This year, many unsuspecting businesses will be hauled into court by a trustee seeking return of a “preferential” payment made by a party now in bankruptcy. To those uninitiated, a bankruptcy trustee’s power to “avoid” or recover payments made by a debtor in the 90 days prior to its bankruptcy filing is not only surprising but seems unthinkably unfair. Below is a primer on the law of preferences, mostly for those who wish they had never encountered it and those who hope they never do.

What is a Preference?

Section 547(b) of the Bankruptcy Code defines a preferential transfer as a transfer that:

• was made to or for the benefit of a creditor;
• was made for or on account of an antecedent debt owed by the debtor before the transfer was made;
• was made while the debtor was insolvent;
• was made in the 90 days before the date of filing the bankruptcy petition (or in the one year before the date of filing of the recipient was an insider of the debtor); and
• enables the creditor to receive more than it would have received in a chapter 7 liquidation.

Each of these is an objective element; it takes no ill intention on the part of either the debtor or the creditor for a transfer to be preferential. As to the last element, a full payment made to a creditor during the preference period virtually always enables the creditor to receive more than it would have in a chapter 7 liquidation. Very rarely are creditors paid 100 percent of their claims in a chapter 7 liquidation and only if that were possible would the last element not be true.

And there’s the purpose of a preference action – to put creditors left with claims against the debtor at the time of the bankruptcy filing on equal footing with those who were paid immediately prior to the bankruptcy. The Bankruptcy Code provides those who are compelled to return a preference payment with a claim against the bankruptcy estate in an equal amount. If estate assets are available for eventual distribution, each creditor receives a pro rata share according to their claim.

Why and How is a Preference Action Initiated?

When a bankruptcy petition is filed, an estate is automatically created for the benefit of creditors. A trustee (or debtor in possession) has a fiduciary duty to maximize the value of the estate so that creditors receive as much as possible on their unpaid claims. In fulfilling this duty, a trustee must pursue preferential payments that he reasonably believes can be avoided and recovered.

Often, a trustee will send a demand letter to a preference recipient prior to filing suit. If the demand letter goes unanswered or the trustee is unable to reach an agreement with the recipient before the statute of limitations is reached, the trustee may file a complaint alleging that the party received a payment that may be avoided as a preference under section 547 of the Bankruptcy Code and demanding turnover of that payment under section 550 of the Bankruptcy Code. Like other federal complaints, a preference action must be answered within 30 days of service of the summons and affirmative defenses may be raised at that time. If no timely answer is filed, a trustee may seek a default judgment for the amount demanded in the complaint.

What are my Defenses to a Preference Action?

The Bankruptcy Code provides several affirmative defenses to a preference action. Among the commonly asserted defenses are:

• The new value defense, which provides an offset against the amount of the preferential transfer for any value (goods, services or otherwise) provided to the debtor subsequent to the preferential transfer. Here, the preference defendant would also hold a claim against the estate.
• The ordinary course of business defense, which provides that any transfers made in the ordinary course of the debtor’s business or according to ordinary business terms may not be avoided. The preference defendant here would have the burden of proving the debtor’s ordinary course of business, either with evidence of a prior course of dealing between the parties or of an industry standard.
• The contemporaneous exchange defense, which provides that a transfer is not a preference if it was intended to be a contemporaneous exchange and was substantially contemporaneous. Cash-on-delivery transactions are a classic example of a contemporaneous exchange that qualifies for this defense.

As noted above, preference defendants are the usually just untimely recipients of funds legitimately due to them. But preference defendants certainly do not feel “preferred” when forced to refund the estate for funds innocently received and incur legal fees to boot.

How can you avoid becoming a preference defendant? There may be no good way. You could refuse payment from a party if they are known to be on the brink of insolvency. On balance, however, most creditors will fare better if they accept payment directly from the debtor and deal with the trustee’s avoidance attempts if, and when, they arise.