Picture this . . .Widget Factory has been providing widgets to Small Business for 5 years.  In those 5 years, Small Business paid each invoice within 30 days of receipt.  The past 6 months of payments, however, have been a bit more suspect.  Small Business began making payments over 30 days past the date of invoicing and missed a few payments here and there.  But, Small Business doubled up on a couple of invoices in the last 90 days to catch up.  After struggling financially to keep up with creditors and the demand of its customers, Small Business filed for bankruptcy protection.  Upon review of Small Business’s schedules and questioning during the meeting of creditors, the trustee filed an adversary proceeding to recover the payments made to Widget Factory in the 90 days before the bankruptcy filing.  This is what the bankruptcy world affectionately refers to as a preference action.

The focus of this post, which is Part I of II in a mini-series on mediating preference actions, is to generally (very generally!) define and outline the elements of a preference action.

“Preference claims customarily arrive as a demand to repay amounts the creditor received from its customer in the 90 days before the customer’s bankruptcy case . . . . To many creditors, preference claims come as surprises.  After all, there is no dispute that the customer owed the debt and the creditor earned the payment.”  Often, creditors view preference claims as unfair, asking why they should be required to repay monies that were legitimately due and owing to them. Under ordinary business circumstances, this position in well-taken.  But,”[t]he primary underlying principle supporting the return of preferential payments is the fair and equal treatment of all unsecured creditors.  Disgorging payments made is intended to redistribute the bankruptcy estate’s assets equitably among all of the unsecured creditors. . . . [C]reditors who repay preferences will hopefully recover at least a part of what they returned by participating pro rata in distributions with other unsecured creditors. . . . Section 547 does not require ‘intent‘ to receive a preference, notice of insolvency, fraud or any other subjective element.  Because the policy behind the preference statutes is equal distribution, intent or notice is irrelevant.”

So, how do we know if a payment is a preference?  Preferences are defined under Section 547 of the Bankruptcy Code by the following five elements:

  1. A transfer of an interest of the debtor in property to or for the benefit of a creditor;
  2. A transfer for or on account of antecedent debt owed by the debtor before such transfer was made;
  3. A transfer made while the debtor was insolvent;
  4. A transfer made during the preference period (the Bankruptcy Code presumes that a debtor was insolvent in the 90 days before the petition date and the reach-back period is extended to one year for insiders—family members, business partners, etc.); and
  5. The transfer enables the creditor to receive more than if the case preceded under chapter 7.

No, no you say, that isn’t right.  Shouldn’t the creditors have some defense?  Well, of course.  There are 10 of them:

  1. The transfer was made in a contemporaneous exchange of new value to the debtor;
  2. The transfer was made in the ordinary course of business;
  3. The transfer was a security interest in property securing a new value to the debtor;
  4. The transfer was made after the creditor provided new value;
  5. The transfer was a security interest in inventory or a receivable;
  6. The transfer was the fixing of a statutory lien;
  7. The transfer was of an alimony or child support payment;
  8. The transfer was of property with an aggregate value less than $600 in a case involving primarily consumer debt;
  9. The transfer was of property with an aggregate value of less that $5,475 in a case not involving consumer debt; or
  10. The transfer was pursuant to an alternative repayment schedule.

There are also several other defenses that are specific to particular industries, such as grain producers, fishermen and warehousemen.

As you would imagine, the assertion of preference claims and affirmative defenses, lead to a flurry of negotiations, charts, documents, calculations and other supporting evidence to whittle down what amount of the questioned payments are actual preferences, if anything.  This is why preference actions are often the subject of mediation.

Stay tuned for Part II on how mediation can be used in preference actions.

Sources:

Quotations and excerpts from Wheeler, David B., ABI Preference Handbook, American Bankruptcy Institute (2d ed. 2008), at 1, 3, 8–21, 29, 36–38.

11 U.S.C. § 547(b) (Elements of Preference Claim).

11 U.S.C. § 547(c) (Affirmative Defenses).