Healthy companies are probably not thinking about bankruptcy right now, but perhaps they should. While business bankruptcy filings have declined in recent years, bankruptcy litigation filings (adversary proceedings) have bucked that trend in certain jurisdictions. According to statistics published by the Administrative Office of U.S. Courts, the number of bankruptcy litigation filings grew last year in 10 districts, the most notable being the District of Delaware where bankruptcy litigation filings rose 72 percent. Rest assured, if there is money that might be recoverable, then debtors, trustees, creditors’ committees, and creditor trusts will think long and hard about using bankruptcy litigation to recover it.
Understanding preference actions under the Bankruptcy Code
One of the most difficult client conversations for a bankruptcy attorney relates to the topic of preference actions. It arises when a client receives a letter or, worse, a lawsuit containing a demand for the return of payment from a company that has since filed bankruptcy. The most common reaction to such a demand is: “How can that be? They owed us that money!” The answer is that the Bankruptcy Code allows it. Strange as it may seem, there is a reason for this – to ensure that all creditors receive equal treatment.
Prior to a bankruptcy filing, a debtor may “prefer” some creditors by paying them, while not paying others. That leaves the creditors that got paid in a better situation than those that did not. Since the goal of bankruptcy, generally, is to treat all similarly situated creditors equally, the Bankruptcy Code provides a mechanism for dealing with any such preferential treatment. This is what is more commonly known as a preference or avoidance action.
The Bankruptcy Code describes a preference as a transfer of an interest of the debtor in property:
- To or for the benefit of a creditor
- For or on account of an antecedent (pre-existing) debt
- Made on or within 90 days of the bankruptcy filing (or 1-year for an insider transfer)
- Made while the debtor was insolvent
- That allows the creditor to receive more than it would have received in a chapter 7 bankruptcy case, or if the transfer had not been made
Defending preference claims
Preference actions are a part of bankruptcy law. Fortunately, there are certain circumstances in which an alleged preference payment does not have to be returned. In future alerts, I’ll examine some of the preference defenses that can be used if return of payment is demanded of you or your company. In the meantime, remember that a reliable bankruptcy attorney can help your company navigate – or avoid – troublesome bankruptcy litigation.
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