When a company begins to experience financial stress, payments to creditors frequently shift from regular terms to irregular terms. The company begins to make choices as to how to use its precious resources, prioritizing those creditors it needs to stay operational. Payments are made and additional collateral may be given to keep
- the secured lender happy so as not to head into foreclosure,
- the government happy so as to avoid any potential personal liability that officers and directors may face for trust fund taxes,
- the employees happy so that they continue to work while the company evaluates what staff is absolutely necessary,
- certain vendors happy so they will continue supplying goods and services needed on a regular basis (often referred to as “critical vendors”), and
- the unsecured creditors aggressively pursuing collections happy to avoid judicial liens and garnishments.
While these creditors may be within their rights under state law to accept these transfers from the company, they could find themselves having to return them if the company files for bankruptcy. This is because once the bankruptcy case is filed, there are mechanisms within the Bankruptcy Code (11 U.S.C. §§ 101 et seq.) that enable the debtor-in-possession or the bankruptcy trustee to recover certain transfers made by the debtor within a certain period of time before the bankruptcy case was filed. This article focuses on just one of those mechanisms: preferences.
What Is a Preference?
A preference is a defined cause of action under section 547 of the Bankruptcy Code. It is, at its core, a provision that seeks to promote fair and equal treatment of all unsecured creditors by allowing the trustee to recapture the debtor’s interest in any property—such as money, real property, inventory—that it transferred close to the filing date and to bring it back into the bankruptcy estate for equitable redistribution among all creditors. The reach-back period is 90 days for most unsecured creditors and one year for “insiders.” (“Insider” is a defined term under section 101(31) and varies depending on the nature of the entity.) In reality, however, the process generally just generates significant fees and administrative expenses, and results in a not-so-large pool of funds for the unsecured creditors the provision seeks to help.
Despite the questionable benefit of preference recoveries, almost all trustees pursue them. When a preference deadline is approaching, it is often the case that the trustee’s or creditor committee’s counsel will forward a letter stating that his or her review of the file has indicated that the creditor has received a potential preferential transfer and demanding a return of the transferred interest in property, which is usually money. If the parties cannot resolve the demand, a lawsuit within the bankruptcy case, called an adversary proceeding, will likely be filed. Pursuant to section 546 of the Bankruptcy Code, the statute of limitations for filing the lawsuit is generally two years from the bankruptcy petition filing date.
For the trustee plaintiff to succeed with a preference recovery, the transfer must meet several core elements, which the trustee has the burden of showing by a preponderance of the evidence. Therefore, when a creditor receives a demand letter or is served with a lawsuit, it should immediately review the transactions in question to see if they meet the underlying elements for the preference cause of action and, if so, whether there are any defenses, safe harbors, or counterclaims that could shield the creditor from liability. In doing so, the creditor should undertake the following general steps, in addition to consulting with bankruptcy counsel for appropriate advice.