ALP: I own a company which supplies goods to other companies. One of the companies we regularly supply goods to filed for bankruptcy about a year ago

September, 2007

Q. I own a company which supplies goods to other companies.  One of the companies we regularly supply goods to filed for bankruptcy about a year ago.  Not only did they owe us quite a bit of money when they filed for bankruptcy, but to add insult to injury, they have now sued us, demanding that we pay back payments they made to us during the three months before they filed for bankruptcy!  Can they really do that?

A. Unfortunately, the answer may be yes.  A debtor in bankruptcy can bring an action against you to recover amounts you were paid by the Debtor company just before bankruptcy in certain circumstances.  But there are defenses!  Your best bet is to hire a lawyer skilled in defending bankruptcy preference claims.

Section 547(b) of the Bankruptcy Code allows a Debtor in bankruptcy or a bankruptcy Trustee to avoid and recover transfers of money or property made by the Debtor to a creditor, for or on account of an antecedent debt, during the 90-day period preceding the filing of the Debtor's bankruptcy petition.  The intended purpose of this provision is to provide for the equal treatment of creditors.  The theory is that if one creditor gets paid on the eve of bankruptcy, while other creditors do not, it is not fair to the creditors which did not get paid.  The idea is that the funds should be gathered back from the creditors which did receive payment and put into the “pot” from which all creditors may share. 

Section 547(b) sets forth the elements that must be established to recover such transfers.  The transfer(s) must have been:

(a) to or for the benefit of a creditor;

(b) for or on account of an antecedent debt owed by the Debtor before the transfer(s);

(c) made while the Debtor was insolvent;

(d) made on or within 90 days before the date of the filing of the Petition, or made within one year if the transfer(s) was to an insider; and

(e) that enables the creditor to receive more than it would have received under a Chapter 7 distribution.

In order to recover a preferential transfer, the Debtor or Trustee must file an adversary proceeding in the Bankruptcy Court against the creditor to which the transfer was made.  The creditor should consult with its bankruptcy counsel for a determination as to whether the transfer meets the criteria set forth in §547(b).  The creditor's counsel should particularly take care to determine that the 90-day period was properly calculated and to determine the exact date parameters at issue.

Preference actions may also be brought under Kentucky Revised Statutes §378.060.  The Kentucky statute also establishes a 90 day preference period.  To succeed under the Kentucky statute, three elements must be established: 

(1) the transfer must have occurred within 90 days of bankruptcy;

(2) it must have been made in contemplation of insolvency; and

(3) made "with the design" to prefer one or more creditors to the exclusion of others.

Kentucky Revised Statutes §378.060 incorporates a subjective standard.  "Intent" on the part of the Debtor must be established.  Accordingly, the Kentucky Statute presents a difficult hurdle to overcome.  Preference actions based on KRS §378.060 are therefore somewhat unusual.

Preference actions are not without defenses.  Two commonly available defenses are  the ordinary course of business defense and the new value defense.  To come within the scope of the ordinary course of business defense, two requirements must be met:

(1) The underlying debt on which payment was made must have been "incurred in the ordinary course of business or financial affairs" of both parties; and

(2) (a) The transfer must have been "incurred in the ordinary course of business or financial affairs" between both parties; or

(b) The transfer must have been made "according to ordinary business terms" using an industry-wide test.

The greatest concern when asserting the ordinary course of business defense is whether the preference payment(s) were made in a timely manner.  In determining "when" the payments were made for purposes of the ordinary course of business defense, the controlling date with regard to checks is the date the check was received by the creditor, rather than the date  the check was written or the date the check was honored by the bank. 

In determining whether the payments at issue were made in a timely manner, a creditor's and Debtor's contractual agreement in theory governs when payments are due, and thus, whether payments were timely made.  Accordingly, the courts are directed to first consult the contract terms.   That said, deviation beyond the contract terms is more typically the case and becomes the governing standard upon a showing that the parties had an established history during the pre-preference period of allowing late payments and that late payments became the ordinary course of the parties' business dealings.  A creditor may avail itself of the Ordinary Course of Business Defense if it can establish that the payments which are the subject of the Debtor’s or Trustee’s preference claim were made in a consistent manner with their prior course of dealing.  This defense will require documentary evidence which your bankruptcy counsel can direct you in compiling. 

The other defense which a creditor may have available is the New Value defense.  It  protects transfers "to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the Debtor. . . ."  New value is typically in the form of additional goods or services delivered by the creditor to the debtor which followed, or came after, one or more of the potentially preferential transfers for which the creditor is being sued.  The new value preference avoidance exception under Section 547(c)(4) of the Bankruptcy Code allows subsequent advances of new value to be used to offset prior preferences, and the creditor is permitted to carry forward preferences until they are exhausted by subsequent advances of new value.  You will also need documentary evidence to demonstrate the new value provided during the preference period.  The type of evidence generally needed are invoices, statements, contracts, bills of lading, shipping statements or any other evidence demonstrating the goods or services which you provided to the Debtor during the 90 day period prior to the bankruptcy filing.

In conclusion, while the Debtor company is entitled to bring an action against you to recover payments made to you during the 90 days preceding the bankruptcy filing, you likely have defenses which will reduce and possibly even eliminate your claim exposure.  Unfortunately, many Debtors are routinely aggressive in pursuing creditors for recovery on preference claims.  Debtors will often demand payment of the maximum possible amount of the preferential transfers, without taking into account the defenses a creditor may have.  Accordingly, it is essential for the creditor to have its bankruptcy counsel review the Debtor's preference claim allegations to determine available defenses and weaknesses in the allegations.  A bankruptcy attorney who is well-versed in preference actions will be able to evaluate the records and documentation you have kept to determine which defenses are available to you.