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I Have to Give Back the Money?

In the most difficult economic times the country has seen in decades, bankruptcies have risen dramatically.  Obviously bankruptcies do not affect only the individuals and businesses filing them.  For example, companies with outstanding accounts receivable are likely to collect only pennies on the dollar, if they are lucky, when a customer lands in bankruptcy court.  But if your company received that big payment before the customer filed bankruptcy, you're sitting pretty.  Or so you think until you receive a letter or, even worse, a complaint telling you that the money must be returned because it was a "preferential payment."  Huh?

The Bankruptcy Code defines a preferential payment as one made:

  1. to or for the benefit of a creditor;
  2. for or on account of an antecedent debt owed by the debtor before such transfer was made;
  3. made while the debtor was insolvent;
  4. made – (A) on or within 90 days before the date the petition was filed; or (B) if the creditor was an insider, on or within one year before the date the petition was filed; and
  5. that enabled the creditor to receive more than the creditor would have received if – (A) the case were a case under Chapter 7 of the Bankruptcy Code; (B) the transfer had not been made; and (C) the creditor received payment of such debt to the extent provided by the provisions of Chapter 7.

This is the Bankruptcy Code's way of saying that a payment made by a debtor while insolvent will be considered a preferential payment.  Although this, in itself, isn't disturbing, the fact that a bankruptcy trustee or someone else responsible for the bankrupt estate may seek to recover the preferential payment is.  Furthermore, a preferential payment can be filed up to two years after the debtor files bankruptcy, creating the real potential for good faith creditors to get blind-sided.  And speaking of good faith, the Bankruptcy Court does not impose any "fault" element before a preferential payment can be recovered.  In other words, you can receive a payment from a debtor in good faith with no idea that the debtor is in difficult financial straits and still get stuck in a preference action.  Although it can be a difficult pill to swallow, the policy behind recovery of preferential payment makes sense:  ensuring that all of the now-bankrupt party's debtors are treated fairly.  That is, when that customer made the big payment to you, someone else was probably not paid.

While the Bankruptcy Code can provide creditors receiving payment a real shock, it also provides them defenses in actions to recover preferential payments.  The are laid out in Bankruptcy Code section 547(c):  1) transfer was made in a contemporaneous exchange of new value to the debtor; 2) transfer was made in the ordinary course of business; 3) transfer was a security interest in property securing new value to the debtor; 4) transfer was made before the creditor provided new value; 5) transfer was a security interest in inventory or a receivable, such as a floating lien, that did not impair other creditors; 6) the transfer was the fixing of a statutory lien; 7) transfer was of an alimony or child support payment; or 8) transfer was of property with an aggregate value less than $600.00.

Of course, not all of these defenses are easy to apply, or even to understand.  However, they do provide the basis for negotiating when hit with or threatened with an action to recover an alleged preferential payment.  The important point is that you should not automatically make out a check for the full amount demanded when a trustee or other representative of the bankrupt party makes a claim.  However, before deciding how to respond, consider whether you have received a demand letter or a complaint.  A demand letter does not compel your appearance in Bankruptcy Court and provides you time to negotiate.  If you have been served with a complaint, however, your time for responding will be limited and you should seriously consider consulting an attorney.  The same is true if you are hit with a substantial demand, regardless of whether in the form of a letter or a complaint.  Some preference claims are so big they present the real possibility of driving the party receiving the demand into insolvency.

Michael McMahon – mmcmahon@carnaclaw.com