If you have have had the bad luck to deal with customers or clients who have filed a bankruptcy case, chances are good that you have or will receive a demand letter to return money paid to you by the customer or client in the months leading up to the filing of the bankruptcy case. These payments are called "preferential transfers" or "preferences" and are governed by section 547 of the Bankruptcy Code (11 U.S.C. § 547(b)). These demand letters, usually from the lawyer for the bankruptcy trustee or the creditors committee, often carry the threat of a lawsuit if you do not respond or return the payment within 10-20 days.
It is important that you take these demands seriously, as a failure to respond could lead to a lawsuit filed against you in the Bankruptcy Court in which the case is filed, which often could be in a completely different state. Further, because often these letters are sent to every creditor receiving a payment in the 90 days prior to the filing, with little research as to the validity of the claims, it is important to review the payments at issue and avoid having to fight a lawsuit.
The purpose of this post is to provide a brief outline of the law of preferential transfers.
1. What is a "preferential transfer?"
A preferential transfer is "a transfer of an interest of the debtor in property." This is usually money, but could be other property. Did a customer return goods to you for a credit? The next element is that the transfer was for, or on account of, an antecedent debt. In short, this means that as of the date of the transfer, the debtor owed you money. Next, the transfer was made while the debtor was "insolvent." It is presumed that the debtor was insolvent in the 90 day period, although there are occasions where this is disputed. Next, the transfer was made in the 90 day period before the bankruptcy case was filed, or within one year if the creditor was an "insider" of the debtor (i.e, close relative, officer/director of the debtor). While the date of the transfer is often undisputed, keep in mind that the date for checks is the date it cleared the debtor’s bank, and not the date the creditor received or deposited the check.
Finally, the transfer allows you to receive more than you would have had the transfer not been made, and the case is a case under Chapter 7. This is often a complicated and litigated element. In short, it means that by receiving the payment, you ended up better off than you would have if you had not received the payment, and simply relied on the Chapter 7 process to get paid a portion of your debt. Keep in mind that the overwhelming majority of Chapter 7 cases result in no payment ro creditors, or a very small payment. Thus, in most situations, creditors who receive a pre-petition payment are better off having received the payment, and this element will be met.
Thus, the first question you must ask is whether the payment(s) at issue meet the definition of preferential transfer. You will want to check your records and, if necessary, ask the lawyer for copies of the checks (including the back of the check showing the date it cleared) or other records of the transfer. If the transfers at issue do not come within the definition, you or your lawyer will want to point this out to opposing counsel.
What is missing from this definition? There is no requirement that the creditor (or debtor) acted improperly in taking the payment. It is simply the Bankruptcy Code’s way of trying to make sure all creditors are treated equally and no creditor benefits because they were "fortunate" to receive a payment just before the bankruptcy case was filed.
If the transfers do come within the definition, you are not out of luck. You may have defenses to the claim, which are discussed after the break….
2. What are the defenses to preferential transfers?
You have determined that you have received preferential transfers from the debtor? Does that mean you should write a check and pay it back? Not necessarily, as there are several defenses that could eliminate or reduce your liability. These are listed in (11 U.S.C. § 547(c)) and each one is discussed below:
A. Contemporaneous Exchange.
The first defense is that the transaction was intended to be, and in fact was, a contemporaneous exchange for "new value." An example of this is where the debtor comes to your location, picks up a load of goods, and pays cash (or cashiers check, etc.) on the spot. This seems straightforward, but it can get murky. What if the debtor handed you a check, but you did not deposit it for a week? What if you deposited it that day, the checked was returned for insufficient funds, and the debtor wrote you another (good) check or paid you cash a few days later? What if the debtor did not pay on the spot, but went back to their office and immediately mailed out a check the same day? These are all facts that need to be explored.
