Chapter 1 Introduction to Preference Analyses and the Ordinary Course of Business Defense

• Jurisdiction: United States

Chapter 1 Introduction to Preference Analyses and the Ordinary Course of Business Defense

Given the economic turmoil observed across a variety of industries in recent years, the possibility of receiving preference demand letters has been a significant concern for creditors of all types. According to § 547 of the Bankruptcy Code, after filing for bankruptcy, the trustee or debtor-in-possession may recover transfers occurring in the 90 days prior to the filing, provided the transfers meet certain criteria. Conversely, the creditor has several defenses against preference claims to retain transfers previously received.

What constitutes a preference has been the subject of many differing opinions since the passage of the Bankruptcy Reform Act of 1978. By way of example, in a 1998 ruling, the Seventh Circuit provided one definition of a preference when it wrote that a "sudden payment in full of all debts in a discrete category, in anticipation of bankruptcy and for the purpose of helping a favored class of creditors, is the paradigm of a preference."¹

In the Jan. 4, 2012, opinion of Hon. Judge Christopher J. Sontchi of the U.S. Bankruptcy Court for the District of Delaware, a comprehensive assessment of preference law and its underpinnings was provided.² Judge Sontchi attempts to provide the reader with an economic understanding of why bankruptcy law exists and what equities it is trying to balance. He notes "[t]he basic problem that bankruptcy law is designed to address is that the system of individual creditor remedies, i.e. 'first come; first served,' may harm creditors as a whole when there are insufficient assets to pay all of them in full." He goes on to discuss how preference law specifically addresses this dilemma: "Preference law enters the picture because the descent of a company into bankruptcy takes time. This allows the more diligent, individual creditor to opt-out of the compulsory, collective proceeding of bankruptcy by exercising its individual, state law remedies or, at least, by pressuring a potential debtor to pay the creditor's claim ahead of other claims."

Bankruptcy law attempts to address this by providing trustees and debtors-in-possession with the opportunity to recover from creditors those payments that might have been preferential, as described by Judge Sontchi. In most bankruptcies, the trustee or debtor-in-possession is permitted by law to review any payments ("transfers") in the 90 days prior to the bankruptcy filing.³

Creditor Defenses to Preference Claims

The Bankruptcy Code provides guidance on how a debtor can assess when a payment might have been preferential, to the detriment of other creditors. As Judge Sontchi notes, this guidance requires "consideration of evidence unique to the creditor that received the preferential payment." The exceptions that are to be considered include the "ordinary course of business" defenses and the "subsequent new value" defense. Judge Sontchi explains that "[t]he...