A Bankruptcy Killer-Pay Back Money Paid By Debtor

09.15.10

By: Stephen J. Nash
Nash Law Firm PLLC
nash@nash-law.com

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Nobody wants to get caught up in a bankruptcy, but with a record number of bankruptcy filings, it becomes more and more likely that you will have to deal with bankruptcy.  Everyone knows that a debt owed to you can get wiped out by a bankruptcy, but did you know that the bankruptcy court can actually seek the return of money already paid to you?

When Can the Bankruptcy Court Require a Creditor to Pay Back Money Received from the Bankrupt Debtor?

The Bankruptcy Code permits a trustee or a debtor in possession to recover certain payments made to creditors prior to the filing of the bankruptcy.  The policy behind this statute is to prevent some creditors being treated better than others.

If the bankruptcy court determines that the payment was a preference, the payment can be recovered.

Ninety Day Preference

Preferences are defined in Bankruptcy Code Section 547 as:

1. Payment on an antecedent debt (as opposed to a current debt);
2. Made while the debtor was insolvent;
3. To a non-insider creditor within 90 days of the filing of the bankruptcy;
4. That allows the creditor to receive more of its claim than it would have had the payment not been made and the claim was paid through the bankruptcy process.

The process of recovering preferences is sometimes referred to as a "clawback". 

Defenses to a Clawback 

The defenses to the recovery of a preference are set out in Bankruptcy Code 547(c) as follows:

• contemporaneous exchanges; 
• payments made in the ordinary course of the business of the debtor and the creditor on ordinary business terms;  and
• security interests that secure debts that bring new value to the debtor.
• amounts of subsequent credit extended and unpaid.

The burden of proof rests with the creditor to prove that they fall under a preference defense.  In some cases, every creditor who received a payment within the 90 day period will be required to establish a valid defense.  If you as a creditor receive such a notice, it is extremely important that you consult with a knowledgeable attorney so that a proper response can be timely made.

The policy behind the 90 day preference rule is to treat all creditors the same, to lessen the advantage a creditor might get from aggressively pursuing old debt and to prevent the debtor from preferring one creditor over another.   

One Year Preference

When insiders receive payments on old debts within one year of the bankruptcy filing, the bankruptcy code permits recovery of these payments.  

An insider includes relatives, corporate officers or directors or related entities.  In a insider preference action there is no presumption that the debtor was insolvent when the payment in question was made.  The burden of proof of insolvency rests with the trustee. 

The policy behind insider preferences is to prevent the debtor from paying relatives and business decision makers at the expense of the trade creditors.  

Why All Businesses Should Be Concerned With Bankruptcy Preference Claims

You never know when a preference claim may come knocking on your door.  Since you cannot predict which of your debtors, if any, will file bankruptcy any payment you received from any debtor may be subject to a bankruptcy preference claim down the road and by the time the claim is made the money received is long gone.

Should you then not accept payments from debtors that you fear might file bankruptcy?  No.  First, the debtor may not file bankruptcy within 90 days and second, you may have a preference defense.

There are some things you can do to put yourself in a better position.  First, keep all accounts receivable current.  If a client is allowed 30 days to pay and historically has paid within that time frame do not allow payments to fall behind or you are turning a current debt into an old debt.  Second, make sure that you keep all of your billing and account receivable records so you can prove payments were received in the normal course of business.  Third, become a secured creditor.  Fourth, protect your security interest as soon as possible.  If you wait too long you may lose your secured creditor advantage.      

With Bankruptcies Rising, the Risk of a Facing a Preference Claim has Gone Up

In the face of the worse economy since the Great Depression, bankruptcies are soaring for individuals and businesses.  When bankruptcies were relatively rare, the odds of you receiving a payment within 90 days of a bankruptcy filing was not all that great.  Today, it seems, that all businesses, large and small, are at risk.  As a result, it is more likely that you will get caught up in someone's bankruptcy.  If you are not careful the bankruptcy court will be looking for you to pay back money received and spent months ago.

Protect yourself the best you can from future preference claims and if you are facing a preference claim make sure that you properly and timely assert your preference defense.

NOTICE The foregoing is not intended to constitute legal advice for any specific circumstance, but is intended to reflect broadly applicable principles, under Minnesota law, relevant to a typical situation. Each set of facts and each contract is, or can be unique; the unique facts and specific language of the contract may require a different legal analysis and may result in a different outcome. Before proceeding in reliance upon this or any other general description of law, consult with an attorney competent in the field of practice relevant to your situation. Copyright 2011 Nash Law Firm