The Truth About Preferences

The Truth About Preferences.

Every bankruptcy lawyer has heard this pained cry of shock and dismay:   "I'm being sued for money that was paid to me by a customer, fair and square, no fraud, nothing wrong at all, and now a bankruptcy trustee wants the money back.  To make it worse, the case is in New York.  What's going on here?"   

The law of preferences in bankruptcy cases probably causes more misunderstanding, frustration and upset toward the system than any other provision of the Bankruptcy Code.  The underpinnings of preferences are well established and go back to "pre-American" debtor-creditor law.  It is presumed that a person or company that files bankruptcy was insolvent for some period before the actual filing date.  The creditors who are owed money at the time of the case filing will have their claims discharged or otherwise compromised, paid over time, and usually at a reduced amount.  Those who happened to have their claims paid in the "eve of bankruptcy", receiving 100% payment of their claim, obviously fare much better.  This has been viewed by the courts and legislatures as unfair, since one of the core principals of bankruptcy is equal treatment of creditors who are similarly situated.  With that in mind, creditors whose claims were paid within the current preference period of 90 days (1 year for relatives and other "insiders" of the debtor) are required to be treated the same as other creditors.  Thus they can be compelled to "put back" the payments which they received during the preference period, and exchange them for a claim against the debtor's bankruptcy estate.    Creditors who are owed money at the time of filing, and creditors who were paid on the eve of bankruptcy, are required to share and share alike in the interest of equal treatment of creditors.

This concept was extremely controversial when the preference law became permanent with the passage of the Bankruptcy Act of 1898.    Prior to that time, the spoils went to the diligent, and if a particular creditor was aggressive, and successfully pressed the debtor for payment, or won the proverbial "race to the courthouse"  he "won", period.  Often a single creditor would seize  all or nearly all of the debtor's assets to satisfy its claim, leaving nothing for other creditors.  This fit in well with the spirit of the times.    The preference law, which resulted in coerced equal treatment of creditors,   with diligent creditors having to give up their hard won payments,  however, so that the diligent and the slack would fare the same, was seen as a socialist plot and a departure from American values.

Returning to the present, if the sabers of preference recovery are rattled, all is not lost.   There are four statutory defenses to a preference, which often save the day.  The defenses, very simply described, are:

• Ordinary Course of Business.   This applies when the debtor paid the creditor within the terms of the invoice, within the course of dealing between the parties, and according to ordinary terms in the industry.
• Subsequent Advance.   This applies when the creditor, in reliance on the payment by the debtor, sells additional products or renders additional services to the debtor.  The value of the new services or products can be set off against the alleged preference amount.
• Contemporaneous Exchange of Value.    This covers cash sales.  If the payment by the debtor was accompanied by an exchange of value by the creditor, then the value of the exchange can be set off against the alleged preference.
• Purchase Money Security Interest.     If the transfer sought to be recovered was the granting of a security interest in property, the creditor has a complete defense if the security interest was a purchase money security interest , the debtor received the collateral at the time of the transfer, and the transfer enabled the debtor to purchase the collateral.

In conclusion, there are two things to remember when preference issues arise,  first:  There is method to the madness, the law of preferences does make sense, although not to one from whom a preference is sought.  Second,  there are defenses to a preference that can eliminate or minimize exposure.