With an uptick in bankruptcies in 2024, we thought it would be timely to revisit preference claims. More specifically how they work, and how to avoid this preference risk.

Picture this: one of your customers just filed for bankruptcy protection, and you have a large unpaid balance. As a credit professional, you’re frustrated and trying to figure out how this will impact your company. You then realize payments can be clawed back by the insolvent debtor’s estate as “preference” payments, and yet another headache arises. Pursuant to section 547(b) of the Bankruptcy Code, a debtor in possession or a trustee can seek to recover certain payments made within 90 days of the bankruptcy filing date, subject to various defenses. In principle, the preference statute attempts to avoid favoring certain creditors, as well as discouraging them from going to court to collect their claims. Preference claims continue to be a thorn in the side of trade creditors’ efforts to minimize their losses from a customer’s bankruptcy.

Key Elements of a Preference Claim:

To establish a preference claim, the trustee must generally prove the following:

(a) The debtor transferred its property to or for the benefit of a creditor;

(b) The transfer was made on account of antecedent or existing indebtedness that the debtor owed to the creditor;

(c) The transfer was made when the debtor was insolvent, which is based on a balance sheet test of the debtor’s liabilities exceeding its assets and is presumed during the 90-day preference period;

(d) The transfer was made within 90 days of the debtor’s bankruptcy filing in the case of a transfer to non-insider trade creditors; and

(e) The transfer enabled the creditor to receive more than the creditor would have received in a Chapter 7 liquidation of the debtor.

A trustee cannot recover a preference if he or she cannot prove any of the above elements of a preference claim.

Defenses to Preference Claims:

Creditors may have defenses to preference claims, such as:

• Subsequent New Value: If the creditor provided new value to the debtor after receiving the preferential payment, it may be able to offset the preference claim. Further explained by Bruce Nathan, Esq. of Lowenstein Sandler, “A creditor satisfies the new value defense by proving that it gave unsecured new value to the debtor by selling goods and/or providing services on credit terms to the debtor after an alleged preferential payment. The new value defense, like other preference defenses, is designed to encourage creditors to continue doing business with, and extending credit to, companies with financial problems. The net effect of the new value defense is that the debtor’s other unsecured creditors are no worse off by the preferential payment to the extent of any new credit the creditor subsequently provides to the debtor.”

• Ordinary Course of Business (OCB): Payments made in the ordinary course of business between the debtor and creditor may not be considered preferential. The OCB defense is supposed to protect a debtor’s payment to a creditor during the 90-day period prior to the debtor’s bankruptcy filing (the “preference period”) that was made in a consistent manner with either the parties’ history or how payments are made. A creditor must demonstrate a pre-preference period payment history or “baseline of dealing” between the debtor and the creditor, then compare that to the alleged preferential transfers. Lowenstein Sandler states that the court usually considers the following factors: (i) the length of time the parties were engaged in the type of dealing at issue; (ii) whether the amounts of the alleged preferential transfers were larger than prior payments; (iii) whether the payments were tendered in a manner different from previous payments; (iv) whether there was any unusual action by either the debtor or the creditor to collect or pay the debt; and (v) whether the creditor did anything to gain an advantage in light of the debtor’s deteriorating financial condition.

Tips to Minimize Preference Risk:

Monitor your Customer’s Financial Condition: Stay informed about your customer’s financial health and any signs of potential insolvency.  When credit risk deteriorates, adjust credit limits to mitigate overexposure. Also conduct regular credit reviews and avoid complacency in your credit risk assessment practices.

Document Transactions Carefully: Meticulously document all transactions with your customer. This should include detailed records of dates, amounts, payment methods, and reasons for each transaction. Additionally, maintain a comprehensive history of your business relationship.

Consider Obtaining Adequate Collateral: To protect your interest, you could secure the debt with adequate collateral.  This could include an irrevocable letter of credit or other credit documents that can reduce exposure.

Consult with Legal Counsel: Seek legal advice from an experienced bankruptcy attorney to understand the risks and develop strategies to mitigate them.

By understanding preference claims and taking proactive steps to mitigate the risks, creditors can better protect themselves in the event of a customer’s bankruptcy.

Disclaimer: This information is for informational purposes only and does not constitute legal advice. We suggest consulting a bankruptcy attorney or general counsel for detailed advice.