Preference Actions Under Bankruptcy

May 6th, 2020 by Bunch & Brock

If you’re a creditor, you may prefer not to deal with preference actions under bankruptcy. When you hear the word “preference,” you probably think it’s a good thing; it’s what you want or like. When it comes to bankruptcy, depending on your position in the proceeding, a preference action may or may not be what you want.

Bankruptcy is a fact of life for some Kentucky businesses, whether your industry is as old as coal mines or as new as legal hemp production. It could be the beginning of the end of a company, such as the GenCanna bankruptcy that shuttered the hemp producer, or it may be the start of a new chapter of its life.

Ensuring Creditors Get Paid Fairly in a Bankruptcy

The Bankruptcy Code intends to make sure that creditors are paid fairly, under the law, without anyone cheating or improperly skipping ahead of other creditors. A trustee is appointed by the bankruptcy judge to make sure creditors are paid fairly. A debtor-in-possession is a party that has filed a bankruptcy petition and remains in possession of property on which a creditor has placed a lien or a similar security interest.

Either of these parties could recover payments made within 90 days of a bankruptcy filing (or a year, if the party is an “insider” of the debtor) if such payments to the creditor may have given it an advantage in the bankruptcy case compared to other creditors, under 11 U.S. Code § 547.

It’s not unusual for a creditor to be subject to preference actions under bankruptcy. The creditor may have thought it was in good shape, received all or part of what it was owed before bankruptcy and was hoping to move on. Now, that creditor may get dragged into the bankruptcy proceeding. There may also be valid reasons for this kind of action if there was a “sweetheart deal” for the creditor. This is particularly true if the creditor is a person with a connection to a corporate officer, director, the owner, or a related business of the entity going bankrupt.

Preference Claims Process

Usually, creditors in this situation get demand letters from the trustee or debtor-in-possession. If the two can’t work out an agreeable arrangement, a legal action may be filed. The trustee or debtor-in-possession needs to file preference claims two years before the petition date or within a year of the appointment or election of the first trustee.

These actions concern payments to a creditor immediately before the bankruptcy filing. To be successful, they would have the burden of showing:

  • A transfer: Normally a payment, but it can include recording a deed of trust or perfection of a security interest.
  • An interest of the debtor in property: This consists of the transfer of any legal or equitable interests of the debtor in property as of the start of the bankruptcy case.
  • The payment was made to or for the benefit of a creditor.
  • The payment was for an account of an antecedent debt: The debt was incurred before the transfer.
  • Payment was made while the debtor was insolvent: Based on a balance sheet assessment, were the debtor’s liabilities more than its assets? For a preference action, it’s presumed the debtor was insolvent during the 90 days before the bankruptcy filing.
  • A payment made within 90 days or one year if the party is an insider: If the person is considered an insider, transfers that can be scrutinized could be made up to a year before the filing.
    • An insider could be a relative of an individual debtor or related to an officer or director if a corporation made the filing. The facts of the situation are considered to determine who’s an insider, such as a member of a limited liability company. If you’re not an insider, only transactions made within 90 of the filing can be at issue.
  • The payment caused the creditor to receive a higher distribution than what would be allowed in a potential Chapter 7 distribution: Fully secured creditors can’t be subject to these kinds of actions.

Preference Defenses for Creditors

Even if all of these elements for preference claims are established, there are preference defenses for creditors, depending on the situation. They protect arm’s length, good faith efforts by creditors who are taking a risk by doing business with a struggling organization.

Examples of Preference Defenses for Creditors

  • Contemporaneous exchange for new value: The law encourages creditors to keep a business going. The creditor provides new value to the debtor in exchange for a preferential transfer.
  • Subsequent new value: A creditor shouldn’t give up a transfer for which the creditor later provided new value to the debtor. If the creditor provides goods or services to a financially troubled company, it shouldn’t have to pay to the bankrupt estate part or all of that transfer.
  • Ordinary course of business: Payments by the debtor were made in the ordinary course of business of the debtor and creditor, according to ordinary business terms.

The Next Step for Preference Actions Under Bankruptcy

The bankruptcy process should be fair and played by the rules. Whether you’re a debtor or creditor, you should hire a business bankruptcy attorney to protect your legal rights and interests to make sure you’re not short-changed.

If you are a business owner who is considering filing for bankruptcy, a creditor whose debtor is in serious financial trouble or has filed for bankruptcy protection, or you want to know more about the preference claims process, call our business bankruptcy lawyers at Bunch & Brock today at 859-254-5522 to schedule a consultation.