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Howard Kleinberg Authors ,"Bankruptcy Basics: What You Need to Know!" for Breakfast Journal

Jun 1, 2005

Publication Source: Arrington’s Bed & Breakfast Journal


“I haven’t done business with that bankrupt company in years. Why are they demanding money from me now and threatening to sue me.”

“They don’t owe me any money; I am not a creditor of theirs. What right do they have to sue me.”

“We did business with them before they filed for bankruptcy and then stopped; how can they sue me for ordinary payments of invoices for goods or services that we actually provided to them and from which they benefited.”

These, and other similar questions and expressions of disbelief, are common among business owners and managers who find themselves caught in the complicated tangle of economics and law that constitute a modern business bankruptcy case.

The answer to why you are being sued now by a bankruptcy company or its trustee lies deep in the heart of the United States Bankruptcy Code where section 547 of the federal statute sets forth the law of “preferences” or “avoidance of preferential transfers.”

The law reflects a federal policy that those who received payments from a bankrupt company during the 90 day period preceding that company’s filing for bankruptcy should return those payments to the bankrupt company (“debtor”). The theory is that those who received such payments were “preferred”, whether intentionally or not, over those who did not receive any payments from the debtor during such prescribed period. Once the recipients of the preferred payments return the money to the debtor’s bankruptcy estate, the money can be pooled and redistributed on a pro rata basis to all creditors of the company, thus promoting one of the fundamental policies of the federal bankruptcy laws, equality of distribution.

Section 547 of the federal Bankruptcy Code, and the common law that has developed around it, is fraught with complications and uncertainty. For example, should the 90 day period during which payments and transfers are subject to attack be counted back from the date that the debtor filed its bankruptcy petition or forward from the date of the payment or transfer.

Complications and details aside, the basics of the law are as follows. The Bankruptcy Code allows a debtor, or a bankruptcy trustee that may have been appointed for the debtor, to sue to recover a payment made by the debtor, or a transfer of property of the debtor, that occurred on or within 90 days before the date of the filing of the petition in bankruptcy.

The recipient (transferee) must have been a creditor of the debtor at the time of the transfer and the transfer must have been on account of a prior (antecedent) debt owed by debtor before the transfer or payment was made. This is usually the case where an invoice is outstanding.

Other technical rules include that the transfer by the debtor must have been made while the debtor was insolvent, but the Bankruptcy Code grants the debtor a presumption that it was insolvent during the 90 day period before the bankruptcy case was commenced. In addition, the transfer must enable the recipient to receive more than the recipient would have received if the transfer had not been made and the recipient had made a claim against and received payment from the debtor’s bankruptcy estate as an ordinary unsecured creditor.

Preference law is considered “objective” in that, for the most part, the intent of the debtor in making the payment and the vendor in receiving the payment do not matter. It is also important to realize that the federal bankruptcy system allows debtor companies to bring lawsuits to recover these preferential transfers with relative ease. Because there is nationwide jurisdiction and service of process in bankruptcy, a company that files for bankruptcy in California can sue a New York recipient of a transfer simply by mailing a summons and complaint to the New York defendant. This requires the New York company to answer the lawsuit in the California court.

The law gives the debtor or trustee up to two years to bring such a lawsuit and many of these types of lawsuits are commenced close to the two year deadline. That passage of time helps explain the shock and surprise that many vendors experience when confronted with a demand letter or lawsuit over an account that they haven’t done business with in years or, worse yet, have been doing regular business with during the administration of the bankruptcy case without any idea that they could still be hit with such a demand for payment or lawsuit.

Because all payments and transfers made by the debtor company during the 90 day pre-bankruptcy period are swept up by this law, the preference statute generates a large number of lawsuits in the bankruptcy courts. It is also one of the most highly litigated areas of bankruptcy law because of the nuances of many of the defenses available to recipients.

So what should you do if your company receives either a pre-lawsuit letter from the debtor or trustee demanding payment of the amount claimed to be an avoidable preferential transfer or a summons and complaint initiating a lawsuit against you in bankruptcy court for recovery of such a payment? It is really indispensable that you consult a bankruptcy attorney. The lawsuit cannot be ignored because if the complaint is not answered in court within 30 days, a default may be taken against you and a judgment entered of record for the full amount claimed. Moreover, while the Bankruptcy Code certainly creates an ample opportunity for the debtor or trustee to increase the bankruptcy pot at your expense by attacking these pre-bankruptcy payments, it also provides numerous bases to defend against these attacks.

There are basically two broad lines of defense available to preference recipients. One is to challenge whether the debtor or trustee can prove the basic elements, as set forth above, necessary to prove the case against you. For example, the invoice terms that you provided to the debtor and the timing of the debtor’s payments may be such that, in fact, you were not a creditor at the time of payment or there was no preexisting antecedent debt.

In addition, the Bankruptcy Code sets forth seven “affirmative defenses.” One of the most commonly used of these defenses is that the challenged transfer was made in the “ordinary course of business.” This defense is based how long after invoicing the challenged payments were made as compared to the history of invoicing and payment between the two companies.

Another commonly used defense is “new value.” This allows the recipient to offset against a challenged transfer, assuming it otherwise meets the standards for avoidance, the value of any goods or services provided on credit to the debtor following the date of any particular challenged transfer.

A skilled bankruptcy practitioner can often use the affirmative defenses, other nuances of preference law and litigation strategies in a cost effective manner to gain an outright defeat of a preference claim. Alternatively, a vigorous defense can be mounted that creates an environment discouraging to the debtor or trustee such that a settlement favorable to the recipient can be achieved.