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Beware of the Bankruptcy Claim!

Beware of the Bankruptcy Claim!

SML Perspectives
(November 19, 2012)

In this era of overbearing government regulations, an unanticipated bankruptcy preference claim remains one of the most frustrating experiences regularly confronted by businesses of all kinds.

Imagine your firm has just completed an extensive, high risk construction project. Your firm just received payment from your customer in exchange for your waiver of lien claims upon final payment, that you signed and submitted last week. You pay downstream subcontractors and suppliers after receiving your retainage, and shortly thereafter learn that the customer has just filed for bankruptcy protection under the United States Bankruptcy Code.

If you never received notice of a bankruptcy preference claim before, notice of a bankruptcy proceeding may mean nothing to you. However, the significance of that proceeding will become
abundantly clear if you receive an “official-looking” demand letter from the lawyer for the bankruptcy debtor, or a bankruptcy trustee, demanding pursuant to 11 U.S.C. §547 that your firm return the retainage it was paid, as well as any other monies paid to your firm by the debtor, during the ninety (90) day period preceding the debtor’s bankruptcy filing.

Do not write a check to the debtor or the trustee just yet. It is astonishing how many parties who receive such a preference claim actually remit payment to the demanding debtor or trustee without addressing the merit (or lack of merit) of the preference claim. Moreover, it is not unusual for a Bankruptcy Trustee to issue demands for repayment of alleged preferences, or initiate lawsuits to recover alleged preferences, without assessing the underlying merits of their claims.1

What is a Preference Claim?
In order to establish such a claim, five elements must be established:

  1. A transfer was made by the debtor to the creditor on or within ninety (90) days before the filing date of the bankruptcy petition or within one year prior to the filing date of the bankruptcy petition, if the creditor was an “insider”. The date of any “transfer” made by check is the date on which the check in issue clears the debtor’s bank, not when the debtor receives it;
  2. The transfer sought to be recovered was made by the debtor from property of the bankruptcy estate to or for the benefit of the creditor;
  3. The transfer was for or on account of an antecedent debt owed by the debtor to the Creditor. This generally means the debt must have been incurred before the transfer or payment in issue was made;
  4. The transfer was made while the debtor was insolvent. A balance sheet test is used to determine insolvency. Although a presumption exists the debtor was insolvent within ninety (90) days of the bankruptcy, such a presumption is rebuttable, and does not extend beyond ninety (90) days prior to the filing date of the bankruptcy petition;
  5. Finally, the transfer must have enabled the Creditor to receive more than it would receive, if the transfer had not been made, under a Chapter 7 liquidation of the debtor’s bankruptcy estate.2

If and to the extent the Trustee can establish all of these elements, a preference is presumed to have occurred and it becomes the creditor’s burden to prove a defense to a preference claim.

Fortunately, circumstances often negate the presence of one or more elements of a preference claim or give rise to one or more available defenses.

Contractors may be able to use applicable state lien law to defeat the presumption that a preference has occurred. A contractor who carefully monitors and preserves its lien rights should receive payment at a time when the contractor can still file and enforce a lien. In certain states (including North Carolina and Georgia), an argument can be asserted that the customer paid the contractor with funds subject to an equitable lien or “constructive trust” for the benefit of the contractor and its own downstream subcontractors and suppliers. To such an extent, the transfer in issue would not be from property of the bankruptcy estate.3 Moreover, in view of the contractor’s state law lien rights, this payment should not cause the contractor to receive more than it would have received as a secured lien creditor in Chapter 7 liquidation.

Similarly, in the case of a supplier, the supplier may have reclamation rights under the uniform commercial code adopted in most states that may afford a supplier either a secured claim or an administrative priority claim if the supplier undertakes appropriate timely measures to preserve those reclamation rights.4 To the extent a supplier is paid during a period where the supplier would have been in a position to assert such rights, an argument can be made that the payment did not cause the supplier to receive more than it would have received in the debtor’s Chapter 7 liquidation, had it not been paid and exercised such reclamation rights.

A number of statutory defenses are available to negate a preference claim.5 The most commonly asserted defenses are as follows:

(1) The transfer challenged as a preference was made by the debtor to a creditor in the ordinary course of business. This is the most frequently asserted defense. To successfully assert this defense, a creditor must show that the debt was incurred in the ordinary course of business or financial dealings between the debtor and creditor, and that the transfer itself occurred in that manner as well. This is a “subjective test”, and will often involve some evaluation of the history of dealings and payments between the debtor and creditor.6

Alternatively, a defending contractor or supplier can establish that the transfer was made according to ordinary business terms. This requires an objective determination, requiring the creditor to provide evidence of the payment terms considered normal in the industry in issue.7

(2) The transfer constituted a contemporaneous exchange for new value provided by the creditor, and was thus not on account of an antecedent debt. This defense generally applies to C.O.D. terms, and requires the creditor to objectively prove that the transfer to the creditor equals the value the debtor received, that both parties intended the transfer to be contemporaneous and the exchange was contemporaneous in nature.8

(3) The creditor gave subsequent new value to the debtor in reliance upon the payment(s) received from the debtor in issue. This defense usually applies where the debtor has an open account with the creditor; the creditor receives an alleged preferential payment, and thereafter grants additional unsecured credit to the debtor prior to a bankruptcy filing. This “subsequent new value” allows the creditor to reduce or eliminate the claimed preference at least to the extent the additional credit remains unpaid at the time of bankruptcy.9

Given the conditions precedent to establishing a successful preference claim, and the available defenses, contractors and suppliers (as well as any other recipients of preference claims) should give careful analysis to those claims before addressing the official demands they receive from a claiming bankruptcy trustee. Such claims may be settled on favorable terms, or even withdrawn, if a proper approach is taken in negotiations, and the facts are properly presented to the Trustee by a party who understands the “rules of the game.”

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1. Pursuant to 28 U.S.C. § 1409, where the alleged preference claim against a non-insider exceeds $10,950.00, a Chapter 11 debtor or Chapter 7 trustee can file the preference action in the jurisdiction where the bankruptcy proceeding is pending, and serve the
unwary creditor with this lawsuit by first class U. S. mail throughout the United States.
2. See 11 U. S. C. § 547(b)(1)–(5).
3. See 11 U. S. C. § 541(d).
4. See 11 U. S. C. § 546(c)(1).
5. See 11 U. S. C. § 547(c)(1)-(9).
6. See 11 U. S. C. § 547(c)(2)(A).
7. See 11 U. S. C. § 547(c)(2)(B).
8. See 11 U. S. C. § 547(c)(1).
9. See 11 U. S. C. § 547(c)(4).

G. Marshall Kent
T (404) 962-1036
F (404) 962-1271
Associated Attorneys

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