In an ideal world, companies are paid on time and in full. Unfortunately, customers and vendors often pay late, make a partial payment – or worse yet, fail to pay at all.
When this continues as a trend, a business owner rightfully becomes concerned, unsure of whether the company can afford to continue to provide its services or goods to this struggling entity, and may have to resort to increasingly aggressive collection efforts. When a check finally arrives from the customer or vendor, that business owner happily rushes to cash the check as soon as possible (and hopes that it clears). However, what happens when that struggling customer or vendor then files for bankruptcy?
What are preference actions?
Many businesses are aware that the filing of the bankruptcy institutes an automatic stay, prohibiting a creditor from taking court action to collect on any outstanding debt. A less-known result of the bankruptcy filing, though, is that creditor businesses may actually be obligated to return payments received from the bankrupt debtor during the 90 days prior to the debtor filing for bankruptcy.
This is a difficult conversation to have with a business owner – that their company must return the hard-earned money that was already deposited and used to pay for employees, inventory or the business’ own debt obligations. Business owners are often livid when they are faced with this scenario, but the legal framework for the return of these funds, known as a “preference action,” is found in the U.S. Bankruptcy Code, Section 11 U.S.C. 547.
This section requires that the following factors be met to be considered a preference: 1) that the debtor’s transfer was made within the 90 days prior to debtor filing for bankruptcy; (2) the transfer was for or on account of an antecedent debt owed by the debtor before such transfer was made; and (3) which would entitle the recipient to receive a greater amount than it would receive in a liquidation of the debt.
Generally, the bankruptcy trustee or their counsel will send a letter requesting a return of funds to parties that received a payment within the 90 days prior to the date debtor filed for bankruptcy. Sometimes, a business will voluntarily return the funds, but if there is no voluntary return of the funds, the trustee can initiate a lawsuit within the bankruptcy case. The lawsuit can be tried just as any adversary proceeding to determine the merits of whether the funds must be returned to the bankruptcy estate.
Why do they exist?
The goal of the preference action is to facilitate equal distribution among debtor’s creditors. One of the theories underlying the preference action is that, sometimes, payments made right before a debtor files for bankruptcy may have been as a result of undue influence or, conversely, were made to give higher priority to certain creditors (perhaps, insiders or related parties), while not paying other creditors. For example, if a debtor knows they are insolvent with a bankruptcy on the horizon, they may pick and choose which debts to pay with the limited funds available – possibly paying debts to their family first, while ignoring debts incurred by other venders (i.e., getting a preferential payment).
By deterring unordinary payments from someone on the brink of bankruptcy, the policy may also allow the debtor to improve their financial situation and avoid bankruptcy entirely.
What are some defenses?
Depending on the facts, defenses may be available to a creditor business that have arisen from the code as well as case law. Only antecedent debts are subject to a preference action – so one defense that can be asserted, if applicable, is that the debt was contemporaneous to the payment, or that the funds were actually a pre-payment.
Another commonly raised defense is that the transactions were made in the ordinary course of business. There are split opinions on what this means in the circuit courts, but at its core, the defense argues if the transaction was one of ordinary course – such as those based upon common industry practices and the parties’ own transactions in previous years – any such payments would be exempt from requirements to return the funds.
Creditors may also use a defense known as subsequent new value, which usually applies when there is a continuing relationship and the business continues to provide further value on top of the original unpaid amount. Sometimes, this new value can reduce some, if not all, of the total preference amount.
There may be more options available to defend against a preference action, but it is always difficult for business owners to learn they may have to return funds to a debtor in bankruptcy. Meyer, Unkovic & Scott can assist businesses when this situation occurs and determine the best strategy.