A Preferred Creditor lawsuit is the very last thing most businesses want, but they’re also not something you can predict. They’re bad news for a couple of reasons, but the main one being that one of your debtors has just filed for bankruptcy, which means you’ll need to find a way to offset that bad debt.
Preference claims are a legal way of ensuring that no one creditor is given preferred treatment over another during any bankruptcy filing. There is the potential for all payments made to your business by a specific debtor to be reimbursed to them, becoming part of their bankruptcy estate in the process.
There are two timeframes to consider here. If a debtor paid money to what is termed an insider (family, friend or associates), payments over the period of the 12 months prior to them filing for bankruptcy can be recalled into the bankruptcy estate. An outside (business the debtor purchased from) must adhere to a preference period of 90 days before their debtor became insolvent.
The court-appointed trustee can, and will, request that money paid to your business is returned to the debtor. The logic behind this is that this money can then be used to pay all creditors an equal amount of money, instead of one single creditor having their entire bill paid, hence the term ‘Preference Claims’.
Defense Against Such Claims
You have a number of defense options, thanks to the Bankruptcy Abuse Prevention and Consumer Protection Act, 2005, to defend your business revenue from a lawsuit of this type.
Contemporaneous Exchange
There are two primary scenarios where this defense can be used. The first of these is when your debtor paid you in full for a product or service. The second one is where the debtor paid you within a very short credit period i.e. 30 days or less. Cash-on-Delivery (COD) payments can also be classed as contemporaneous exchange, which makes sense because COD deliveries are quite common in businesses suffering from restricted cash-flow because of issues with their creditors.
Subsequent New Value
This defense applies if you have a customer who has operated on a 90-day invoicing system with you. Using “subsequent new value” as your defense will not prevent a court trustee from reclaiming all the payments made but can protect you from losing substantial amounts of money.
Let’s say, for example, that you received a payment of $14,000 on February 1st. Then on February 10th you provided another $6,000 worth of goods. On February 12th your customer files for bankruptcy, and you’re sued for preference to the tune of $17,000. By using the subsequent new value defense, you can in theory reduce your financial liability here to $8,000. You’ve been paid $14,000, but not the other $6,000 you’re owed by your now insolvent debtor.
Ordinary Course of Business
Any payments made to you by a debtor, that can be defined as being made in the ordinary course of business, are exempt from a preferred creditor lawsuit. While this defense might sound very straightforward, it can be quite difficult to prove in court. Firstly, you need to define what “ordinary course of business” is in relation to both your own industry and that of your debtor/customer.
If, for example, you’ve always operated a 30-day invoicing system with a customer, then any payments made within that timeframe would be exempt from the preference suit. Any payments made much earlier, or later, than 30 days could be reclaimed as part of the bankruptcy estate; such payments would be classed as being made outside the ordinary course of business.
The bankruptcy court will fully analyze your dealings with this debtor both during and before their NJ bankruptcy filing. It would be unwise to attempt to deceive the court to protect your financial interests – the penalties will cost far more than any reclaimed payments.
Being sued for preference is something you can defend against, but we strongly suggest you seek professional legal advice challenging any lawsuit.