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Defending Preference Payments in Bankruptcy

You've just learned that a long-time client has filed for Chapter 11 bankruptcy protection. The good news is that despite your client's misfortune (or mismanagement), you're in great shape - a week earlier you received a substantial payment that cleared up most of the client's outstanding balance.

Don't spend the money just yet.

Cash paid within 90 days of a client's bankruptcy filing is known as a "preference" payment, which means that a bankruptcy trustee may ask for it back to ensure the equitable redistribution of the estate's assets among all of its unsecured creditors.

Weigh Your Options

"After receiving a preference demand, creditors have several choices," says Gleason & Associates' Bill Krieger, "return the payment and hope for the best in bankruptcy, attempt to settle the demand for a lesser amount, or engage counsel and attempt to defend against the preference."

While there are a number of legal defenses to a preference payment, Krieger notes, Gleason & Associates is often asked to conduct a financial analysis of the common three-part "Ordinary Course of Business" argument and, if necessary, present the evidence at trial. According to bankruptcy code, a transfer of funds is not a preference payment if:

The debt was incurred in the ordinary course of business between the debtor and creditor. Payment was transacted in the ordinary course of business (the "subjective test").
The debt was paid according to ordinary business terms (the "objective test")

If an analysis determines that the business dealings and terms between the debtor and creditor are consistent between the 90-day periods before and after the bankruptcy filing, then a payment will generally satisfy the "subjective test," Krieger says.

To meet the "objective test," a creditor must present evidence that the payments it received were made in accordance with ordinary business terms for its industry. In a recent engagement, research conducted by Gleason & Associates determined that "standard payment terms" in the client's industry ranged from 29 to 43 days. Because the creditor's collection activity with the debtor both prior to and during the preference period was near the midpoint of this range, the analysis enabled counsel to meet the "objective test" and establish that the payments were not preferential. As a result, the case was settled without protracted litigation.

"Because creditors have the burden of proof in defending preference payments," Krieger explains, "be prepared to support your claim with empirical evidence and an analysis of past practices between you and the debtor."

Determining Preference Payments

Regardless of whether a creditor intended to receive preferential treatment, a transfer of funds is considered a preference payment by bankruptcy trustees if it:

Continuing financial losses are draining cash.
Changing business conditions are negatively effecting cash flow projections.
Accounts receivable and inventory balances are increasing.
Raw material supply has deviated from the norm.
Market share and customer orders decline precipitously.