Preference Actions in Chapter 11: How to Defend Against Them
A preference in a Chapter 11 bankruptcy is generally defined as a debtor’s pre-filing transfer of property that unfairly favors one creditor over others. The bankruptcy code authorizes the trustee to bring an action to “claw back” the transfer and bring the property back into the bankruptcy estate.
The purpose of a preference action, as empowered by Bankruptcy Code 11 U.S.C. § 547, is to ensure that creditors are treated equally. To bring the claim, the trustee must show that the transfer was:
- of a debtor’s interest in property
- to or for the benefit of a creditor
- on account of an antecedent debt
- made while the debtor was insolvent
- made within 90 days prior to the Chapter 11 filing (or one year if the creditor was an insider)
Most critically, it must be shown that the transfer left the recipient creditor better off than it would have been had the transfer not been made and if the creditor asserted its claim in a Chapter 7 liquidation.
The bankruptcy code allows creditor to raise any of these affirmative defenses to avoid a clawback:
- Contemporaneous exchange for new value — A transfer is not avoidable if it was a swap; namely, the creditor gave new value (goods, services, money or release of a lien) at the same time at the time of the transfer. Such an even-handed exchange does not diminish the estate.
- Subsequent new value — A creditor can show that after receiving the alleged preferential transfer, it repaid the debtor’s estate by extending new value in the form of goods, services, credit or the release of a lien. Thus, the estate was not depleted overall.
- Ordinary course of business — Preference law is not meant to punish ordinary, recurring business transactions. To raise this defense, a creditor must show the transfer was either consistent with the parties’ historical payment practices (e.g., timing, method, amount, collection behavior) or consistent with standard business terms in the relevant industry.
Because these are affirmative defenses, the burden of proof is on the creditor. The strength of these defenses depends on the specific facts and documentation surrounding the transaction. For example, a contemporaneous exchange must be supported by evidence of the parties’ objective conduct, such as invoices and payment terms. The subsequent new value defense requires careful assessment of what was transferred. As for the ordinary course of business defense, the creditor must show the challenged payment is similar in timing, method, amount and collection behavior to prior dealings.
In many cases, preference actions are resolved through negotiation rather than litigation. One strategy is providing context for the payment, which may potentially align with one of the common defense strategies referenced above. It may be possible to reach a settlement that limits the losses incurred by a creditor during Chapter 11 preference actions. Early evaluation of potential defenses and strategy is critical for both debtors and creditors involved in a Chapter 11.
The Law Offices of Michael Jay Berger in Beverly Hills handles complex Chapter 11 bankruptcies and adversary proceedings for businesses in southern California. Schedule a free initial consultation by calling 310-271-6223 or contacting us online.
