Know the Law: Bankruptcy Code Helps to Recover Previous Payments

Steven J. Dutton
Director, Litigation Department
Published: Union Leader
March 14, 2016

Q:  We provided services for a customer and were timely paid for the work.  A couple of months later, the customer filed for bankruptcy.  We recently received a demand from the bankruptcy trustee for the return of the money that the customer paid.  We performed the work and the money was owed, how is it possible that we need to return the payment?

A:  The answer is that the payment is being viewed as preferring one creditor over others who were not paid and the Bankruptcy Code empowers the bankruptcy estate, with certain exceptions, to recover payments (or other transfers) made within the 90 days prior to bankruptcy (or one year if the payment is made to an insider).  These payments are referred to as “preferential transfers.”  This provision of the Bankruptcy Code is intended to further the policy of equal treatment for similarly situated creditors.  Preferential transfers recovered by the bankruptcy estate become available for distribution in accordance with the Bankruptcy Code.

Payments within 90 days prior to the date of the debtor’s bankruptcy are presumed to be preferential.  Specifically, under the Bankruptcy Code, a preferential transfer is (1) a payment or transfer to, or for the benefit of, the creditor on account of an existing debt; (2) occurring within the 90 day period before the bankruptcy filing or, if the payment was made to an insider (typically an officer, director, controlling shareholder or relative of the debtor), within one year prior to the bankruptcy filing; (3) while the debtor was insolvent; and (4) resulting in the creditor receiving more than it would receive in a Chapter 7 liquidation.

A recipient of such a payment is liable for return of the payment, unless the creditor can show the payment falls within one of the exceptions or defenses set forth in the Bankruptcy Code.  The three most common defenses which can be asserted by a creditor are: (1) after the contested payment was made, the creditor gave the debtor “subsequent new value” by providing more goods or services for which it was not paid; (2) the contested payment was not for antecedent debt but instead was a “contemporaneous exchange” of new value (e.g., goods or services) for the payment; and (3) the contested payment was made in the “ordinary course of business” of the debtor and the creditor.

While the bankruptcy estate (typically acting through a trustee) has the burden of proving the elements of a preferential transfer, a person who receives an alleged preferential payment bears the burden of showing that one or more of the exceptions applies to avoid liability.