Defending Against Preference Claims: Key Legal Defenses for Creditors

In the intricate realm of bankruptcy law, preference claims stand as a pivotal concern for creditors. When a debtor files for bankruptcy, transactions made prior to the filing can come under scrutiny. Specifically, payments made to creditors within 90 days before the bankruptcy petition may be deemed preferential. This notion implies that certain creditors received more favorable treatment compared to others, potentially compromising the equitable distribution of the debtor’s assets. Understanding the legal defenses against such claims is essential for creditors aiming to safeguard their interests.

C. Edward Hartman III

Christian Hartman

Zachary Zepko

Understanding the Basics of Preference Claims

Preference claims arise under Section 547 of the U.S. Bankruptcy Code. The core idea is to prevent a debtor from favoring one creditor over others before filing for bankruptcy. If a creditor receives a payment or other benefit that improves their position relative to other creditors shortly before the bankruptcy, the trustee might attempt to recover those payments. The intention is to ensure an equitable distribution among all creditors, preventing any from gaining an unfair advantage.

For a trustee to successfully establish a preference claim, certain elements must be proven. Firstly, the transfer must benefit a creditor and be for or on account of an antecedent debt. Secondly, it must be made while the debtor was insolvent, within 90 days before the bankruptcy filing (or one year if the creditor is an insider). Lastly, the transfer must enable the creditor to receive more than they would have under Chapter 7 liquidation. Recognizing these elements is the first step in crafting a defense strategy.

The Ordinary Course of Business Defense

One of the most prominent defenses against preference claims is the ordinary course of business defense. Under Section 547(c)(2) of the Bankruptcy Code, a transfer is protected if it was made in the ordinary course of business or financial affairs of both the debtor and the creditor. This defense aims to exclude routine transactions from the purview of preference claims, ensuring that regular business dealings aren’t unduly penalized.

To invoke this defense, creditors must demonstrate that the transaction aligns with the historical dealings between the parties or conforms to industry standards. Courts often examine factors such as the payment’s timing, method, and amount compared to prior transactions. If, for instance, payments were consistently made within 30 days of invoicing, a payment made within that timeframe during the preference period would likely fall under this defense. However, deviations, such as unusually large payments or those made under unique circumstances, might weaken this argument.

Contemporaneous Exchange for New Value

Another potent defense is the contemporaneous exchange for new value. As per Section 547(c)(1) of the Bankruptcy Code, if a creditor provides new value to the debtor in exchange for a transfer, and both parties intend this exchange to be contemporaneous, it can shield the transaction from preference claims. The rationale is that such exchanges don’t diminish the debtor’s estate, as the debtor receives equivalent value in return.

For example, if a supplier delivers goods to a debtor and receives immediate payment, this transaction can qualify for this defense. The emphasis lies on the simultaneity and mutual intention of the exchange. Delays between delivery and payment, or ambiguity in the parties’ intentions, can complicate the applicability of this defense. Documentation, such as invoices and payment records, play a crucial role in substantiating this claim.

Subsequent New Value Defense

Distinct from the contemporaneous exchange, the subsequent new value defense under Section 547(c)(4) offers another avenue for creditors. If a creditor, after receiving a preferential transfer, provides new value to the debtor that remains unpaid, the value of this new contribution can offset the amount recoverable by the trustee. This defense acknowledges that the creditor’s later contributions benefit the debtor’s estate, warranting protection.

Consider a scenario where a vendor receives a payment during the preference period and later supplies additional goods without immediate payment. The value of these goods can reduce the potential preference liability. It’s imperative for creditors to maintain meticulous records of such transactions, highlighting the chronology and value of goods or services provided.

Enabling Loan Defense

Section 547(c)(3) introduces the enabling loan defense, tailored for creditors who extend loans enabling the debtor to acquire property. If such a loan is secured by the acquired property and perfected within 30 days, it can be shielded from preference claims. The essence is that the loan facilitated the debtor’s asset acquisition, and the creditor’s security interest doesn’t prejudice other creditors.

For instance, a financier providing funds for the debtor to purchase equipment, with the equipment serving as collateral, can invoke this defense if the security interest is timely perfected. Delays in perfecting the interest or deviations from standard lending practices can jeopardize this defense’s viability.

Floating Lien and Subsequent Advances

Creditors with security interests in a debtor’s fluctuating assets, such as inventory or accounts receivable, often employ floating liens. Section 547(c)(5) offers a defense for such creditors, acknowledging the dynamic nature of the collateral. If the creditor’s position doesn’t improve during the preference period relative to other creditors, the transfer might be exempt from preference claims.

Additionally, if a creditor makes subsequent advances secured by the floating lien, these can further bolster the defense. The key is demonstrating that the creditor’s net position remained consistent or didn’t gain an advantage over others during the relevant period.

Minimal Transfer Value

While not explicitly a statutory defense, the concept of de minimis transfers offers practical protection. Trustees might deem it uneconomical to pursue preference claims for negligible amounts, considering litigation costs. While the Bankruptcy Code doesn’t specify a threshold, courts often exercise discretion in such matters. Creditors receiving minimal payments during the preference period might avoid claims based on this practical consideration.

Defending Against Insider Preference Claims

Insider transactions receive heightened scrutiny, with the preference period extending to one year before the bankruptcy filing. Defending against such claims requires meticulous attention. Demonstrating that transfers were in the ordinary course of business or that equivalent new value was provided can be challenging. Insiders, including relatives, corporate officers, or entities with close ties to the debtor, must ensure transparent and well-documented dealings to fortify their defenses.

Challenging the Debtor’s Insolvency

One of the foundational elements of a preference claim is the debtor’s insolvency at the time of the transfer. While the Bankruptcy Code presumes insolvency during the 90 days preceding the filing, creditors can challenge this presumption. Presenting evidence that the debtor was solvent during the transaction can invalidate the preference claim. Financial statements, balance sheets, and testimonies can play pivotal roles in this defense.

Navigating Statutory Exceptions

Beyond the primary defenses, the Bankruptcy Code outlines specific exceptions that can aid creditors. For instance, payments of domestic support obligations or transfers made as part of an alternative repayment schedule approved by a non-profit budget and credit counseling agency can be exempt. Familiarity with these nuances can provide additional layers of protection.

Strategic Considerations for Creditors

While understanding legal defenses is paramount, proactive strategies can mitigate the risks of preference claims. Creditors should consider shortening payment terms, requiring cash on delivery, or obtaining security interests where feasible. Maintaining comprehensive records, documenting transactions, and adhering to standard business practices can fortify defenses. Engaging in regular audits and consultations can also preempt potential vulnerabilities.

Navigating the complexities of preference claims demands a deep understanding of bankruptcy law and strategic foresight. Creditors, while striving to recover dues, must remain vigilant about the potential ramifications of their transactions preceding a debtor’s bankruptcy. Employing robust legal defenses, backed by meticulous documentation and a keen grasp of statutory provisions, can safeguard their interests.

For creditors facing the daunting challenges of preference claims, seeking adept legal counsel is indispensable. Hartman, Attorneys At Law stands ready to guide you through these intricacies, ensuring your rights are robustly defended. Reach out to us today to fortify your position and navigate the labyrinth of bankruptcy proceedings with confidence.