Understanding Preferences in Bankruptcy: Protecting Your Business from Clawbacks

Bankruptcy is generally a difficult process for all involved. One of the most misunderstood aspects for business creditors is the concept of preferences. If you’ve been doing business with a company that suddenly files for bankruptcy, you could find yourself facing a demand to return money you were already paid. Why? Welcome to the world of preference actions.

What Are Preferences?

The intent of the preference statute is to prevent a debtor from favoring certain creditors over others and to ensure that all creditors are treated fairly.Under bankruptcy law, specifically Section 747 of the Bankruptcy Code (11 U.S.C. §547), a preference is a transfer made by the debtor to a creditor within 90 days before the bankruptcy filing (or one year, if the creditor is considered an insider) with respect to an antecedent that enables the creditor receive more than it would have received if the transfer had not been made and the debtor filed a chapter 7 (liquidation) case. The transfer is frequently a payment made voluntarily by the debtor but it can also be a lien on property obtained by a creditor, whether given voluntarily by the debtor or obtained by other means (an attachment of a bank account or real property for example) 

The Risk of Clawbacks

Here’s the tough part: if you received a payment or other transfer from a company as payment of (or to secure the payment of) an antecedent debt within that 90-day window, a bankruptcy trustee (or a debtor in possession in a chapter 11 case) may try to claw back that payment or transfer as a preferential transfer. This can be a hard pill to swallow, especially if you’ve provided goods or services in good faith, were eventually paid and now receive a demand to return the money or property.

Defending Against Preference Claims

The good news is that not every payment or transfer within 90 days of a bankruptcy filing is subject to clawback. There are a number of defenses to preference actions, including:

• Ordinary Course of Business: If the payment or transfer was made in a way consistent with how you and the debtor usually did business, it may be exempt from being clawed back by a trustee. As an example, if over the course of the relationship your payment terms were within 90 days of the date of the invoice, and the payments were generally made within 90 days and the payment that the trustee is seeking to recover was made within 90 days of the date it was invoiced, you may be able to defend against a preference complaint.
• New Value: If you provided new goods or services to the debtor after receiving the payment or transfer and you were not paid for those new goods or services, you may be able to set the amounts due for those unpaid goods or services off against the amount of the payment sought to be recovered. If, as an example, on the 89^th day before the bankruptcy you are paid $10,000 and between the 88^th day and the date of the bankruptcy filing, you provide goods with a value of $6,000 and are not paid for those goods, the amount that you will have to pay back to the Trustee as a preference would be reduced by $6,000 to $4000.
• Contemporaneous Exchange: Payments that are made in exchange for goods or services provided at the same time the payments are made can be shielded from clawback.

Protecting Your Business

To minimize your risk of having to defend against preference action, it’s crucial to stay informed about the financial health of your clients. Be cautious if you notice unusual payment behavior or delays. While every circumstance is different, consider either terminating the relationship if a customer starts to fall behind, or changing the payment terms to a c.o.d. basis. Generally if you are concerned about accepting a payment for an old debt, take the money as the debtor may not file bankruptcy within 90 days, there may be defenses to a preference complaint if they do file, and, again generally speaking, it’s better to have the money and have a trustee asking for it back than to not get paid and end up filing a claim that you may be paid pennies on the dollar for or nothing at all.

Bankruptcy preference laws are somewhat complex, but with the right strategies, you can protect your business at least to some extent from unpleasant surprises. If you find yourself in this situation, it’s critical to consult with a legal professional who can help you navigate these waters and defend against potential claims.