Anticipation of Litigation Advisor

Best Practices to Minimize Exposure to Bankruptcy Preference Actions

August 21, 2018

By: Elizabeth Amandus Baker

The Bankruptcy Code permits a bankruptcy debtor (or a bankruptcy trustee standing in the debtor’s shoes) to sue creditors to recover transfers made by the debtor within the 90-day period before the bankruptcy case was filed, commonly referred to as the “preference period.”¹   Clients often think it is unfair to be required to give back a transfer that they rightfully received from the debtor in payment of goods or services just because it was received within 90 days before a bankruptcy case.

While it may seem like an unfair concept, Congress’ intent behind granting debtors this preference recovery power is to ensure fairness to creditors vis-à-vis other creditors.  For instance, it would be unfair if the debtor’s favorite unsecured creditor (or the unsecured creditor with the most aggressive collections department) is paid 100% a few days before the bankruptcy petition was filed, while all other unsecured creditors must wait until a plan is confirmed several years later to receive only pennies on the dollar for their claims.  The Bankruptcy Code was designed to encourage “inter-creditor equity” and to prevent against the competitive first-come, first-served collections process available under state law.  Thus, Congress gave debtors (or their trustees²) the power to “avoid” preferential transfers so these transfers can be taken back into the debtor’s bankruptcy estate and then apportioned, pro rata, among all unsecured creditors.

There are a few defenses to a preferential transfer action that can help protect against, or to at least reduce, liability. The creditor-defendant (“Defendant”) bears the burden to prove these defenses.  To the extent the Defendant can prove these defenses, the debtor cannot “avoid” the transfer (meaning that the Defendant can keep the transfer³).

1. Contemporaneous Exchange for New Value Defense. If the Defendant can show that the Defendant contemporaneously gave the debtor “new value” when the Defendant received the transfer, the debtor cannot avoid the transfer.
2. Ordinary Course of Business Defense. The debtor cannot avoid a transfer made during the Preference Period if the Defendant can show either that (a) the transfer was made in the ordinary course of financial affairs of the Defendant and the debtor OR (b) the transfer was made according to ordinary business terms.⁴ Such defenses often require bankruptcy courts to undertake a highly factual inquiry and examine the history of transactions between the Defendant and the debtor, including (a) the length of time the parties were engaged in the transaction at issue, (b) whether the transfers were in an amount more than usually paid, (c) whether the amount or form of the transfer differed from past practice, (d) whether the debtor or Defendant engaged in any unusual collection or payment activity and (e) whether the creditor took advantage of the debtor’s deteriorating financial condition.⁵ “Unusual payment activity” can include an analysis of the number of days between invoicing and payment, the type of payment, communication between the parties and special payment arrangements.⁶
3. Subsequent New Value Defense. The debtor cannot avoid a transfer made during the Preference Period if the Defendant can show that, after the transfer was made, the Defendant gave new value “to or for the benefit of the debtor” that was “(A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer.”⁷  In other words, after the Defendant received the transfer, the Defendant gave the debtor new value (such as goods provided to the debtor on credit) that was never paid for by an unavoidable transfer from the debtor.

Careful and complete record-keeping is critical to a Defendant’s ability to prove any of these defenses.  The preference defenses described above require Courts to consider evidence unique to the Defendant and the Defendant’s specific relationship with the debtor.  To complicate matters, it is often the case that a preference action is commenced years after the Defendant received the transfer, making it harder to locate personnel employed at the time. Moreover, there is no cap on the amount of money a debtor can recover through a preference action, and preference suits often seek recovery of transfers in the thousands, hundreds of thousands, or even millions of dollars.  

Below are a number of best practices that, if implemented consistently, can reduce a company’s potential exposure in a preference action. 

• First, it is important to ensure that the terms and conditions of a purchase order are clearly stated, understood and complied with throughout the transaction, including the terms of credit and terms of payment.  Deviations from these terms and conditions should be avoided as much as possible because they may make a transfer appear “unusual,” increasing the risk of liability. If deviations from the ordinary terms and conditions are necessary, the nature and reasons for those deviations should be carefully recorded.
• Second, it is important to standardize the requirements for keeping clear, uniform records of invoice and delivery data (i.e., invoice number, goods/services provided, price, delivery date and payment due date). This information is necessary to establish a history of “ordinary course” business dealings between the debtor and the Defendant. It is important to ensure that such records are maintained in a consistent way across affiliate companies and during the course of mergers or acquisitions.  
• Third, it is critical to standardize and maintain clear and consistent payment records, including the dates that payment is received by the Defendant (this will be the date of the transfer, not the date the payment is sent), the method of payment (i.e., check, ACH or wire transfer), whether the payment is on-time or late and whether late fees or other penalties apply. It is important to track and be cognizant of trends in the timing and manner of payment from a debtor. Deviations from the manner of payment and original payment terms should be addressed to avoid creating “unusual circumstances” that would prevent a payment from appearing “ordinary course.”
• Fourth, it is important to standardize collection procedures across the company that will ensure that customers with delinquent accounts are processed in a predictable, uniform manner, avoiding sudden, aggressive deviations from collections practices that could be viewed by a court as “unusual collection activity.” Collections efforts should be documented to prove that the company’s standards were appropriately followed during the Preference Period.
• Finally, it is advisable to create company standards relating to credit policies, invoice-tracking, record-keeping, accounting and documenting correspondence with the customer to ensure that employees comply with these standards in a consistent manner over time, making it easier to create seamless “ordinary course” transaction history. 

Additionally, companies have a duty to preserve relevant information that they know may relate to a preference action, and there can be serious consequences if this information is destroyed. Thus, when a customer is known to have filed a petition for bankruptcy relief, additional steps should be taken to ensure that information relevant to potential preference actions is not destroyed. These steps include: (a) issuing a company-wide “litigation hold” memo directing employees to preserve potentially relevant information, (b) identifying key personnel and ensuring their paper and electronic records are preserved and (c) suspending standard document destruction or deletion policies as they relate to potentially relevant information.⁸
 

¹ 11 U.S.C. § 547(b) (“Except as provided in subsection (c) of this section, the trustee may avoid any transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made – (A) on or within 90 days before the date of the filing of the petition…; (5) that enables such creditor to receive more than such creditor would receive if – (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.”). For the debtor’s “insiders,” the preference period is even longer – one year before the petition was filed.

² References to debtor below can also apply to a debtor’s Chapter 11 or Chapter 7 Trustee.

³ See 11 U.S.C. § 547(c)(1) (stating that the debtor cannot avoid transfers to the extent the transfers were “(A) intended by the debtor and the creditor…to be a contemporaneous exchange for new value given to the debtor and (B) in fact a substantially contemporaneous exchange.”).

⁴ See 11 U.S.C. § 547(c)(2).

⁵ Neil Steinkamp, Understanding Ordinary 20–21 (Matthew D. Sobolewski, Esq., et al. eds., American Bankruptcy Institute 2016

⁶ Id. at 22.

⁷ See 11 U.S.C. § 547(g).

⁸ For additional information, see Neil Steinkamp, Understanding Ordinary (Matthew D. Sobolewski, Esq., et al. eds., American Bankruptcy Institute 2016).