Bankruptcy Preferences FAQ

What is a preference?

Section 547(b) of the Bankruptcy Code permits the debtor-in-possession or a trustee to recapture payments made by the debtor prior to its bankruptcy filing. Although it is not always achieved in practice, the asserted policy goal underlying the preference statute is to further the goal of equality of treatment of creditors of the debtor. Accordingly, the Bankruptcy Code authorizes the recapture of payments to certain creditors for the benefit of those creditors whose debts remain unpaid by the debtor.

What are the elements of a preference?

The elements of a preference set forth in Section 547(b) of the Bankruptcy Code are the following:

  • The transfer was made to or for the benefit of a creditor (i.e., creditor receives a check from the debtor, goods are returned by the debtor to the creditor or an obligation of the creditor is reduced by the debtor);
  • The transfer was made for or on account of an antecedent debt owed by the debtor before the transfer was made (this is merely a payment or transfer made on an old debt, i.e., not a cash on delivery or cash in advance payment);
  • The transfer was made while the debtor was insolvent;
  • The transfer was made 90 days before the date of the filing of the bankruptcy petition (extended to one year if the transfer was made to an insider); and
  • The transfer enables the creditor to receive more than it would have received if the case were a Chapter 7 liquidation. A payment received within 90 days of the bankruptcy filing almost always enables a creditor to receive more than it would have received in a Chapter 7 case. Indeed, the only time this would not be true would be in the unusual case where creditors were receiving 100% on their claims pursuant to a plan of liquidation.

It is neither wrong of the debtor to make a preferential payment nor wrong of the creditor to accept it. Creditors are almost always better off attempting to get payment of their clams from debtors and dealing with any efforts to recover the money when, and if, such attempts are made in bankruptcy.

What are the major affirmative defenses to a preference action?

There are several affirmative defenses to a preference action. Three of the major affirmative defenses which can be asserted by the creditor/defendant are:

  1. the new value defense;
  2. the ordinary course of business defense; and
  3. the contemporaneous exchange defense.

What is the new value defense?

New value is defined under Section 547(a)(2) of the Bankruptcy Code as "goods, services or new credit…" In connection therewith, Section 547(c)(4) of the Bankruptcy Code provides an offset against a preferential transfer if a creditor subsequently gives new value to the debtor after the allegedly preferential transfer. Accordingly, if a creditor supplies services or ships new goods on an unsecured basis after that transfer, the value of those goods or services would ordinarily be subtracted from the original preference because the estate has been replenished. This is known as the "subsequent advance rule" and often provides the best defense to a preference because dollar-for-dollar credit is provided when it is applicable. Unfortunately, that also means the creditor has a claim against the debtor for unpaid invoices.

Further, Section 547(c)(4)(B) provides that the trustee may not avoid an alleged preference to the extent that after such payment, the creditor gave new value "on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor."

What does the confusing language of Section 547(c)(4)(B) mean – does new value have to remain unpaid?

Courts have divided on this issue, but the evolving standard is that new value credit will be given if (1) the new value remains unpaid or (2) the new value has been paid for by a payment which otherwise could be set aside as a preference. On the other hand, if the debtor's subsequent payments cannot be set aside as a preference because the prima facie elements of Section 547(b) are not satisfied or because the creditor has another affirmative defense under Section 547(c), the new value which gave rise to those payments will not qualify for new value credit. This avoids double credit being given to defendants for new value relating to a payment which is already insulated from preferential recovery. See, In re Pillowtex Corp., 416 B.R. 123 (Bankr.D.Del. 2009).

How does the subsequent advance rule apply to specific situations?

  • There are any number of scenarios, but below is an example.
  • The creditor receives $10,000 from the debtor on December 1st and an additional $5,000 on December 5th on account of services rendered. The creditor then provides $18,000 in additional services on December 12th and subsequently receives $7,000 on December 18th on account of prior services previously rendered in November. The debtor files for bankruptcy on December 31st.
  • In that instance, the creditor would be entitled to $15,000 in new value credit advanced on December 12th which remained unpaid to offset the two payments totaling $15,000 made on December 1st and December 5th, but would not be able to offset the final $7,000 payment received on December 18th because there were no subsequent advances after that payment. Accordingly, under this scenario there is a possible preference of $7,000 subject to other defenses.

Can there ever be an exception to the new value defense when the creditor has not been paid for its goods or services before the bankruptcy filing?

Possibly. Section 503(b)(9) of the Bankruptcy Code accords administrative priority status to claims for goods received by the debtor in the ordinary course of its business within 20 days of its bankruptcy filing ("20-day claims"). Accordingly, several bankruptcy courts have held that it would be unfair to the bankruptcy estate by allowing a creditor to receive both (1) payment on its 20-day claim for goods sold and (2) new value credit in defending against a preference action at the same time. In re Circuit City Stores, Inc., 2010 WL 4956022 (Bankr. E.D. Va. 2010); In re TI Acquisition LLC, 429 B.R. 377, 385 (Bankr. N.D. Ga. 2010).

