What Is Considered A Preferential Payment When It Comes To Bankruptcy?

Preferential payments arise under 11 USC 547 of the Bankruptcy Code. They are transfers must be affirmatively be disclosed on the debtor’s bankruptcy petition within specific dollar amounts and within certain time periods of the bankruptcy. As a result of a trustee’s due diligence, the transfer payments will likely be something that a trustee would investigate. A trustee must meet all six elements to pursue a preference case. Before filing the preference case, the trustee, based upon some recent changes to the bankruptcy code, must proceed with reasonable due diligence understanding the circumstances of the case and take into account a party’s known or reasonably known defenses.

The six elements of a preference case are, 1) a transfer; 2) to or for the benefit of a creditor; 3) on account of an antecedent debt owed by the debtor before the transfer was made; 4) made while the debtor was insolvent; 5) made within 90 days before the date of the filing of a petition; or between 90 days and one year before the date of the filing of the petition if the creditor was an insider; and 6) that enables the creditor to receive more than if the case was not a chapter 7 case and the transfer had not been made, and the creditor received payment to the extent provided the provisions of the bankruptcy code. A creditor who doesn’t prove all six elements of the case will not establish liability. The main issues that come up in a preference case often deal with the timing of the payment, which is 90 days as calculated from the date a check is honored, not when drafted.

How Far Back Can The Bankruptcy Trustee Look For Preferential Transfers?

As described in 11 USC 547, the preference statute is 90 days for general creditors and one year for insiders. Insider is a defined term in the bankruptcy code. For individuals who file bankruptcy, an insider would be included in the definition of a relative of the debtor or general partner of the debtor, a partnership in which the debtor is a general partner, a general partner of the debtor or a corporation of which a debtor is a director, officer, a person in control. If the debtor is a corporation, insiders are considered directors of the debtor, officers of the debtor, persons in control of the debtor, partnership in which the debtor is a general partner, general partners of the debtor or a relative of a general partner, director, officer or person in control of the debtor. However, the definition of an insider remains subject to case law. Just because a transfer is to a related entity, it may or may not precisely fit within the meaning of insider and can still be challenged. Some cases have even resulted in preference liability under the extended one-year payment period concluding that the payment recipient was an insider.

Can Bankruptcy Affect A Payment Paid Before Filing?

The answer is absolutely yes. A trustee’s duty as a fiduciary for creditors or debtors in possession’s duty is to look to investigate and potentially challenge any transactions, especially transactions that occur shortly before a bankruptcy filing as potentially preferential or fraudulent payments that can be challenged and recovered from a recipient known as a transferee for the benefit of all creditors.

What Is The Preference Action?

A preference action is essentially an adversary proceeding that would be brought either by a chapter 7 trustee or a debtor in possession who is also obligated as a fiduciary for its creditors to bring actions in the bankruptcy court to try to collect payments from creditors that fit within the definition of the preference statute 11 USC 547. This assumes an understanding that the new changes to the statute that require due diligence and consideration of potential defenses before bringing such actions.

What Defenses Can Be Used Against Preference Actions?

The first line of defense for a defendant who is sued for a preferential payment may challenge is a failure of the Plaintiff to satisfy the six statutory elements under 11 U.S.C. 547. For instance, the transfer or payment received may not have been from the debtor but rather from a third party. The transfer must be on account of an antecedent debt or a pre-existing debt owed. Further, there is a statutory requirement that the debtor was insolvent when the transfer was made. There is a presumption that the debtor was insolvent in the 90 days immediately preceding the filing. That presumption does not apply for the period more than 90 days prior to the filing date of the Bankruptcy case. In some cases, the debtor’s insolvency can be a complex element for a plaintiff creditor to establish.

Two primary preference defenses are often litigated. One of the defenses commonly asserted is that after receiving a preferential payment from a debtor, a creditor provided “new value” which is often a further extension of credit. For instance, if a creditor received the $5,000 payment from the debtor and then extended new credit for $5,000 allowing new purchases, that will be considered new value to offset the challenged preferential payment. Another defense is the ordinary course of business defense, which has two different components. First, according to ordinary business terms, a transfer must be made in the ordinary course of the debtor’s business or financial affairs and the transferee. The ordinary course of business of financial affairs of the debtor and the transferee is a subjective review. The second part is that the transaction could be compared to commercial parties in the same industry and whether it’s standard or ordinary for payments to be late or payments to be made within invoice terms commonplace to the industry.

The Bankruptcy Code does not explicitly define the term ordinary course of business. The courts say that they are left to interpret what is known to be a “peculiarly factual analysis” in determining the ordinary course of business defense. These defenses are to further the general legislative purpose of the bankruptcy statute to leave undisturbed regular financing transactions between parties. This is because the preference statute is designed to discourage unusual action by the debtor or creditors while the debtor may be sliding into bankruptcy.

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