Bankruptcy Code Section 547 governs preference claims and defenses. This statute is designed to discourage a debtor from preferring one creditor with payments at the expense of the debtor's other creditors who receive little or no payments during the debtor's slide into bankruptcy. The intent of the statute is to ensure that all creditors are treated fairly, and thereby discourage creditor enforcement actions that prematurely force a debtor into bankruptcy.
Elements of the Bankruptcy Trustee's Preference Case
A bankruptcy trustee can recover preferential transfers for the benefit the debtor's bankruptcy estate by establishing the following:
(i) the debtor transferred its property to or for the benefit of a creditor;
(ii) the transfer was made on account of antecedent indebtedness owing by the debtor to that creditor;
(iii) the transfer was made within 90 days of the commencement of the bankruptcy case for non-insider creditors;
(iv) the debtor was insolvent at the time of the transfer. (A rebuttable presumption of debtor's insolvency exists within the 90-day preference period); and
(v) the transfer enabled the creditor to receive more than it would have received if the transfer had not been made and the debtor was liquidated under Chapter 7.
Once the trustee establishes all of these elements for the preference claim, the creditor ("Preference Defendant") can seek to reduce its preference exposure by establishing one or more of the defenses permitted under the Bankruptcy Code
DEFENSE: Contemporaneous Exchange for New Value
One common defense to preference liability under the Bankruptcy Code is for payments or other transfers that the debtor and creditor intended to be "contemporaneous exchanges" for new value and that was, in fact, a substantially contemporaneous exchange. The contemporaneous exchange defense typically involves cash on delivery (COD) payments.
The purpose behind the contemporaneous exchange defense, like the other defenses, is to encourage creditors to continue their dealings with troubled debtors without the fear that they will have to return payments for value given if the debtor files bankruptcy. In some circumstances, it is even possible that the debtor can avoid bankruptcy altogether as long as its creditors continue to deal with it.
The contemporaneous exchange defense protects only those transfers in which the creditor establishes that the value of the goods/services given by the creditor is equal to the payment received.
DEFENSE: Transfer for Subsequent New Value
Another typical preference defense is the "new value" defense. This defense allows creditors to reduce their preference claim in an amount equal credit extended to the debtor subsequent to the alleged preferential transfer. To qualify for this defense, the new value extended cannot be secured by an otherwise unavoidable security interest and cannot be paid by an otherwise avoidable transfer. In other words, even if a creditor received a preference, it may still offset against the preference claim by any subsequent unsecured credit that it extended to the debtor.
The policy behind the new value defense is to encourage creditors to work with troubled companies by preventing the trustee to avoid and recover preferences without giving a matching credit for subsequent advances of credit for which the debtor failed to pay.
DEFENSE: Ordinary Course of Business Payments
The "ordinary course" defense is another frequently raised defense to preferences. Under this defense, a transfer is not preferential if it was in payment of a debt incurred in the ordinary course of business or financial affairs of the debtor and creditor AND either: (i) made in the ordinary course of business or financial affairs of the debtor and the creditor; OR (ii) made according to ordinary business terms. The first element of the defense, incurring the debt in the ordinary course of business, is straight forward and is usually satisfied by an extension of credit to the debtor. The second requirement, payment in the ordinary course of business, requires a consistency between the payment histories (number of days sales were outstanding) for payments made prior to the preference period and the alleged preference. Alternatively, the Preference Defendant can establish that the alleged preference was made under consistent payment practices of the Preference Defendant's industry.
The preference defenses discussed in this article, and the other preference defenses contained in the bankruptcy code, are intended to encourage a continuing business relationship between creditors and financially distressed businesses. Small businesses and other creditors would have little incentive to continue dealing with troubled companies or persons without the preference defenses. This article is designed to provide a basic understanding of concepts of the law. The law, however, is subject to change and differing interpretations by courts. Additionally, the applicable law varies from situation to situation. Accordingly, this article should be viewed as educational in nature, and not as either legal advice or a substitute for competent advice from a qualified attorney. The Gorski Firm, APC, and the author of this material encourage you to seek independent legal counsel to address any questions pertaining to particular issues or situations you encounter.