Bankruptcy Preference Actions - What Every Company Must Know

When a business files for bankruptcy and liquidates its assets, the occurrence of which is increasing tremendously with the distressed economy, the debtor or an appointed trustee normally seek to recover what are called avoidable or preferential transfers from creditors who received payments from the debtor as the debtor was approaching bankruptcy. While there are defenses available to fight these lawsuits, every company should be aware of this possibility in an attempt to avoid it as much as reasonably possible.

Federal bankruptcy law provides a debtor in bankruptcy with a cause of action for what are known as preference payments. Under the United States Bankruptcy Code, a debtor may “avoid any transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor for such transfer was made; (3) made while the debtor was insolvent; (4) made (A) on or within 90 days before the date of the filing of the petition; or (B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider ..." In simple terms, a payment is presumed to be a preference if made within ninety (90) days of filing and it is for an old debt. In reality, since most business transactions are on credit, most creditors will fall under this category, and so it is not uncommon for debtors (or trustees) to file hundreds of preference actions against companies that rightfully received money. It is usually their position to file now and ask questions later. In other words, sue everyone and if a company can rebut the presumption of the preference, then maybe they will dismiss the claim, or more likely settle it.

The theory behind this law is that some creditors, likely larger, more influential creditors, have the ability to put pressure on debtors to pay their debts quicker or face the creditor shutting off their supply and hastening the debtor’s fall into insolvency/bankruptcy. The preference law, theoretically, then puts all creditors back on an even playing field, so that all creditors receive, on a prorated basis, what the others receive, thereby eliminating the influential creditors’ advantage.

There are a few defenses available for preference actions. The most common are the so-called “ordinary course of business” defense, and the “new value” defense. The ordinary course of business defense is pretty self explanatory. It is available for transfers of money as payments for debt incurred by the debtor in the ordinary course and made according to ordinary business terms. The second defense is available when the transfer was a new, immediate transaction for new value. In other words, the payment was for a new order and not a payment made on an old debt.

One final thought (and this isn’t earth shattering news) – always pay close attention to your accounts receivable, especially in a down economy. There are usually signs that a debtor is slipping towards insolvency and possible bankruptcy. I realize that it is sometimes impossible to avoid continuing to do business with companies that are not paying their bills, or stretching payments out longer and longer. But, the longer a debtor takes to pay you, the more it will look like preferential payments if the debtor ends up in bankruptcy court because the court will look at the payment history of the account when making a determination.

If you have any questions or concerns about a customer’s payment history and how it might affect you in a possible bankruptcy, or if you need assistance collecting debt, we would be glad to speak to you about it.

Curtis & Curtis, P.C. is a full service law firm located in Jackson, Michigan providing superior legal services and advice to individuals, families and businesses throughout mid-Michigan since 1901.

This publication is provided for general informational purposes only and does not constitute formal legal or other professional advice. No attorney-client relationship is created with you when you read this information. The above information may be changed without notice and is not guaranteed to be complete, correct or up-to-date, and may not reflect the most current legal developments. If you have any questions or need assistance, please contact Curtis & Curtis, P.C.