preference provisions is twofold. First,
it discourages creditors “from racing
to the courthouse to dismember the
debtor during his slide into bankruptcy.”
Second, “preference provisions
facilitate the prime bankruptcy policy
of equality of distribution among
creditors of the debtor.” 502 U.S. 151.
Congress enshrined preference actions
in federal law under 11 U.S.C. Section
547. Creditors who within 90 days of
a debtor’s bankruptcy filing receive
payments on debts owed to them by the
debtor may be subject to a preference
action filed pursuant to this statute. In
keeping with the spirit of “equality of
distribution,” a creditor that is forced to
return money as a result of a preference
action can file a proof of claim with the
estate for this sum and thus share in
the (usually meager) distributions from
the estate. 2 In this fashion, Congress
continues the old English idea of
having all creditors return money
they received just before a bankruptcy
filing so that all creditors can share
pro rata from that pool of cash based
on the amount of their claims.
In reality, the system rarely works that
smoothly. It is the rare creditor (perhaps
nonexistent) who enthusiastically
wants to return money it lawfully
earned. Usually the debtor owes
the creditor additional sums that
were not paid—and never will be.
Refunding to the trustee the paltry
amounts the creditor was able to
collect feels like insult added to injury
or rather, injury added to injury.
Once a creditor becomes aware of
the existence of preference actions,
it may hesitate to have further
dealings with financially distressed
customers. If enough creditors
reacted that way, a debtor’s signs
of financial weakness could result
in the company being shunned by
the business community, thereby
hastening its descent into bankruptcy.
Although Congress wanted to
ensure equality of distributions
among creditors, it did not want
to make bankruptcy a foregone
conclusion for a company exhibiting
detectable signs of financial strain.
Thus, lawmakers added a number
of defenses to a preference action.
These defenses were intended to
reassure creditors that payments
they receive from debtors with
fiscal woes would not necessarily
be subject to forfeiture if the debtor
later filed for bankruptcy protection.
Preference defenses make the
phone call to the trustee’s counsel
described earlier a perilous exercise
if undertaken blindly. These defenses
may shield some or even all of
the amount demanded. Often, a
company’s actual liability is far less
than the trustee initially claimed. As
a result, a quick 30 percent “savings”
might actually result in the company
paying a significant premium
over what it would have to pay.
Several preference defenses are easily
understood, although implementing
them properly requires skill and
analysis. The strongest defense is
“subsequent new value,” which is
found in Bankruptcy Code Section
547(c)( 4). The concept is simple:
if the debtor makes a preferential
payment to a creditor, but the creditor
subsequently delivers goods or
services to the debtor worth an equal
or greater amount, then the debtor is
no worse off than it was before it made
the payment. Rather, the amount
expended has replenished the debtor.
The caveats are that the goods or
services must be provided after the
debtor made its payment, and the estate
truly must be enriched by receiving
them. In other words, if the value
provided by the creditor is subject
to a security interest or is otherwise
later recoverable by the creditor,
then this defense would not apply.
The defense is often helpful in
scenarios in which the company and
a debtor have frequent transactions.
For example, assume that on every
Monday Vendor A supplies 10 widgets
to Customer B, billing the customer
$1,000 for each shipment. Customer
B never pays its invoices within
the 30 days that Vendor A lists on
its invoices, but manages to pay
them about 90 days after shipment.
Payment occurs every Friday,
the day Customer B processes its
accounts payable. Thus, each week,
Customer B pays Vendor A $1,000
on Friday, even though the payment
is actually for an order Customer B
received months ago, rather than
the one it received the previous
Monday. Vendor A then sends a new
shipment of $1,000 worth of widgets
to Customer B the following Monday.
Now assume that Customer B files
for bankruptcy. The trustee seeks to
have Vendor A return the payments
it received from Customer B each
Friday within the 90 days before
the company’s bankruptcy filing.
The subsequent new value defense
shields virtually all of Customer B’s
payments to Vendor A, because
after each payment was received, a
shipment of an equivalent amount of
widgets was subsequently shipped to
Customer B. Any payment that was
followed by a shipment of equal or
greater value cannot be clawed back.
The strength of the new value defense
lies in its simplicity and objectivity.
One can establish this defense
by providing copies of invoices
showing the goods or services
provided during the preference
period, along with a history of
when payments were received.
This defense is straightforward to
compute. Further, there are rarely
subjective issues that can diminish
the defense’s effectiveness. Because
of these factors, creditors often
can prevail on this defense at the
summary judgment stage of litigation,
minimizing their legal bills.
Trustees understand all of this
and thus take the subsequent new
value defense seriously, negotiating
favorable resolutions when it applies.
For these reasons, turnaround
professionals always should
determine whether this defense is
available before agreeing to pay any
amounts to a bankruptcy trustee.
Another common defense is the
“ordinary course of business” defense
provided in Section 547(c)( 2) of
the Bankruptcy Code. During the
preference period, if the debtor pays a
debt to a company that was incurred
“in the ordinary course of business or
financial affairs” of the parties and the
payment was made “in the ordinary
course of business or financial affairs”
or according to “ordinary business
terms,” then the payment may not
be recovered as a preference.
On the surface, this may seem
like a stronger defense than the
subsequent new value defense, but
the reverse is actually true. Unlike
the subsequent new value defense,
which is essentially supported by
an objective mathematical exercise,
the ordinary course defense
involves subjective interpretation.