However, the law in this area is unsettled as at least one court has rejected that carve-out as unfairly depriving trade creditors of the priority accorded payment of 20-day claims under the Bankruptcy Code. In re Commissary Operations, Inc., 421 B.R. 873 (Bankr. M.D. Tenn. 2010). Further, a Delaware bankruptcy court has held that post-petition payment of a claim for pre-petition wages by virtue of the equitable doctrine of necessity allowing payment for a critical vendor did not eliminate the new value defense based upon providing those services. In re Friedman's Inc., 2011 WL 5975283 (Bankr. D.Del. November 30, 2011). While this case did not involve a 20-day claim, the key issue for the Court was that payment was made after the bankruptcy filing, thus satisfying the Third Circuit's holding in In re New York City Shoes, 880 F.2d 679, 690 (3rd Cir. 1989) which, inter alia, required that the debtor must not have fully compensated the debtor for the "new value" as of the date it filed its bankruptcy petition. If that reasoning were to be followed in subsequent Delaware cases, new value supplied on account of 20-day claims would count as a valid defense because it was not paid for prior to the debtor's bankruptcy filing.

What is the ordinary course of business defense?

A second major affirmative defense to an alleged preference is provided for in Section 547(c)(2) of the Bankruptcy Code, which protects transfers made in the "ordinary course of business". The purpose of the ordinary course of business exception is to "leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor's slide into bankruptcy". House Report 95-595, 95th Cong., 1st Sess. 373. Accordingly, payments within invoice terms are generally not preferential, unless the terms have changed close to the 90-day preference period due to creditor pressure or special treatment of a favored vendor by the debtor.

How did the law relative to the ordinary course of business defense change under the 2005 amendments to the Bankruptcy Code?

Previously, defendants had to prove that alleged preferences (1) were consistent with the parties' prior course of dealing (the "Subjective Test") and were also (2) consistent with common industry practice (the "Objective Test"). However, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 Section 547(c)(2) of the Bankruptcy Code was changed to provide that for bankruptcy cases filed as of October 17, 2007, defendants only need to prove either the Subjective Test or the Objective Test. In some instances, this will make the defense of a preference action easier for the defendant.

What are the factors considered by courts in determining whether the Subjective Test has been satisfied?

The following factors are usually considered to determine whether a transaction was ordinary:

  1. the prior course of dealing between the parties;
  2. the amount of the payments;
  3. the timing of the payments; and
  4. the circumstances surrounding the payments.

What are the key issues in analyzing the parties' prior course of dealing?

In reviewing the parties' prior course of dealing, a key issue would be the creditor's ability to demonstrate that the allegedly preferential payments were made in a time frame which is reasonably close to the average number of days late during the period preceding the 90-day preference period, with the greatest emphasis placed upon the payment history closest in time to the alleged preference. Some courts have gone as far as to take a weighted average of payments for a period of months before the preference period or to look at five and ten day "buckets" of payments. However, creditors should be aware that the standard employed in analyzing the ordinary course defenses varies around the country and each case will be decided on its particular facts.

Some courts will also look at the range of payments prior to the preference period as the basis of comparison rather than a statistical average, either independently or together with an average. Regardless of whether an average or a range is utilized, the payments in question must not have been made in response to additional or different requirements imposed by the creditor during the preferential period. For example, a payment made timely can be deemed preferential because of unusual collection practices, i.e., the creditor received a certified check from the debtor whereas it previously was always paid by regular check.

What if the parties have no prior history?

In some cases, there will be no history between the parties prior to the preference period. Most courts have held that a first-time transaction is not per se ineligible for protection from avoidance. Generally, the courts look to the terms of the parties' agreement in order to determine the ordinary course of business between the parties. If payment was in accordance with the terms of the agreement, then the defense is established. See, e.g., Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003).

How does a defendant satisfy the Objective Test?

The defendant should present evidence demonstrating that the payments sought to be recovered were made in a time frame which is consistent with the industry standard. This frequently requires the use of experts and industry source materials.

Accordingly, defendants who are sued frequently for preference should now give greater consideration to the industry standard which is often ignored in the earlier stages of negotiations with plaintiff's counsel. Those creditors should obtain access to recent industry studies or surveys which provide a range or average of the time to pay in their industry. If creditors have that information readily available, they will be able to present it at the beginning of the negotiation if it is advantageous. This could potentially result in a better settlement for the defendant.

The industry standard varies somewhat among the various circuits, but many have fairly lenient standards. This arises out of the influential case of Matter of Tolona Pizza Products Corp., 3 F.3d 1029, 1033 (7th Cir. 1993), in which the Seventh Circuit held that "ordinary business terms refers to the range of terms that encompasses the practices in which firms similar in some general way to the creditor in question engage, and that only dealings so idiosyncratic as to fall outside that broad range should be deemed extraordinary and therefore outside the scope" of the industry standard defense (emphasis supplied by the Court).

What is the "contemporaneous exchange" defense?

