Preferences (Preferential Transfers)

Under the U.S. Bankruptcy Code, a payment may be considered a preference if it can be proved that the payment was:

• a transfer of the debtor's assets;
  
• made for the benefit of a creditor against an outstanding indebtedness owing by the debtor; and
• made within 90 days of the debtor's bankruptcy filing (or one year for payment to or for the benefit of an insider);
• made when the debtor was insolvent; and
• enabled the creditor to receive more than it would have in a Chapter 7 liquidation.

In a Bankruptcy, a trustee has the power to avoid preferential transfers that occurred during the preference period. The theory behind preference avoidance is that all general unsecured trade creditors should be treated equally and suffer the same (proportionate) loss when a customer files for bankruptcy protection, and any creditor that receives a greater payment than similar creditors during the preference period must disgorge (return) the preference to the debtor.

Fortunately, not all transfers made within the preference period are avoidable by the trustee. For general unsecured trade creditors, the most potent defenses against demands made to return transfers made during the preference period include these:

1. The new value exception.

This applies when a creditor has sold goods or delivered services to the debtor and the debtor made a series of payments to the creditor during the preference period. To the extent that a creditor extends new value to the debtor by shipping goods or providing services on open account terms, the "new value" reduces the amount of the preference claim. In most jurisdictions, trade creditors can carry preferences forward until they are fully offset by subsequent new value. This methodology recognizes that open account credit involve a series of payments and shipments. In order for the new value defense to apply, all of the following must be true:

a. the creditor receives a transfer which would be avoidable but
b. after receipt of the preferential transfer, the creditor advanced additional credit (ships additional product) to the debtor on an unsecured basis and
c. that additional credit advanced to the debtor was unpaid when the debtor filed bankruptcy.

2. The ordinary course of business exception.

Under this legal theory, a trustee cannot avoid a transfer made during the preference period if transfer was in payment of a debt incurred by the debtor in the ordinary course of business, and payment was made according to ordinary business terms. The ordinary course exception to the preference rule was written to give trade creditors a reason to continue to extend credit to a customer in financial trouble.

3. The contemporaneous exchange of value exception.

The trustee cannot avoid a preference payment if a creditor can prove that the transfer was intended by the debtor and the creditor to be a contemporaneous exchange for new value given to the debtor, and the transfer was in fact a substantially contemporaneous exchange. [An example would be a sale made on COD terms within the 90-day preference look back period]. This exception only protects preference transfers to the extent that the value given to the creditor equals the value the debtor received.

Source: Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.