by Scott Schuster

There is perhaps nothing more frustrating than when one of your customers files bankruptcy and avoids paying money that they owe your company. However, anyone that has dealt with a “preference action” knows that merely writing off a debt as uncollectible is not the worst thing that can happen when a customer enters bankruptcy. A preference action has the potential to be much worse, because it is a lawsuit by the debtor or the bankruptcy trustee against your company, seeking to recover payments that were made by the debtor to your company before the bankruptcy. Fortunately, the Bankruptcy Code provides creditors with certain defenses that can be used to defeat a preference action.

The Bankruptcy Code permits the trustee to avoid and recover from creditors payments made within the 90-day period before the bankruptcy filing. The policy behind this provision is to prevent aggressive collection activities that often force the debtor into bankruptcy. 

A “preference” is defined by Section 547 of the Bankruptcy Code as:

1. Payment on an “antecedent” (meaning a previously incurred as opposed to current) debt;
2. Made while the debtor was insolvent (meaning its assets are less than its liabilities);
3. To a non insider creditor, within 90 days of the filing of the bankruptcy;
4. That allows the creditor to receive more on its claim than it would have, had the payment not been made and the claim paid through the bankruptcy proceeding.  

Section 550 of the Bankruptcy Code allows the trustee to avoid and recover any preference payments by filing a lawsuit against the creditor.

Typically, a preference action is often preceded by a “demand letter” from the debtor or the trustee. The demand letter sets forth the trustee’s claims and demands immediate payment. Often times the trustee is willing to settle the preference action for an extremely reduced amount if the settlement is reached before the lawsuit is filed. Consequently, when the creditor receives a “preference demand letter,” the creditor should always have experienced bankruptcy counsel review the case to determine whether the creditor has valid defenses. Bankruptcy counsel can often negotiate a favorable settlement and allow the creditor to avoid having to expend large sums of money in litigation.

If the parties do not reach a settlement, the preference action is initiated with a complaint filed with the bankruptcy court. The preference complaint is similar to any other lawsuit with the exception that its filed in bankruptcy court, rather than federal district or state court.

by Scott Schuster, Esq.

There is nothing more frustrating that having one of your biggest customers file for bankruptcy, leaving your company holding a large unpaid debt, and then to be sued later for a “preference.” Clients often ask us: “I was not getting preferential treatment by the debtor, why am I being sued for a preference?” The answer to that question lies at the root of the supposed purposes of preference statutes in the bankruptcy code.

Congress enacted preference statutes for two reasons: 1) to prevent creditors from “dismembering” a struggling debtor during the debtor’s slide into insolvency; 2) to promote equality of distribution (of debtor’s assets) amongst debtor’s creditors.

The former is based on the premise that creditors typically realize when a debtor is struggling financially. Concerned that they debts may not be paid if the debtor enters bankruptcy, those creditors threaten the debtor (with lawsuits) until the debtor agrees to pay the debt. The debtor, at a time when cash flow is already a major problem, pays the debt in hopes of staying afloat by avoiding legal expenses.

If multiple creditors take the same action, the debtor’s limited assets are haphazardly distributed amongst a few select creditors to the detriment of debtor’s other creditors. In the meantime, debtor is stripped of its operating capital and forced into bankruptcy, leaving most of its creditors with unpaid debts.

In theory, the threat of bankruptcy preference actions may prevent creditors from demanding payment once a debtor is in financial turmoil. In reality, the creditor takes whatever action it would normally take and then hopes that more than ninety days pass before the bankruptcy is filed.

The second foundation for preference statutes is equally dubious. More often than not, preference payments are made to unsecured creditors. When money is recovered through preference actions during the preference case, significantly less than 100% of that money is paid to unsecured creditors. Usually, a substantial portion of the recovered assets are paid to administrative creditors (i.e. those that provided goods and services after the bankruptcy was filed) and priority creditors (like taxing authorities and employees).

In fairness, preference actions usually benefit more creditors than they hurt. Again, more often than not, those receiving payments during the 90-days preceding the bankruptcy filing are less in number than creditors that did not receive such payments. Consequently, the end result of preference actions is usually some benefit to unsecured creditors as a whole, but often very little.

In any event, the dual aims of preference statutes described above are rarely achieved.