Creditors face unanticipated risks when customers file for bankruptcy protection. One such risk is “preference liability,” where the bankruptcy estate seeks to claw-back payments made to a creditor within the 90-day period before the bankruptcy filing. In this circumstance, a creditor’s first notice of its potential obligation to pay back such “preference” payments is the receipt of a demand letter.
Understandably, the receipt of a preference demand letter may be met with frustration and possibly anger by a creditor that rightfully provided its customer with goods or services. Receiving a demand letter, or even being served with a complaint, however, does not mean that the creditor will be required to pay back the funds in question. Rather, the U.S. Bankruptcy Code contains several provisions that, if correctly used, can shield a creditor from “preference” liability. In fact, in December 2020, creditors received an additional, powerful tool that, if properly used, will protect certain creditors who attempt to work with a distressed customer by permitting the customer to enter into a payment plan for amounts overdue on a nonresidential real property lease or a supply agreement.
What Are Preferences?
Preference liability is set forth in Section 547 of the Bankruptcy Code. Specifically, Section 547(b) of the Bankruptcy Code defines a preference payment as: (i) a payment by a debtor to a creditor for an antecedent debt; (ii) made while the debtor was insolvent; (iii) within 90 days of the bankruptcy filing (or longer for “insiders” of the debtor); (iv) that enables the creditor to receive more than the creditor would have received if the payment had not been made and the creditor’s claim was paid through the bankruptcy proceeding.
One intent behind Section 547 was to provide for an equality of distribution amongst a company’s creditors during the time a company was insolvent. To a creditor who provided services or sold goods to a company that soon thereafter files a bankruptcy petition, however, the provisions can seem patently unfair.
To help address the fairness of preference provisions to creditors, Congress included several well established preference defenses in the Bankruptcy Code. The three most common defenses against a preference action are as follows:
- Contemporaneous Exchange. If a creditor provides new goods or services at or near the same time as a customer paid the creditor, the Bankruptcy Code would not require the creditor to return the payment in question.
- Ordinary Course of Business. If a payment was made to a creditor based on the terms of the contract or business relationship between a creditor and its customers or on the ordinary business terms of the industry in question, the creditor would not be required to return the funds. This preference defense is intended to encourage creditors to continue doing business with financially troubled debtors.
- New Value. A creditor is permitted to keep an allegedly preferential payment if it can show that it provided “new value” — meaning it provided additional goods or services after the payment was received.
Recent Developments in Preference Actions
On top of the three common defenses identified above, Congress recently provided enhanced protections to creditors who attempt to work with their distressed customers. Specifically, the Consolidated Appropriations Act of 2021, which incorporated stimulus relief for the COVID-19 pandemic, included a provision broadening creditors’ preference protections by shielding from liability certain situations in which a creditor permits a troubled customer to enter into a payment plan with the creditor. This provision, codified as Section 547(j) of the Bankruptcy Code, protects both landlords and suppliers of goods or services.
The provision protects payments received by a creditor based on a payment plan entered on or after March 13, 2020, related to nonresidential real property leases and supply agreements entered before March 13, 2020, with a distressed company. If such a payment plan equals the total amount due that was agreed to between the parties in the original pre-March 13, 2020, agreement, and if the payment plan does not include fees, penalties or interest exceeding that due under the original agreement, Section 547(j) would shield the creditor from preference liability.
Before the insertion of section 547(j) into the Bankruptcy Code, there was little incentive for a supplier or lessor to place a distressed customer on a payment plan, due to the risk of preference liability if the distressed customer filed a bankruptcy petition. Section 547(j), at least for the time being, provides creditors with strong preference protections while giving borrowers breathing room to pay amounts overdue on leases and contracts.
The protection afforded creditors under subsection 547(j) expires on December 27, 2022.
Although the preference defenses set forth above appear straightforward, the application of each defense is more nuanced then it appears and creditors should consult with an experienced professional to avoid potential preference liability pitfalls if they have any serious concerns about an account debtor’s payment irregularity or financial health.