The Law of Recovery of Preferential Transfers

by David M. Reeder

The Law of Recovery of Preferential Transfers; "Can They Really Do This"?

        No area of bankruptcy law is less understood, and causes more shock and upset, than the law pertaining to the recovery of preferential transfers, referred to as "preferences". A businesses’ first exposure to the law of preferences usually comes when they receive an unpleasant letter, or a complaint initiating a lawsuit, from a bankruptcy trustee, or a debtor-in-possession in bankruptcy, demanding the return of a payment made on a legitimate debt by a company that later filed bankruptcy. Every attorney has heard the following hue and cry: "It was a legitimate debt, not fraudulent; Can they really do this? I got the complaint in the mail; can they do that? Is there any way to fight this? The answers are yes, yes and yes. The details follow.

        Two things are helpful to a business facing a preference demand or lawsuit: 1) knowing that there is "method to the madness" regarding the recovery of preferences; 2) knowing that all is not lost, and that there are well established defenses which may be asserted even before a lawsuit is filed.

        Preference law exists due to the overriding principle in bankruptcy that all creditors with the same type of claim should be treated equally. When a company files bankruptcy, it is presumed that it was insolvent 90 days prior to the date of filing. In order that all creditors be treated equally, certain payments made by the debtor within 90 days of the bankruptcy filing can be brought back into the "pool", with the creditor receiving a claim against the bankruptcy estate equal to the amount that it was forced to "put back". In a nutshell, preference law exists to even the playing field between those that were preferred by receiving payments in the 90 days prior to bankruptcy (thus the term preferences), and those who did not. The concept is that creditors, preferred and non-preferred, should share and share alike.

        The payment is a preference if it was a transfer of property of the company that filed bankruptcy: 1) to or for the benefit of a creditor; 2) on account of a pre-existing debt; 3) made within 90 days of the bankruptcy filing (or 1 year if the transferee was a relative or entity closely related to the debtor); 4) while the debtor was insolvent; 5) which allowed the transferee to receive more than it would have received in a chapter 7 bankruptcy case if the transfer had not been made.

        Congress has granted the Bankruptcy Courts jurisdiction over any person who has received a preference. Service of process can be accomplished by first class mail; personal service of the summons and complaint on the transferee is not required.

        A company which is the target of a preference action or demand does have defenses which are built in to the Bankruptcy Code. These are:

1. Contemporary Exchange of New Value. This applies when the transfer of money from the debtor to the transferee was accompanied by a transfer of value from the transferee to the debtor. Example: a cash sale.
   
   
2. Ordinary Course of Business. This is the "softest" and most difficult defense to prove. It applies when the payment meets three separate standards of "ordinariness". Example: a payment within the terms of the invoice.
   
   
3. Subsequent Advance: This defense applies when the transferee advanced value to the debtor after the original transfer. For any amount which is a preference, the transferee is given a dollar-for-dollar credit for all amounts advanced to the debtor after the initial transfer. Example: after receiving a payment from the debtor within 90 days of bankruptcy, the transferee ships additional merchandise to the debtor. The transferee is given a dollar-for-dollar credit for the invoiced value of the merchandise shipped. This applies whether or not the transferee was ever paid for the subsequent advances prior to the debtor’s bankruptcy case.

        The foregoing is a very basic description of the law of preferences, and is not meant to be taken as legal advice in any specific instance. Consult an attorney knowledgeable regarding preferences in bankruptcy for advice regarding specific maters.