If you receive a payment, collateral, or other transfer shortly before the payor or transferor is in bankruptcy, beware. One of the fundamental principles of the US bankruptcy system is that similarly situated creditors should be treated equally, which would be tough to achieve if creditors were permitted to race to carve up a troubled borrower’s assets by extracting money and other value during the debtor’s slide into bankruptcy. Therefore, the US Bankruptcy Code permits the trustee or debtor-in-possession to avoid (i.e., unwind) certain “preferential” transfers made to creditors in the period prior to the filing of the debtor’s bankruptcy petition.
What Is a Preferential Transfer?
There are five requirements that must be met for the debtor’s transfer of its property to be deemed a preference.
- The transfer must be to or for the benefit of a creditor.
- The transfer must relate to a debt owed before the transfer.
- The transfer must have been made while the debtor was insolvent.
- The transfer must have occurred within 90 days prior to the filing of the bankruptcy petition (or one year prior to the filing if the creditor is an “insider” of the debtor).
- The transfer must not have provided a benefit to the creditor in excess of what the creditor would have received in a Chapter 7 liquidation if the transfer had not been made.
A payment on a fully secured debt would likely not meet the fifth requirement and, thus, would not constitute a preference. For unsecured debts, these requirements are relatively easy to satisfy when a transfer is made by a debtor to a creditor in the 90 days before the bankruptcy filing. However, that is not the end of the analysis, as the Bankruptcy Code provides creditors with multiple potential defenses to a preference claim.
Preference Defenses
Preference defenses are not mutually exclusive, and creditors often raise—and sometimes prevail—on multiple defenses. The four most common preference defenses are substantially contemporaneous exchange for new value; subsequent new value; recently perfected security interest in acquired collateral; and ordinary course of business.
Substantially Contemporaneous Exchange for New Value
This defense applies when a debtor pays a creditor for goods or services contemporaneously with the supply of those goods and services, which typically would include payment by a tenant to a landlord under a lease. For example, cash on delivery (COD) transactions generally qualify for this defense because the payment and delivery of goods and services occurs substantially contemporaneously. The defense may also apply if a creditor receives payment of an obligation in exchange for releasing collateral for the obligation.
Subsequent New Value
This defense applies when a preferential transfer is offset by the new value—often in the form of goods and services—that the preference recipient provided after receiving the contested payment. For example, where a creditor-vendor has received a preferential payment from a customer, such as payment for goods previously shipped, and the creditor-vendor subsequently provides additional goods to the customer on credit, the value of the goods shipped following the preferential payment can be set off—on a dollar-for-dollar basis—against the creditor’s liability as to the previous preferential payment.
Recently Perfected Security Interest in Acquired Collateral
The grant of a security interest in collateral is not a preference if the security interest secures new value that is used to acquire that collateral, so long as the security interest is perfected within 30 days after the debtor’s collateral acquisition. The defense is only applicable if the grant of a security interest, and the new value provided, are part of the same contract or transaction.
Ordinary Course of Business
This defense is available when a payment is made in the ordinary course of business or financial affairs of the debtor and transferee on a debt incurred in the ordinary course of business or financial affairs of the debtor and transferee or under ordinary business terms. It typically arises as it relates to lenders for regular payments under a loan or where a trustee or debtor seeks to avoid payments to trade vendors, utilities, goods suppliers, service professionals, and landlords who routinely provided the debtor with goods and services used in the course of the debtor’s business prior to bankruptcy. Whether a transfer was made in the ordinary course is a factual inquiry that ultimately must be determined by the bankruptcy court. To be successful, the creditor must demonstrate that the transfer was made in the ordinary course of business between the debtor and creditor or made according to ordinary business terms in the debtor’s or creditor’s industry.
If you receive a demand letter seeking repayment of alleged preferential transfers, do not reach for your checkbook. Instead, reach for your phone and call your bankruptcy attorney, as you will likely have defenses available.
The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the author, Ilan Markus, partner, at imarkus@barclaydamon.com; Janice Grubin or Jeff Dove, Restructuring, Bankruptcy & Creditors’ Rights Practice Area co-chairs, at jgrubin@barclaydamon.com and jdove@barclaydamon.com; or Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com.