A Three Question, Preliminary Self Assessment of a Bankruptcy Preference Claim

By asking and answering three simple questions, a bankruptcy preference defendant can perform a rough cut, preliminary self-assessment of exposure to an avoidable transfer claim under Section 547 of the Bankruptcy Code.  The three questions are:

  • During the 90 days before the bankruptcy was filed, what was the total of the payments the debtor made to you against obligations that existed before the date of payment?
  • What is the difference between the highest amount you were owed at any time during the 90 days before the bankruptcy filing and the amount you were owed on the date of the bankruptcy filing?
  • During the 90 days before the bankruptcy filing, was any aspect of the payments you received (e.g. timing, amount, method) different from the payments made before the start of the debtor’s financial distress?

What will the answers to these three questions tell you?

Answers to these three questions should give you an idea of how the preference claim looks after being filtered through a few fundamental bankruptcy preference concepts.

Answers to these questions will not tell you how much you owe or how your preference defense will end up.  These questions and answers provide a starting point, but not an end point, in the process of defending against a bankruptcy preference claim.  After answering these questions you should know the total amount of potential liability for avoidable transfers and the extent to which the three most common defenses are likely to apply in your favor.

Importantly, the process of answering these questions will provide an initial, practical bridge between the statements of bankruptcy preference law that you find on this website and the circumstances of your bankruptcy preference defense.

The Purpose and Concepts behind Question 1 – During the 90 days before the bankruptcy was filed, what was the total of the payments the debtor made to you against obligations that existed before the date of payment?

The answer to the first question is an estimate of your baseline bankruptcy preference exposure.  It goes to the heart of bankruptcy preference analysis by identifying the transfers that are subject to avoidance and recovery.

There are three steps in answering Question 1.

Step One – Define the start and end dates of the “Preference Period”.

Step Two – Add up all the payments you “received” during the preference period.

Step Three – Subtract payments you received as prepayments against goods and services you later provided.

Step One requires that you identify the start date of the “Preference Period” by counting backwards 90 days from the date of the bankruptcy filing, excluding the date of the bankruptcy filing and including the 90th day.  For more help on determining the start date of the Preference Period click here. The end date of the Preference Period is the date the bankruptcy was filed.

Step Two requires that you add up all the payments you “received” during the Preference Period.  In the case of payments by check, bankruptcy preference law generally considers the date that the funds were removed from the debtor’s bank account to be the date of your receipt.  (Make sure that the debtor’s checks did not bounce.  A bounced check is not a transfer.)

Of course, there is no way for you to be certain when a check you deposited was debited from the debtor’s account.  For this reason, look to see if any payments by check from the debtor were credited to your account within 3 days before the preference period and recognize that these fringe payments also may turn out to be within the Preference Period.  For a discussion of identifying the preference payment click this link.

If the payment was in the form of a cashiers check or wire, the date the funds were credited to your account will be the date the transfers were made for bankruptcy preference purposes.

To complete Question 1, Step Three takes out of the total of all potential avoidable transfers (the Step Two total) any prepayments against later provided goods or services.  Prepayments can never qualify as an avoidable transfer since the payments were not made to satisfy an “antecedent debt”.  To learn more about the concept of “antecedent debts”, click this link.

By answering Question 1, you have estimated the total of all potentially avoidable transfers.

The Purpose and Concepts behind Question 2 – What is the difference between the highest amount you were owed at any time during the Preference Period filing and the amount you were owed on the date of the bankruptcy filing?

The answer to the second question provides a threshold determination of the limits of protection afforded by two of the three most common defenses against bankruptcy preference liability.  The three steps in answering this question are:

Step One – Determine the largest amount you were owed by the debtor at any time during the 90 days before the bankruptcy filing.

Step Two – Determine the amount you were owed by the debtor on the day of the bankruptcy filing.

Step Three – Subtract the Step Two amount from the Step One amount.

If the result of these three steps is zero or a negative number, the concepts underlying bankruptcy preference law support a conclusion that you should not owe a preference.  If the answer is a positive number, this is the amount by which you “improved your position” during the preference period.  To the extent you improved your position during the Preference Period, two of the key defenses are unlikely to be available and you will need to look to other defenses and circumstances that still may protect these payments from preference liability.

