Receiving a bankruptcy preference demand letter can be scary, infuriating and confusing. Often, you are aware your customer or client has filed for bankruptcy and that you are likely going to have to write-off some unpaid invoices; however, you are not prepared for the preference demand letter from the bankruptcy trustee demanding you pay back the monies you received from the customer or client in the 90 days prior to the bankruptcy proceeding – until now. Below are key details on actions you should take.
You may be asking “what is a preference?” Section 547 of the Bankruptcy Code permits a bankruptcy trustee (or certain other parties) to “claw back” payments made to creditors in the 90 days prior to a debtor’s bankruptcy filing. In some instances, during the few months prior to the bankruptcy filing, a debtor may have chosen to pay certain creditors and not others. The intent behind Section 547 of the Bankruptcy Code is to promote equality among creditors and to require creditors to return payments made by the debtor in the 90 days prior to the bankruptcy filing to be redistributed to the entire creditor body in a more equitable fashion. In short, it is an attempt to level the playing field amongst similarly situated creditors.
So, what do you do when you receive a bankruptcy preference demand letter?
1. Do Not Ignore the Demand Letter
While the bankruptcy trustee may have a legitimate claim to recover as a “preferential transfer” the monies you received in the 90 days before the bankruptcy filing, there are defenses that may limit or eliminate liability. Too often, creditors simply ignore the trustee’s demand letter because the creditor believes “I didn’t do anything wrong,” or they think “I was simply paid what I was owed.” However, burying your head in the sand will not make the issue go away.
If you ignore the preference demand letter, then it is highly likely the bankruptcy trustee will file a lawsuit against you in the bankruptcy case (called an adversary proceeding), demanding the entire balance you were paid in the 90 days before bankruptcy. At that point, you can either: (1) try to settle the case for likely a larger amount than if you had not ignored the demand letter; (2) retain an attorney to defend the lawsuit; or (3) ignore the lawsuit and likely be held liable for the full amount of the demand.
2. Do Not Pay the Amount Demanded in the Letter
So, you now know not to ignore the demand letter, what next? Should you pay the amount demanded? The answer is “NO!” Oftentimes, the bankruptcy demand letter will set forth the full amount owed and offer a reduced amount the creditor can pay to resolve the claim (typically between 85 to 95% of the full demand).
However, if you do not ignore the demand letter and, alternatively, respond to the demand letter explaining your defenses under bankruptcy law, it is common that you can resolve the issue without the need for litigation and for a fraction of the amount originally demanded. Do not simply pay the demand because you do not want the legal trouble. As frustrating as the demand may be, especially when the debtor still owes you money, your approach should be similar to any other potential legal business exposure – which is to pay as little as possible for your legal peace of mind.
3. Gather Your Records
The key to efficiently and effectively resolving a preference demand is substantiating available defenses with relevant business records. The three most common defenses are that a payment in the 90 days before the bankruptcy was filed was: (1) made in the ordinary course of business; (2) a contemporaneous exchange for value; or (3) offset by new value provided by the creditor after the payment was received.
The ordinary course defense generally applies when a payment is made in the ordinary course of business between you and the bankrupt company. In determining whether a payment was made in the ordinary course of business, courts consider the timing, credit terms, manner of payment and collection efforts surrounding the payment at issue, versus those same factors during the parties’ historical baseline period. Thus, to substantiate an ordinary course of business defense, you will need invoice and payment records showing the timing, manner and terms of payment during the 90 days before bankruptcy and during the 1 to 2-year “baseline” period before then. Importantly, if the alleged preference payment was the first transaction between you and the debtor, or if you do not have a long history of transactions between you and the debtor, the ordinary course of business defense may still apply.
The other two common defenses – contemporaneous exchange and subsequent new value – apply where you have provided valuable goods or services to the bankrupt company, either around the same time or after the alleged preference payment was made. Examples of “new value” are providing new goods or services to the debtor, making a new loan or extending credit to the debtor or releasing a previously transferred property interest to the debtor (among others). To substantiate these defenses, you will need invoice and delivery records confirming the timing and value of the bankrupt company’s receipt of goods or services. Other defenses may also apply depending on your situation, such as where the payment was a prepayment, or if the payment was fully secured by collateral.
4. Consult an Attorney Immediately
Upon receiving a preference demand letter, do not wait to consult bankruptcy counsel. Armed with the relevant information, experienced counsel can quickly size up the claim, assess potential defenses, provide an accurate estimate of potential exposure and devise the most effective strategy for resolving the claim. By contrast, as discussed above, once litigation has commenced, you will need counsel to represent you in the Bankruptcy Court, compounding your legal expense and increasing the ultimate price of resolving the claim. The key to success is for you to act promptly when you receive a demand letter. Harris Beach Murtha’s bankruptcy attorneys have successfully resolved thousands of preference claims arising out of bankruptcy proceedings all over the country and have the experience necessary to provide you the most effective representation in each case.
If you are dealing with customers or clients who are having financial difficulties, or if you are facing your own financial struggles, the experienced Financial Restructuring, Bankruptcy and Creditors’ Rights Practice Group at Harris Beach Murtha have a proven track record to address and resolve your situation in an efficient and cost-effective manner.
If you have any questions about the matters in this Legal Alert, please contact attorney Brian D. Roy at (315) 214-2052 and broy@harrisbeachmurtha.com; attorney Robert E. Kaelin at (860) 240-6036 and rkaelin@harrisbeachmurtha.com; or the Harris Beach attorney with whom you most frequently work.
This alert is not a substitute for advice of counsel on specific legal issues.
Harris Beach Murtha’s lawyers and consultants practice from offices throughout Connecticut in Bantam, Hartford, New Haven and Stamford; New York state in Albany, Binghamton, Buffalo, Ithaca, New York City, Niagara Falls, Rochester, Saratoga Springs, Syracuse, Long Island and White Plains, as well as in Boston, Massachusetts, Newark, New Jersey and Washington, D.C.
