In a bankruptcy case, the trustee has authority to recover payments made to creditors within a specific period preceding the bankruptcy. Trustee claims of this type are called preferences or avoidable preferences. A creditor who receives a preference claim has several options for proceeding, including asserting defenses against the claim.
The provisions of Section 547 of the U.S. Bankruptcy Code govern preference claims. An amendment to that section took effect on February 25, 2020. The revision may benefit a creditor facing a preference claim or potential preference exposure. Please read on to learn more about the amendment and potential defenses to a preference claim.
The preference provisions in Section 547 of the Bankruptcy Code are sometimes referred to as the “clawback” provisions, because they enable the trustee to recover payments or interest transfers made by the debtor prior to bankruptcy. The goal of the provisions is to put all creditors on equal footing, rather than giving an advantage to those who received recent payments or transfers.
For the trustee to assert a preference claim, a payment or transfer must meet certain statutory requirements, including a time limitation. For insider creditors (relatives, friends, partners, officers, directors, etc.), the trustee may assert a claim to recover a payment or transfer made within one year prior to the bankruptcy. For non-insider creditors, the period is 90 days.
Payments and transfers beyond the statutory time periods cannot be subject to a preference claim. Other criteria also apply, including that the debt existed prior to the payment/transfer and that the debtor was insolvent at the time of the payment/transfer.
In addition, the Small Business Reorganization Act of 2019 (H.R. 3311) added an important new requirement relating to a trustee’s preference claim authority. The amendment took effect on February 25, 2020.
The SBRA amended Section 547 of the Bankruptcy Code to state that a trustee may assert a preference claim “based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses.” The SBRA amendment likely will affect the initial stages of a preference claim, giving a creditor the opportunity to demonstrate defenses to the claim early in the process. As such, the amendment may benefit creditors facing preference exposure or claims.
Under the preference provisions, if all of the other requirements are met — and if the payment resulted in the creditor receiving more than the amount that the creditor’s pro rata entitlement would be under the bankruptcy — the trustee has authority to assert a preference claim to recover the payment or interest.
Even if a preference claim meets the statutory requirements, the Bankruptcy Code provides a creditor with a number of potential affirmative defenses against a trustee’s preference claim. These are the defenses that the trustee must now take into account in asserting a preference claim.
Commonly asserted affirmative defenses include:
One of the most frequently used defenses is the ordinary course of business defense. To establish this defense, the creditor must demonstrate that the debtor made the payment or transfer of interest in the ordinary course of business. That means within the normal practices for the debtor and creditor (if they have an ongoing relationship) or in the debtor’s business or trade.
A payment or transfer that was part of a substantially contemporaneous exchange also is exempt from a preference claim. This defense is available if the creditor can show that the debtor and creditor intended the payment or transfer in question to occur at the same time as the transfer of something of value to the debtor. The exchange must have taken place relatively soon after the payment or transfer. COD (cash-on-delivery) transactions are an example of this type of exchange.
The new value defense applies if a creditor gave the debtor new value that remains unpaid after the payment or transfer in question. The new value must be given after the preference payment or transfer was made.
There are other available defenses when a trustee asserts a preference, including exemptions relating to perfected security interests and floating liens. If a creditor faces a preference claim from a bankruptcy trustee, the best strategy is to consult a bankruptcy litigation attorney to explore all potential affirmative defenses before responding to the trustee’s claim.
A bankruptcy trustee typically initiates a preference claim by sending a demand letter to the creditor. If the creditor does nothing, the letter likely will be followed by a formal legal action — bankruptcy litigation — in the bankruptcy court.
A better approach is for the creditor to talk immediately with knowledgeable bankruptcy litigation counsel and respond to the demand letter in an appropriate manner, based on the circumstances of the payment or transfer. If there is a valid defense — or the claim does not meet the statutory requirements — the creditor may be able to avoid the claim entirely. In many cases, preference claims end in a settlement negotiated with the bankruptcy trustee after the demand letter is issued.
While any repayment may not be entirely satisfactory to a creditor, reaching a settlement avoids the cost (and stress) of defending against a preference action in bankruptcy court. In any specific case, the best resolution and outcome will depend entirely on the circumstances surrounding the payment or transfer that is the subject of the trustee’s preference claim.
If a creditor receives a demand letter from a bankruptcy trustee, the creditor has several options. Ignoring the demand is one possibility. Since doing that likely will result in the trustee filing an avoidable preference action against the creditor in the bankruptcy court, doing nothing is not a wise choice.
Paying the full amount (or transferring the interest) to the trustee is a second option. But capitulation usually is not the most beneficial strategy either.
A creditor may be able to defeat the claim by disproving one of the necessary statutory elements or asserting an affirmative defense. The recent amendment to Section 547 requires the trustee to take the circumstances and known or reasonably knowable affirmative defenses and the circumstances into account before pursuing a preference action. As such, in many cases, making the trustee aware of defenses is the logical first step in responding to a claim.
To evaluate the situation, defenses, and options, the best strategy for a creditor who receives a demand letter is to talk with an experienced bankruptcy litigation attorney. That is particularly in view of the recent amendment, which may provide an opportunity to resolve the claim early in the process.
At the Dave Burns Law Office, I represent creditors in adversary proceedings in the United States Bankruptcy Courts in Minneapolis and St. Paul. Bankruptcy litigation is a primary focus of my practice.
If you receive a preference demand letter from a bankruptcy trustee, I can assist by evaluating the facts, determining if the payment or transfer meets the statutory requirements, analyzing potential defenses, and explaining the available options for responding. You will then be able to make an informed decision about how to proceed.
If you face a preference claim or any other type of adversary proceeding in a bankruptcy case, I welcome you to contact me at (612) 677-8351 or by sending an email to me at firstname.lastname@example.org. I am available to meet with clients in both Minneapolis and St. Paul and welcome inquiries from clients and referring attorneys throughout the State of Minnesota.
The Dave Burns Law Office hopes you find this article helpful. But please do not rely on it as legal advice. The law changes regularly and the outcome of any legal matter depends on its unique circumstances. View full disclaimer