Question 2 hits at the very reason bankruptcy preferences exist.  The concept behind bankruptcy preferences is that, during the Preference Period, a creditor should not be allowed to reduce its credit exposure to a debtor by receiving payments at the expense of other creditors.

Correspondingly, Question 2 sheds light on the availability – and the limits — of 2 of the most common and frequently applicable defenses that rely on the “no improvement in position” concept – the “subsequent new value” defense and the “contemporaneous exchange for new value” defense.  Click either of the following links to read a more detailed explanation of the subsequent new value defense and the contemporaneous exchange for new value defense. Both defenses are intended to protect from avoidance any payment to the extent that it can be paired with “new value” provided to the debtor.  Neither defense can operate to protect payments to the extent that, during the preference period, payments by the debtor exceed new value given by the creditor.

The answer to Question 2 will not tell you affirmatively that either the subsequent new value defense or the contemporaneous exchange defense is available.  In the bankruptcy courts of some states, an unfortunate interpretation of the subsequent new value defense [FN1] results in Question 2 giving a “false negative”.  Additionally, the contemporaneous exchange for new value defense is notoriously difficult to establish because of its proof requirements.

Despite its uncertainties, the answer to Question 2 the answer provides a good initial, disqualifying indication of the applicability of the subsequent new value and contemporaneous exchange defenses.

The Purpose and Concepts behind Question 3 – During the 90 days before the bankruptcy filing, was any aspect of the payments you received (e.g. timing, amount, method) different from the payments made before the start of the debtor’s financial distress?

The answer to question 3 will provide the limits of protection afforded by the third most common defense to a preference claim.  The three steps in answering this question are:

Step One – In the history of your dealings with the debtor, identify a 6 month period (ending at least one year before the bankruptcy filing) during which the debtor was not in financial distress (this is called the “baseline period”;

Step Two – Identify the payment cycle and any other key payment terms (such as manner of payment) that existed during the baseline period; and

Step Three – Compare the historical relationship during the baseline period against the payment history and terms during the 90 days before the bankruptcy filing.

If there is no variation in payment terms between the baseline period and the preference period, then the Bankruptcy Code protects otherwise preferential payments as payments made “in the ordinary course” of the relationship between you and the debtor.  You can review a more detailed explanation of the “ordinary course of business” defense by clicking on this link.

The answer to Question 3 does not have to be all or nothing.  There may be some payments that you can say were made consistently with a historical baseline of dealings and some payments that were inconsistent.  To the extent that payments were inconsistent, the “ordinary course of business” defense will not be available

Summarizing Your Answers

In preparation for your initial conference with your counsel, you might summarize the answers to your three questions as follows:

The total possibly avoidable transfers received from the debtor during the preference period equals $_______ (A).

During the preference period the amount owed by the debtor was reduced by $______ (B) (insert $0 if the amount owed increased or stayed the same) and the product of (A) minus (B) – $__________ -  is the maximum amount that is likely to be insulated from preference liability by application of either of the “new value” defenses.

Approximately $_______(C) of the payments received during the preference period might be characterized as inconsistent with the historical course of business dealings with the debtor and the product (A) minus (C) – $__________.-  is the maximum amount that might be insulated from preference liability by application of the ordinary course of business defense.

Next Steps

As we explain in more detail in another article, in the case of multiple payments during the Preference Period, you can mix and match defenses.  What may not be covered by one defense might covered by another.  The objective is to cover ever payment with one or more defenses.

The next steps, which are beyond the scope of this initial assessment, involve analyzing each payment, one by one, to see which of the three defenses discussed above or which of the multiple other defenses to a bankruptcy preference claim might apply to protect each of the payments. And you also should never ignore the elements of a preference claim that the preference claimant is required to prove under Section 547(b), which typically require information that you do not control or have access to.

On a final note, one of the most important skills in bankruptcy preference defense is the preparation of a comprehensive, convincing presentation.  Please keep in mind, your self assessment is intended to help you seek and obtain legal advice and is not something that you would ever want to use in a presentation to a bankruptcy preference claimant.

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[FN1]The unfortunate interpretation in some states of the subsequent new value defense precludes its application where a creditor receives payment for the goods or services that otherwise would constitute new value.  This interpretation means that a creditor only gets subsequent new value credit if it is still owed for the new value at the time the petition is filed.