B. The transfer was made in the "Ordinary Course of Business."
The second defense is that the transfer was made in the "ordinary course of business" between the parties, and according to ordinary business terms. For example, if you have been doing business with the debtor for several years, and the history between you is that you have delivered goods to the debtor, and the debtor always pays invoices by the due date, that is your "ordinary course of business." When the trustee asks you to return the 90 day payments, you will want to point out to the trustee that you have a long history with the debtor that did not change during the preference period and, therefore, you have a defense. What if the debtor suddenly started paying late in the several months prior to the bankruptcy filing, or only paid when you sent reminders, which is common for companies in trouble? You will have a problem, as the recent payments differ from the "ordinary course." But what if the history of the relation was such that the debtor always paid late and this continued during the 90 day period? This could give you a valid defense! What if the debtor has a history of late payments, but suddenly started paying on time just prior to filing? What if you just started doing business with the debtor 5-6 months before the filing, but the debtor made all payments on time? Was there enough time to establish an "ordinary course of business?" These are all issues that need to be reviewed in detail. It is common, and often required, that creditors prepare a chart or spreadsheet that details the history of the parties going back several years. This often pays off when the creditor is able to persuade the trustee that the payments were not recoverable. If the analysis gets to this point, it is important to see a lawyer to discuss the strategy.
C. The creditor provided "new value" to the debtor after the transfer at issue.
You may have a defense to a preferential transfer where you have provided new value to the debtor after the transfer(s) at issue. For example, perhaps the debtor pays off an old debt to you, but it was within the 90 day preference period. Because the debt was paid, you decide to start doing business with the debtor again, and ship goods to the debtor on credit. The debtor then files for bankruptcy without paying for this goods, and you get a demand letter to return the money they did pay you. This is bad news, as you are out the payment and the goods. Not necessarily, as you have a defense to the demand, up to the value of the goods you shipped to the debtor after the payment was made. This defense acknowledges that you enhanced the value of the bankruptcy estate for the benefit of all creditors, and you get creditor for that. If you have several payments and shipments, you will need to chart out the transactions to match up payments and "new value" to the debtor. Note that the new value must be provided after the payment. What if the debtor pays you (during the 90 day period) $5,000, you then ship $10,000 of goods ("new value"), and then the debtor pays you another $5,000? You have been paid $10,000, and you have provided $10,000 in new value, so it is a wash, correct? No. You have a defense to the first payment, but no new value was provided after the second payment.
The three defenses set forth above are the most common in business situations. However, there are several other defenses that may apply:
D. The preferential transfer at issue was a transfer the created a security interest (such as the recording of a security deed or UCC Financing Statement), where the creditor contemporaneously provided the goods subject to the security interest, or provided the funds with which to purchase the goods. Examples are the closing of a house, where the debtor "transfers" the security deed to the lender, or where the supplier delivers goods to the debtor and takes an immediate security interest. This protects creditors who act diligently in taking steps to take a security interest. It does not protect creditors who do not act diligently, such as lenders who fail to properly and timely record the security deed.
E. Transfers that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent the secured creditor improved its position (relative to the value of the collateral) during the preference period.
F. Some statutory liens.
G. Transfers made pursuant to a domestic support obligation, such as alimony or child support.
If you have made it this far, you realize that there are defenses that cover many situations that arise in normal business relationships. As many trustees simply mail demand letters to everyone in the check register, it is important to review the facts before responding, and figure out the amount of the recoverable transfers (preferential transfers, less transfers subject to defenses). Trustees do not want to spend their time on lawsuits that will not lead to a recovery, and will almost always offer to settle for less than the amount of the recoverable transfers.
Finally, I am often asked by a creditor whether they should accept payments from a customer who is headed toward bankruptcy. They have often heard horror stories about the "90 day rule" and lawsuits against creditors. The answer is usually yes, take the money. Just be prepared for the chance you will get the demand letter and you will need to review the defenses discussed above. The best case scenario is that the customer never files for bankruptcy, or files more than 90 days in the future, or that no one ever asks for the money back. The worst case is you have to give the money back, or settle for a lower amount.