A debtor’s bankruptcy is never a good thing (usually it means little or no payments on the debt will be forthcoming). Even greater insult to this injury is to receive a demand letter from a chapter 7 Trustee asking that you return funds paid to you by the account debtor in the days or months preceding the bankruptcy filing, which you have undoubtedly already used. This un-Godly process typically begins with the receipt of a letter from the chapter 7 Trustee or his law firm advising that their review of the debtor’s books and records indicate an avoidable transfer has taken place and the funds should be returned or litigation will ensue. The demands – or dare I say “shake-downs” – often include a proposal for settlement. Before you whip out your check book and return your “hard earned” – or at least hard fought/sought for – money, you should consult with a bankruptcy attorney to find out (a) if the transaction at issue actually qualifies as a preference transfer, (b) whether and to what extent applicable statutory defenses may be available, and (c) your possible negotiation strategy.

A. What is a Preference?

Preferential transfer law is a creature of Congress as part of the Bankruptcy Code’s attempt to level the playing field for all creditors by not allowing one creditor to be favored (receive more) than it would have received if it were to wait in line with all of the other creditors in the debtor’s bankruptcy case. Some States have assignment for benefit of creditor statutes that contain similar provisions, but none of these compare the avoiding punch of section 547 of the Bankruptcy Code.

Simply put, a preference is a payment (called a “transfer”) of some property (usually cash represented by a check but can also be real or other personal property) of the debtor (important factor – it must be the debtor’s property) to a creditor (that is you or your agent), for the purpose of paying a pre-existing debt (called an “antecedent” debt) within 90 days prior to the filing of the bankruptcy case (calculated by not including the filing date and adding backwards), at a time when the debtor was insolvent, and which payment enables you to receive more than you would receive if you had not received the payment and got paid with all of the other creditors in a chapter 7 liquidation. These are the elements of a preference transfer action. The chapter 7 Trustee has the burden to prove these elements. Insolvency is presumed to exist (i.e., you must prove otherwise, which can be expensive). Further, in the context of receiving a check or other payment instrument (which are the most common forms of payment on a debt) the transfer takes place when the instrument is honored by the bank on which it is drawn (i.e., cash the check quickly).

B. What Defenses Are Available to a Preference Demand/Action?

There are generally only 2 ways to attack a preference allegation. First, ask whether the Trustee can establish all of the elements of a preference transfer? Second, ask whether you can assert one of the statutory defenses set out in section 547(c) of the Bankruptcy Code. Common law defenses – like estoppel, waiver, off set, and good faith – do not apply. The preference amount must exceed $600 (if the debtor’s debts are primarily consumer debts) or $5,850 (if the debtor’s debts are primarily non-consumer debts). Also, if the demand involves a money judgment for less than $1,175, consumer debt of less than $17,575, or a non-insider/non-consumer debt of less than $11,725, any action will have to be filed in the district court for the district in which you reside.

The two most common defenses that you might have to a preference are (1) new value and (b) ordinary course of business. The new value defense is similar to set off except that it applies only to prospective services rendered or good supplied. The other defense, ordinary course of business, involves transfers to you in payment of a debt which are in the ordinary course of yours and the debtor’s financial business or recognized in your industry. A trustee might not want to pursue an action or would be willing to settle cheaply if you can readily establish either or both of these defenses from examining the kinds of payments that had been received in the past. If these defenses are available you want to make this known up front to the trustee. Many cases have been settled quickly when the creditor could provide documentation that would support these defense.

C. Should I (or How Should I) Respond to a Preference Demand Letter?

First, remain calm. It is just a letter. A stronger reaction might be justified if you were served with an actual lawsuit. Second, resist the temptation to throw the demand letter in your “circular file” (i.e., your trash can). Ignoring a demand letter may only serve to embolden the Trustee and eliminate a later opportunity to resolve the matter. As noted above, you may have certain valuable, sustainable defenses that you want to flesh out and/or as to which you require additional information. Often the source of the Trustee’s information, which led to the issuance of the demand, is incorrect and/or based on limited data. An initial response may be necessary to gather information to establish whether the Trustee can prove the elements of a preference and/or to support a defense. This also will provide a breathing period to get your arms around what is happening and whether you will be able to mount a good defense and/or enable you to begin the settlement negotiation process. Further, most demands contain relatively small discounts for up-front payments, so unless the offer is just “too good to refuse” you are better off delaying the process while you evaluate the Trustee’s evidence and applicable defenses. Bottom line: you want to respond verbally or in writing to all demands.

D. What Information is Needed to Determine Defenses?

You will likely be the source of information to enable your attorney to respond to a preference demand letter. Before contacting counsel, you may want to gather the payment history involving the debtor for at least the year preceding the bankruptcy filing. This information typically will include:

• Copies of all correspondence, contracts, credit applications, telephone logs, emails, and the like involving the debtor;
• A copy of all invoices, showing invoice date, terms and amount of each invoice;
• A copy of all payments received from the debtor identifying the method of payment (EFT, check, cashier’s check, money order, cash) and the date the payment was posted to your bank account;
• The number of days elapsed between date of invoice and date of payment was received; and
• All persons involved with the debtor’s account, so they can advise as the business terms between the parties and how payments were made, applied and any unique issues involving the debtor.

This information will prove valuable to your counsel in assessing your risk and exposure to avoidance of alleged preference payments.

E. Do I Need an Attorney? Are Attorney’s Fees Recoverable?

If successful, a trustee is not ordinarily entitled to recover attorney’s fees in prosecuting a preference action (they will be paid from the “estate”), but interest will continue to accrue on the amounts at issue. Also, you will not be able to recover fees and expenses paid to your attorney in defending against a preference demand or lawsuit. However, while it may not be very appealing to hire an attorney to help you get through this process, kind of like adding salt to the wound, the reality is that there are risks going it alone and having an attorney represent you can actually save time and money, particularly if a settlement is in prospect. In bankruptcy, like many other areas of the law, it really does help to walk-the-walk and talk-the-talk. Also, most attorneys will set fee rates based on amounts in dispute and will be willing to work with you on terms of engagement given the particular circumstances involved.