A trustee in bankruptcy may avoid certain statutory liens, fraudulent transfers, as well as preferences. The Bankruptcy Code provides that certain transfers made by a debtor within close proximity of bankruptcy are preferential to the recipient and violate the Bankruptcy Code’s policy of equal treatment of creditors. The elements of a so-called “preference” or “preferential transfer” are easy for a trustee in bankruptcy to prove. The defenses available to the creditor are limited and the cost to litigate can be high.
The essential elements of a preference are that (1) a transfer is made to a creditor on account of an antecedent debt, (2) while the debtor was insolvent, (3) within the 90-day period prior to bankruptcy, and (4) that the transfer enabled the creditor to receive more than it would under a liquidation of the debtor.
The bankruptcy trustee, who may be a debtor in possession if the debtor is permitted to operate its business in bankruptcy, has the burden of proving to the bankruptcy court each element of a preference. However, that burden is often easily met by demonstrating that based on the parties’ existing agreement, the debtor had an obligation to pay the creditor and did so within the preference period. Preference liability is strict liability, which means that the intent or motive of the creditor is irrelevant in the consideration of an alleged preference.
Once the trustee establishes that a preferential transfer was made, the burden then shifts to the creditor-transferee to prove that it is entitled to one of the exceptions from liability contained in the Bankruptcy Code. Most preference actions are settled without litigation. It is common for a trustee to accept settlement at less than the full amount of its claim so that it can dispose of the matter quickly. However, in order to effect a settlement at a significantly reduced level, the creditor will ordinarily need to demonstrate to the trustee that it has a good defense and intends to challenge the action vigorously.
The most common exception or defense to a preference action is that the debtor made the payments in the ordinary course of business. To prove this the creditor must show that the debt was incurred by the debtor in the ordinary course of business or financial affairs of the debtor and either the payment was made in the ordinary course of business or financial affairs of the debtor and the transferee or the payment was made according to ordinary business terms. In addition, if the debtor’s debts are not primarily consumer debts, a preference is not recoverable if the aggregate value of all property that constitutes or is affected by the transfer is less than $ 5,000.
Other exceptions to preference liability are intended to encourage creditors to provide value to troubled debtors without fear of having to repay amounts previously received. If a debtor pays for goods or services at the time he or she receives the goods or at the time the services are rendered, there may be no preferential transfer. This is known as the “contemporaneous exchange” exception. Contemporaneous transfers are protected to the extent that the creditor can demonstrate that the value given to the creditor equals the value provided to the debtor. In addition, to the extent that the creditor gives new value to the debtor after receiving an otherwise preferential transfer, the trustee may not avoid that transfer. This is known as the “subsequent new value” exception.