It is another affirmative defense to an alleged preference. Under Section 547(c)(1) of the Bankruptcy Code, a transfer is not preferential if the parties (1) intended a contemporaneous exchange and (2) the payment was in fact substantially contemporaneous. Accordingly, cash-on-delivery transactions will generally qualify for this defense. Payments made in advance are also not recoverable as preferences, because they do not satisfy the requirement under Section 547(b)(2) of the Bankruptcy Code that the payment be on account of an antecedent debt owed by the debtor before the transfer was made.

In considering the contemporaneous exchange defense, the focus is on the first test which relates to the parties' intent. See In re Hechinger Inv. Co. of Del., Inc., 489 F.3d 568, 574 (3rd Cir. 2007) (holding that a credit relationship does not preclude, as a matter of law, a finding of contemporaneous exchange for new value and that the determination of whether the parties intended a contemporaneous exchange is a question of fact to be decided by the fact finder).

While the case law varies, courts have generally allowed defendants to employ the defense if they have been paid within 2 to 3 weeks and the intent to create a contemporaneous exchange has been established.

What is the date of a preferential transfer – is it the date that the debtor's check is delivered to the creditor or the date that the check was honored by the debtor's bank?

This distinction is critical because it could determine whether or not the transfer falls within the 90-day preference period under Section 547(b)(4). The issue was decided by the United States Supreme Court in the case of Barnhill v. Johnson, 125 S.Ct. 1386 (1992). There, the Court determined that for the purposes of a preference action brought pursuant to Section 547(b) of the Bankruptcy Code, a transfer made by check is deemed to occur on the date the check is honored by the payor's bank, rather than the date of the payee's receipt of the check.

However, the Supreme Court refused to address the issue of when a transfer is made for the purpose of analyzing both the new value and ordinary course of business defenses under Section 547(c). Nevertheless, it should be noted that most courts which have subsequently considered the issue have concluded that a date of delivery rule should apply to check payments for purposes of defenses to preference actions. These courts have recognized that as a matter of policy, it is critical for vendors to agree to ship goods or supply services to purchasers upon receipt of a check because those vendors do not have the capability to determine whether the payor's bank will honor that obligation.

Are payments under an agreed-upon payment schedule preferential?

If a debtor does not pay in accordance with terms and later enters into a stipulation with a creditor to make payment over time in accordance with the terms of a payment stipulation, the payments may still be preferential. It is well established that unusual collection activity during the preference period supports a finding that payments made during that period are outside the ordinary course of business. The courts are divided, however, on whether payments made pursuant to a settlement or restructuring agreement prohibit use of ordinary course defense.

For example, the Third Circuit disfavors payment plans, which it stated in In re Molded Acoustical Products, Inc., 18 F.3d 217, 228 (3rd Cir. 1997) is "an act which does not suggest business as usual within the industry but, quite to the contrary, resembles a calculated response to a deteriorating creditor–debtor relationship. In contrast, the Second Circuit held in In re Roblin Industries, Inc., 78 F.3d 30, 42 (2nd Cir. 1996) that a creditor that agrees to restructure a debt by instituting a repayment plan "in a manner consistent with industry practice in those circumstances does not lose the benefit of the exception". However, even in circuits where payments made pursuant to payment plans may not be preferential, the burden is on the creditor to demonstrate that the restructuring of the debt is consistent with prior dealings of the parties or the customary practice in the relevant industry.

On of the prima facie elements of a preference claim is that the transfer must be made when the debtor is insolvent. Is there a presumption of insolvency?

Yes. Pursuant to §547(f) of the Bankruptcy Code, the debtor is presumed to have been insolvent during the 90 days immediately preceding the bankruptcy filing. However, while the presumption requires the creditor being sued for preference to come forward with some evidence to rebut the presumption, the burden of proof remains upon the debtor-in-possession or the trustee bringing the preference action.

What is the legal standard in determining insolvency?

Section 101(32)(A) of the Bankruptcy Code defines "insolvent" as a "… financial condition such that the sum of such entity's debts is greater than all of such entity's property, at a fair valuation…." Many courts have defined "fair valuation" as the reasonable estimate of what could be realized from the assets by converting them into or reducing them to cash under carefully guarded, if not ideal, conditions. However, this raises the question of whether a going concern or liquidation standard should be used, or a combination thereof. Once again, the resolution of this issue will depend on the particular facts of a case.

Litigation of this issue therefore often involves the retention of accountants or other financial consultants as experts to analyze the debtor's financial condition 90 days before it filed for bankruptcy. Accordingly, when confronted with a preference action, a creditor can often delay the action or improve its position in settlement negotiations by asserting the insolvency defense and by seeking discovery on this issue, particularly if the debtor's schedules or SEC filings (if any) show a positive net worth.

What is the statute of limitations for a preference action?

Under Section 546(a) of the Bankruptcy Code, a preference action may not be commenced after the earlier of:

  1. the later of (a) 2 years after the entry of the order for relief or (b) 1 year after the appointment or election of the first trustee (if any); or
  2. the time the case is closed or dismissed.
Related Contacts
Jay Indyke Partner, New York
Eric Haber Special Counsel, New York
Related Practices & Industries

Business Restructuring & Reorganization