Imagine you are a representative for a principal who is struggling financially. You are owed commissions and have been patient in dealing with the principal’s slow pay. After many promises, you push the principal and finally, you receive a long-awaited commission check and life is good.

Within three months of your receipt of the commission check (or checks), your principal files for bankruptcy protection. Several months later you receive a letter from the trustee appointed in the bankruptcy claiming your receipt of commissions was “preferential” and demanding that the payments you received be returned. You say to yourself, “How can this be? They owed me the money which I earned and why should I have to give it back?” You ignore the letter and find yourself named as a defendant in a federal bankruptcy court lawsuit. Depending upon the amounts you received, that lawsuit may be pending in a bankruptcy court very far away. Again, you ask yourself, “How can this happen?”

The above scenario is not unusual. Given the economic downturn and the very slow recovery, manufacturers’ representatives can become involved in “preference” claims in bankruptcy proceedings.

In a typical bankruptcy case, the debtor or its trustee will review records of all payments made by the debtor within the 90-day period prior to the bankruptcy filing and seek to have those payments reversed as “preferential.”

The theory behind the preference provisions of the Bankruptcy Code is that those creditors receiving payments in that 90-day period were “preferred” by the debtor over its other creditors. To treat creditors more equally, those receiving such payments are made to return them and all creditors then receive pro-rata distributions, usually at the end of the case. Distributions, however, are typically pennies on the dollar. For a creditor, successfully defending a preference claim can be the difference between being paid in full and almost not being paid at all.

There are a number of grounds upon which a preference claim may be successfully defended and you should not automatically heed a trustee’s demand and make a return.

The Elements of a “Preference”

Section 547 of the Bankruptcy Code permits a bankruptcy trustee or debtor in possession to obtain a reversal of transfers of money which are “preferences.” A “preference” is generally any transfer of an interest of the debtor in property (including money):

(1) to or for the benefit of a creditor;
(2) for or on account of an “antecedent debt” owed by the debtor;
(3) made while the debtor was insolvent;
(4) on or within 90 days before the date of the filing of the debtor’s bankruptcy petition; and
(5) that enables the creditor to receive more than the creditor would have received had it not received the transfer.

The “within 90 days of filing” requirement appears to be straight-forward. However, a payment is not deemed made until it clears the accounts of both the company receiving funds and the debtor issuing payment. Therefore, deposit your payments as soon as you can to start the clock running.

Defenses

There are also certain defenses that can be established to defeat a claim. The “subsequent new value defense” can apply when a creditor gives new value to or for the benefit of the debtor after receiving the challenged payment. Continuing to provide services to the debtor could constitute “new value.”

Another defense is the “ordinary course of business defense” which can be established by making either of two showings.

First, the creditor may show that the payment was made in the ordinary course of the parties’ business or financial affairs. This is the so-called “subjective test,” meaning the payment was within the parties’ ordinary terms used in the pre-preference period — i.e., it was not coerced by threat of litigation, threat of non-performance of future services, etc.

Second, the creditor may show that the payment was within the range of terms ordinary within the relevant industry; the so-called “objective test” (for example, by showing that payment to the creditor occurred within 90 days in an industry where it is established by competent expert testimony that payment within 90 days is within the range of payments ordinarily found to occur in that relevant industry).

It is also a complete defense to a preference claim that the total of the payments received by the creditor in the preference period was less than $5,000.

Summary

Bankruptcy preference claims are by far the most frequent form of litigation in bankruptcy cases. By looking closely at the elements and defenses, a manufacturers’ representative may successfully defend a preference claim. The key is not to ignore a preference claim but rather contact an attorney with experience in handling these claims for assistance. Most preference claims are resolved by settlement. The amount of settlement will depend upon how successfully the defendant marshals the relevant facts and law to establish a defense, if one is applicable. As a final thought, you are almost always in a better position to have received the payment and be defending a preference claim compared to not receiving payment in the first instance.