consistent with terms in your industry).   Remember that a payment may be preferential if “normal payment terms” between you and a financially troubled customer (such as 60 days) significantly exceed payment terms for your industry (such as 30 days).  

There are many ways of keeping a customer within ordinary business terms, such as requiring advance payment of an “evergreen” deposit (that is, funds replenished as they are used), but the most important strategy is simple diligence.  Be careful with additional extensions of credit for “out of term” customers and with automatic “late notice” or “collection” letters because such letters may be used against you in a subsequent bankruptcy case to show that payments were out of ordinary terms.

After the Bankruptcy Filing  

In a sluggish economy, often the first real sign of your debtors’ financial troubles is a notice of bankruptcy filing.  While you can’t change facts that exist on the date of filing, you can create a record and take other steps that may provide you with a defense against a preference claim.

Keep Records

In most large bankruptcy cases, preference actions are administered by lawyers or by outside companies retained to pursue thousands of preference claims; significant errors in the debtor’s accounts receivable/accounts payable records are common.   Not surprisingly, your internal records regarding the “ordinary course” relationship between your company and the debtor/customer are often far better than the information available to the collection agency or attorney.   Thus, you should centralize and preserve all records regarding your relationship with the debtor so that they are accessible should you receive a preference demand long after the bankruptcy filing.   In one recent case, the collecting attorney did not realize that the debtor had written payment terms of 45 days, which provided our client with a defense against tens of thousands of dollars of potentially preferential transfers.   

“New Value” Set Offs

Equally important are records showing the value of goods and services you supplied to the debtor/creditor, but were never paid for, prior to the bankruptcy filing.  Such unpaid receivables may provide you with a “new value” defense that can be offset against any potentially preferential payments.  Exactly how “new value” is defined may vary from district to district but generally the following three factors are required:

• The creditor must have received a transfer which is otherwise an avoidable preference.
   
• After receiving the preferential transfer, the preferred creditor must have advanced additional credit or goods to the debtor on an unsecured basis.
   
• The additional post-preference unsecured credit or goods must be unpaid in whole or in part as of the date of the bankruptcy petition. 

In re Sonicraft, Inc., 238 B.R. 409, 414 (Bankr. N.D.Ill. 1999)

The second factor is the most difficult to apply — that is, the “new value” must be supplied after you receive the allegedly preferential payment.  For example, assume that a preferential transfer in the amount of $20,000 was made to a creditor 60 days prior to the filing of a bankruptcy petition.   If, 50 days prior to the bankruptcy, the creditor shipped $20,000 worth of goods to the debtor and was not paid for those goods, then the creditor could set off the “new value” goods it provided to the debtor (that is, $20,000) against the $20,000 preferential payment.  The creditor’s preference exposure would be zero. 

However, if the “new value” goods were transferred to the debtor on the 70th day before the bankruptcy filing (that is, 10 days prior to the date the debtor transferred the preferential payment to the creditor), then the creditor could not set off the value of goods transferred to the debtor and the creditor’s preference exposure would be $20,000.   As you might expect, calculation of a creditor’s “new value” defense is best done in chart format comparing the dates of transfers of money with the dates of the provision of goods or services to the debtor. 

Assumption Defense

Chapter 11 debtors have the power to keep valuable licenses and contracts that did not expire pre-petition and to terminate less valuable agreements.  If the services provided by a creditor pursuant to its license agreement or executory contract are important, then the debtor may be inclined to reaffirm (in bankruptcy parlance “assume”) its agreement with the creditor.  

One of the requirements of assuming an agreement is that the debtor must “cure” all deficiencies, which includes payment of pre-petition payment defaults.  A developing doctrine is that a bankruptcy debtor (or trustee) cannot bring a preference action to recover allegedly preferential payments made pursuant to a validly assumed contract.  Matter of Superior Toy & Mfg. Co., Inc., 78 F.3d 1169 (7th Cir. 1996) and In re Philip Services (Delaware) Inc., 284 B.R. 541 (Bankr. D. Del. 2002).  This means that in many (but not all) districts a debtor cannot recover a pre-petition preferential transfer if, after the filing of the bankruptcy case, it assumed the agreement under which the preferential transfer was made.  

Recently, we used this defense to convince debtor’s counsel to dismiss a $50,000 preference action against our client.  Because the “assumption defense” doctrine is still developing, many attorneys and collection agencies are either unaware of the doctrine or will resist applying the doctrine to its claim against you.  In our case, debtor’s counsel had recovered tens of thousands of dollars from creditors whose contracts had been assumed and he dismissed our action only after reviewing the cases mentioned above.

For more information, e-mail Robert Labate at robert.labate@hklaw.com or call toll free, 1-888-688-8500.