When a company files for bankruptcy, creditors receive a notice from the bankruptcy court and must halt all collection efforts, including legal proceedings, outside of the confines of the bankruptcy forum. See our article on Bankruptcy: the Constitutional Right to Start Over.
This can come as quite a shock to the company which has extended credit to the now bankrupt company, but that is nothing to the shock that can arise a few months later when the creditor receives notice (or is subject to litigation begun in the bankruptcy court) alleging “preferential” payments” were made and that the creditor has to repay to the bankruptcy trustee or creditor’s committee all sums received from the debtor for the ninety days prior to bankruptcy.
This can be a staggering blow to a business which has received sizable payments from the debtor and the outrage of the creditor business is predictable. It is not usual for millions of dollars to be reclaimed by the trustee in bankruptcy and if not promptly repaid, the trustee will soon file suit in the Federal court having jurisdiction of the debtor and that can be thousands of miles from the locale of the creditor.
There are valid defenses to a claim to retrieve “preferential payments” and this article shall outline one way in which the creditor can resist the claims. Of course, competent legal counsel and excellent business records will be essential for any business seeking to allege this defense. The Ordinary Course of Business Defense to Preferential Claims in Bankruptcy is discussed in a companion article.
The Basic Preference Laws in Bankruptcy:
The preference laws are intended to further the bankruptcy policy of equality of treatment between creditors. Within the 90-day period prior to filing bankruptcy (the “Preference Period”), some creditors receive payment but many do not. By forcing the return of transfers made during the Preference Period, the debtor-trustee ensures that the assets of the bankruptcy estate are increased. The assets of the estate are then distributed to creditors on a pro rata basis in accordance with the distribution priorities set forth in the Bankruptcy Code. In this manner, creditors that were not “preferred” have a better chance to recover a percentage of their claims. The key is payments made in the 90 days prior to bankruptcy filing.
Normally, any payment received during the ninety days prior to filing bankruptcy are to be repaid to the trustee in bankruptcy for such pro rata distribution and if the creditor refuses to repay the sums, suit is brought against the creditor in the bankruptcy court. Most bankruptcy trustees are quite aggressive in filing such actions and pursuing them to judgment. They do not care how much was owed the creditor-defendant nor what promises were made by the debtor as to the payments prior to filing bankruptcy. Large bankruptcies commonly have a dozen or more such preferential payment retrieval actions filed.
But there are valid defenses and the one discussed herein is the New Value Defense.
Basic New Value Defense:
A defendant resisting the claim of the trustee for preferential payments may have a defense pursuant to section 547(c)(4). Section 547(c)(4) provides:
[The trustee may not avoid under this section a transfer-- (4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor—(A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.]
11 U.S.C. § 547(c)(4).
Note that to meet the requirements of the new value defense, new value must (i) be given to the debtor after the preferential transfer; (ii) be unsecured; and (iii) remain unpaid. Mosier v. Ever-Fresh Food Co. (In re IRFM, Inc.), 52 F.3d 228, 230 (9th Cir. 1995).
“[S]ubsequent advances of new value may be used to offset prior (although not immediately prior) preferences. A creditor is permitted to carry forward preferences until they are exhausted by subsequent advances of new value.” Id. at 232.
The underlying rationale for the new value defense is to encourage creditors to continue to supply product or services to companies that may be in economic trouble but have yet to file bankruptcy. The courts reasoned that without such encouragement, the danger of bankruptcy would be a self fulfilling prophecy since the very danger of such bankruptcy would dry up all sources of vendors to supply the troubled company.
Thus the essence of the defense is to demonstrate that the payment received during the ninety days prior to bankruptcy was for product or services rendered during that time or in the future, NOT for pay down of an old debt. Thus the payment must be tracked directly to the delivery of new product or service.
Why no security allowed for the new value sale? Again, that would place the creditor in a position of seeking to improve his credit position at the possible expense of other creditors, thus preferential.
Note that this defense can be utilized in conjunction or separately from the Ordinary Course of Business defense.
The strong policy in the bankruptcy courts to provide means for struggling companies to remain in business by encouraging creditors to continue credit underlies this defense and once the creditor can demonstrate these were simply ongoing sales to a customer, the preferential transfer claims can be avoided. The key, again, is good record keeping, good advice from a capable CFO, accountants and attorneys, and some patience as the trustee and, perhaps, the judge reviews the records.