As a business owner or manager, it is frustrating to receive a bankruptcy preference demand letter. Unless you want to pay the preference demand, you have little choice but to undertake a defense. Unfortunately, the business disruptions caused by the COVID-19 pandemic have further complicated the legal landscape surrounding defense of preference claims. The purpose of this article is to briefly summarize preference procedures, explain the COVID pandemic impact regarding preferences, and discuss some general strategies for businesses responding to or defending against preference claims.
I. Preference Process
Transfers made by a business within 90 days of it filing a bankruptcy petition under the Bankruptcy Code are potentially subject to a preference action. In many cases, such transfers consist of payment for goods or services received by the bankrupt party in the months prior to filing its bankruptcy petition. The preference statutes are intended to prevent the bankrupt party from preferentially transferring assets to favored parties or individuals before the bankruptcy is filed, to the detriment of other creditors, during the time leading up to the bankruptcy (when the business is likely insolvent).
Bankruptcy trustees and debtors-in-possession have the right to seek the return into the bankruptcy estate of preferentially transferred assets or funds, so the assets can be allocated and distributed as part of the orderly bankruptcy process. 11 U.S.C. § 547(c)(2). Typically, a preference claim begins with a demand letter being sent to the party who received the funds, demanding that payment be made back to the bankruptcy estate. If the preference claim is not resolved based upon the demand letter, the matter may progress to an adversary proceeding, a lawsuit within the bankruptcy case for recovery of the alleged preference funds.
The most common defense against preference claims is that the transfer at issue to the bankrupt party was made “in the ordinary course” of business. Proving the “ordinary course’ defense requires the party defending against the preference claim to show: (A) the transfer was made in the ordinary course of business or financial affairs of the debtor and the transferee or (B) the transfer was made according to ordinary business terms. 11 U.S.C. § 547(c)(2). (A) requires a subjective comparison of the historical transactions between this debtor and this creditor. (B) requires an objective comparison with other transactions between parties in the same industry. Either way, the question is whether the alleged preferential transfer was “ordinary”.
II. COVID Impact
With the impact of COVID-19 since early 2020, very little has been “ordinary” about how many, or even most, businesses or industries have functioned. This lack of normality makes it more difficult to present and prove the “ordinary course” defense. When a course of dealing between the debtor and creditor, or even an entire industry, has been disrupted due to impacts of COVID-19, parties defending against preference actions need to think creatively. Referring back to the business relationship between debtor and creditor preceding the 90 day preference period might not provide much value, if that time frame was influenced by COVID-19 effects.
III. Defense Perspective
When defending against preference claims, creditors preparing a defense need to take a broader look than in the past and be prepared to present extensive evidentiary support. Developing and presenting an effective defense requires the assistance of experienced counsel to identify the best way to identify and present supporting evidence.
Questions for the creditor to evaluate include:
What relationship did this debtor and this creditor have prior to COVID-19 impacts and what changed? How can these separate periods be quantified? When was the last time their business relationship was “ordinary”? If the transfer that is the subject of the preference claim was affected by COVID-19, what still makes it “ordinary”?
Was this transfer “ordinary” pursuant to a broader analysis of industry practices? How can the industry be redefined to show what is “ordinary”?
As discussed above, defending against preference claims requires a solid understanding of relevant bankruptcy law, and effective application of bankruptcy law to the current business environment. Erickson|Sederstrom’s bankruptcy attorneys are ready to help if your business needs to defend against a preference demand.