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How to Deal With a Preference

Ira P. Goldberg

In a bankruptcy proceeding, preference law is the means by which the debtor or a trustee, can recover a payment or other transfer which was made by the debtor within 90 days of the debtor’s bankruptcy filing or alternatively within one year in the case of a transfer to an insider. An insider is generally a person or entity that bears a close relationship to the debtor.

The preference law is designed to treat all creditors equally. The main purpose of the law is to clawback transfers and eventually make them available for redistribution among the creditors of the estate. This purpose, however, does not always work perfectly and certainly does not provide much solace to a creditor who is being sued for such a recovery. After all, the creditor was simply paid a debt owed to it for services or products it actually provided. The creditor may also still have an unpaid balance with the debtor. Therefore being sued for a preference, from the creditor’s viewpoint, is simply rubbing salt in the wounds.

If you operate a business you may run into a preference payment situation. DiMonte & Lizak is well versed in this area of law and may assist in softening the blow or minimizing the risk when you suspect that someone you are dealing with may be heading towards bankruptcy. This article is only intended to give you a primer on how to deal with such situations.

The basic elements of a preference are as follows:

  1. A transfer of an interest of the debtor in property;
  2. To or for the benefit of a creditor;
  3. For or on account of an antecedent debt owed by the debtor before such transfer was made;
  4. Made while the debtor was insolvent;
  5. Made on or within 90 days of the date the bankruptcy was filed (or within 1 year if the creditor was an insider); and
  6. That enables the creditor receive more than it would have received in a Chapter 7 liquidation.

There are various defenses to a preference. The most common are as follows:

  1. The parties intended the transaction to be a contemporaneous exchange for new value and it actually was one;
  2. The ordinary course of business, generally either based upon the parties history of dealings or of the norms of the industry;
  3. Perfection of a lien for which a relevant statute provides for relation back if compliance is within a statutorily specified time period;
  4. Subsequent new value. The delivery of goods or services after the alleged preference; and 5) Solvency. Insolvency, however, is presumed within 90 days of the filing.

There are also various business practices, when dealing with a person or entity that is likely to wind up in a bankruptcy, that may insulate you or provide some protection. One simple method is to receive prepayment or simultaneous payment (Cash on Delivery). Prepayment results in the transfer not being made on the account of an antecedent debt. You must take care to document/evidence that the parties agree to, intend to, and have actually consummated the desired business practice. Generally, under the preference law, unless otherwise specified by the parties (best practice in writing), payments are applied to the oldest invoices. Therefore if you did not document a prepayment or contemporaneous payment, as being the intent between both you and the debtor, the payment will most likely be allocated to the earliest invoice, which very well might result in preference exposure.

The adherence to a prior consistent course of conduct between the parties may also provide some protection. For instance, if there is a history under which the debtor always paid your business within 30 days of invoice, and assuming invoices are promptly issued and not backdated, the adherence to that practice will strengthen an ordinary course defense. A separate defense would be adherence to the ordinary terms of payment of the industry that is involved. Regardless of the forgoing it almost always is best to accept payment without concern of a clawback. The person or entity may never file for bankruptcy or the filing, as relevant to you, could be outside the clawback period. Preferences can also be settled. We can assist you if such litigation is threatened or filed.

In the event you suspect someone who you are dealing with is unfortunately heading towards a potential bankruptcy, it is prudent to contact a lawyer specializing in bankruptcy law. At DiMonte & Lizak we have several attorneys with that specialization.

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