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More than 89,000 companies filed for bankruptcy relief in 2009, a 38% increase over the number of filings in 2008. Consequently, it is increasingly likely that someone you do business with will file for bankruptcy, and that some day you will get a letter in the mail asserting that you have received a preference and demanding the return of money received from a bankrupt debtor.

WHAT IS PREFERENTIAL TRANSFER?

You, like other suppliers and businesses, will be wondering why in the world you have to return money that you received for goods that you sold to a business that thereafter filed bankruptcy. As a business slides into bankruptcy, it is presumed that the business had insufficient funds to pay all of its bills as they came due. Consequently, creditors receiving payments from the insolvent debtor are deemed to have been preferred over those creditors who were not paid by the debtor. Fairness of distribution - ensuring that similarly situated creditors are treated equally and share pro rata in the distribution of the debtor's assets - is one of the fundamental precepts of the Bankruptcy Code. To ensure equal treatment to all creditors, bankruptcy law empowers a debtor or a bankruptcy trustee to "avoid" or recover such payments from these "preferred" creditors.

To establish that a payment is preferential, the debtor or trustee must demonstrate that the payment was:

1. A transfer of the debtor's property;
2. For or on account of a debt owed by the debtor before such transfer was made;
3. Made while the debtor was insolvent;
4. Made within 90 days before the date of the filing of the petition for relief in the bankruptcy court; and
5. One which enabled the recipient to receive more than the creditor would have received had (a) the debtor's assets been liquidated in a case under chapter 7 of the Bankruptcy Code, (b) the transfer not been made, and (c) the creditor had been paid on his claim under the distributive provisions of the Bankruptcy Code.(This final element is satisfied in all cases where unsecured creditors will receive less than full payment on their claims).

All of these elements must be proven to establish a preference claim.

YOU MAY HAVE DEFENSES TO THE PREFERENCE CLAIM.

A preference demand letter from a debtor or trustee is, in reality, nothing more than a mere allegation that all of the elements of a preference are satisfied. Recipients of alleged preferences should first verify whether the debtor or trustee can prove that all of the elements of a preference have been established. Cash in advance or C.O.D. payments do not, for example, constitute preferential transfers because they are not payments made on account of an antecedent or existing debt. Additionally, the Bankruptcy Code provides recipients of preferential transfers with certain defenses that may limit or eliminate their preference exposure. Payments of debts incurred in the ordinary course of business of the debtor and the transferee are excepted from avoidance to the extent the payment was also made in the ordinary course of business of the debtor and the transferee and according to ordinary business terms. A careful examination of the history and specific data of the account with the debtor is necessary to determine whether any of the defenses listed in the statute may be applicable in your case.

WHAT YOU SHOULD DO IF YOU RECEIVE A PREFERENCE DEMAND LETTER.

FIRST, DON'T PAY IT. You may have defenses to all or part of the claim. Further, even if you have no defenses and are liable for the full amount, you can almost always negotiate a settlement that will reduce the amount you have to repay to the debtor's bankruptcy estate. A debtor or trustee will routinely settle a preference claim for less than the amount of the alleged preference because the settlement permits the bankruptcy estate to avoid the costs and risks associated with litigating the claim.

SECOND, DON'T IGNORE IT. Get your ducks in a row. Gather the account data. Compile a payment history of the account for the year prior to the commencement of the debtor's bankruptcy case. Prepare a chart indicating the number of days between the invoice dates and the dates on which payments were received. Put together a file containing (a) copies of all correspondence, contracts, notes, e-mails and any other communications with the debtor, (b) copies of all invoices, showing invoice date, terms and amount of each invoice, (c) copies of the payments received - checks, wires, cash deposit slips - and the date on which the payments were posted to your bank account, and (d) a list of personnel involved with the debtor's account, i.e., those individuals familiar with the payments and how they were applied and any other issues unique to the debtor.

Preference demands are often initially asserted in a letter from the debtor in possession or the trustee. Sometimes, however, a looming statute of limitations deadline may compel the debtor or trustee to forego a demand letter and simply commence a lawsuit to recover the alleged preference. If the preference demand is asserted by way of a complaint and summons, contact an attorney immediately. The summons provides you with a limited time in which to file an answer to the complaint. If you fail to file a timely answer, the debtor in possession or trustee could obtain a default judgment for the full amount of the alleged preference.

THIRD, CONSULT WITH AN ATTORNEY EXPERIENCED WITH PREFERENCE LITIGATION. Preference cases are unique and most attorneys are not familiar with the nuances of preference law. Accordingly, if you receive a preference demand letter you should consult with a creditors' rights or bankruptcy attorney who has experience with preference litigation. Such an attorney will assist you in (a) determining whether the debtor or trustee has proven his case, (b) evaluating your potential defenses, and (c) preparing the appropriate response to the demand for repayment of the alleged preferential transfer.

If you have any questions or concerns about this or other creditors' rights issues, you should consult with an attorney who is familiar with Creditors' Rights and Bankruptcy law. The Creditors' Rights and Bankruptcy attorneys at Walter & Haverfield will be pleased to help.