By Franklin Barbosa, Jr. 

Part One

Introduction
Many business owners are familiar with the dreaded demand letter sent by a bankruptcy trustee, liquidating trustee or Chapter 11 debtor in connection with the bankruptcy of a current or former customer. The letter demands the return of sums paid by the debtor during a defined period of time preceding the debtor’s bankruptcy filing.  Typically, the demand is premised upon the allegation that the debtor made a “preferential” payment to its creditor, as defined under Section 547(b) of the United States Bankruptcy Code (the “Code”), or that the debtor made a fraudulent transfer to its creditor, as defined under Section 548(a) of the Code or applicable state law.

The demand letter is a precursor to an adversary proceeding in bankruptcy court.  The letter proposes a settlement of the sender’s claims, typically at 80%-90% of the contested payment.  Failure to respond to the letter in a timely manner will be followed by litigation.  Therefore, it is important that businesses diligently monitor their mail and promptly forward the correspondence to counsel.

In this alert, we will explain several potential defenses and strategies for combating preference claims under Section 547 of the Code.  A subsequent alert will address defenses and strategies applicable to fraudulent transfer claims.

Background
Built into the United States Bankruptcy Code is Section 547, a statutory mechanism empowering a bankruptcy trustee, liquidating trustee or debtor to “claw back” payments made by a bankruptcy debtor to a creditor within 90 days of the debtor’s filing, or made to an “insider” within one year of the bankruptcy filing.  The purpose of Section 547 is to nullify a debtor’s pre-bankruptcy efforts to pay its insiders or favorite vendors at the expense of its other creditors.  The aims of Section 547, however admirable, unfortunately ensnare payments made to innocent creditors who were paid for the good faith services or goods provided to the debtor.

A payment meeting the statutory definition of a “preference” is not per se recoverable; creditors are afforded multiple statutory and non-statutory defenses to liability.  Careful and strategic analysis and application of the statutory defenses can shield some or all of the contested payments from clawback efforts.

Common Preference Defenses
A. Ordinary Course of Business
Section 547(c)(2) permits a creditor to shield a preference from clawback efforts if the subject payment or transfer was made in the ordinary course of business.  To prevail on this defense, a creditor must demonstrate that the contested transactions were consistent with the parties’ pre-preference period dealings – typically the two-year period immediately preceding the preference period – or industry norms.  In assessing the applicability of this defense, courts consider a host of factors such as payment terms, payment frequency, and size of the transactions, among other factors.  To give an example, if a preference payment was made by a debtor to its materials supplier within 60 days of invoicing and the debtor’s payments during the pre-preference period were of similar or comparable amounts and made, on average, within 50-60 days of invoicing, the supplier possesses a solid argument for application of the ordinary course of business defense.

B. Subsequent New Value
Creditors may also rely upon the new value defense afforded under Section 547(c)(3) of the Code.  The new value defense applies where a creditor extended new value to the debtor on credit after the alleged preferential transfer was consummated, provided the debtor did not make a voidable transfer to the creditor on account of the new value extended.  If the new value defense applies, the creditor can offset the new value amount against the amount of the alleged preference transaction.  By way of illustration, if a materials supplier received a $100,000 preference payment, but subsequently shipped $50,000 of widgets to the debtor on credit, the supplier’s total preference exposure is reduced to $50,000, provided the supplier has not received a preference payment in connection with the $50,000 extension of credit.  As one can probably surmise, this defense is intended to encourage creditors to continue doing business with financially distressed debtors without fear of losing payments received during the preference period.

C. Contemporaneous Exchange for New Value
A party may defend against a preference claim by establishing that a challenged transaction involved a contemporaneous exchange for new value, as set forth in Section 547(c)(1).  This defense requires proof that the debtor received something of value, in exchange for the payment, and the exchange was substantially contemporaneous with the transfer.  The prime example of a contemporaneous exchange of new value is a cash-on-delivery (COD) arrangement.

D. Other Defenses
The foregoing list of defenses is non-exhaustive.  There are a host of other defenses, not expressly referenced herein, that a party may raise depending on the factual circumstances surrounding the contested transactions.  For example, a party can defend itself by contesting the necessary elements of a “preference” as set forth in Section 547(b).  Specifically, a party asserting a preference claim must prove that a payment was made within 90 days of the debtor’s bankruptcy filing, the payment was made to or for the benefit of a creditor and on account of an antecedent debt,  the debtor was insolvent at the time of the payment, and the subject transaction permitted the creditor to receive more than it would have received in a Chapter 7 (liquidation) case.  If a party can successfully disprove one of those elements, the contested transaction is not a voidable preference.

Burden of Proof and Practical Considerations:
In connection with preference claims, the trustee has the burden of proving the elements of a preference as set forth in Section 547(b) of the Code by a preponderance of the evidence, and the creditor bears the burden of proving the elements of their chosen defense by a preponderance of the evidence.

Conclusion:
Understanding and strategically employing preference defenses under Section 547 of the Bankruptcy Code is crucial for parties navigating the complex landscape of bankruptcy proceedings. By carefully examining the circumstances surrounding alleged preferential transfers and presenting compelling evidence, creditors can protect good faith payments made by a debtor.

Analysis regarding the applicability of any preference defense is fact-intensive and must be accompanied by knowledge of applicable case law.  Therefore, it is recommended that the recipient of a demand letter or preference complaint promptly retain experienced counsel. 

In the forthcoming installment of this alert series, we will delve into the realm of fraudulent transfers and discuss the prevailing defenses available to businesses implicated in the receipt of such transfers. The discourse will encompass several nuanced subjects such as the concept of “reasonably equivalent value,” occurrences of “actual” fraudulent transfers, contributions to charitable entities, and other pertinent themes.

For more information about this alert or any other bankruptcy issue, please contact Franklin Barbosa, Jr. at 973-539-1013 or fb@spsk.com.

DISCLAIMER: This Alert is designed to keep you aware of recent developments in the law. It is not intended to be legal advice, which can only be given after the attorney understands the facts of a particular matter and the goals of the client.