COMMENTARY: Bankruptcy preference actions--analyze carefully, but do not fear


By David J. Hutchinson

These days, every business (and a lot of individuals as well) gets hit once in a while with a Bankruptcy Preference Action, which is a lawsuit by a bankruptcy trustee (or Debtor in Possession) to get back money paid out by a bankrupt entity in the time just preceding the filing of its bankruptcy case.

The City of Detroit is currently in the process of filing a number of these suits. There are some sensible reasons for allowing such suits. The theory behind these claims is that we don't want folks deciding to pay what little remains of their resources to their "favorite" creditors just before filing a bankruptcy, leaving the others with nothing; we want the creditors of a bankrupt entity to share the limited available resources in a fair manner. If the law looked for the mindset of the entity making such a payment, perhaps the theory would resemble the practice. However, Preference Actions are not equitable actions, but, in fact, statutory actions, and the statutes that enable them do not (and realistically cannot) carry out this theory effectively. Nowhere in the statute does the mindset of the paying debtor enter into the analysis. As a result, Preference Actions usually involve what most business people would see as normal payments for the parties involved.

Here is what actually happens in most cases. The trustee (or Debtor in Possession) looks at the checks written by the debtor in the 90 days preceding the bankruptcy (In cases involving closely held companies, they also look for checks written to or for the owners of the business in the year preceding the bankruptcy). Without making any analysis of these payments whatsoever, demand letters are sent to the payees demanding a return of the money paid during that period. If no resolution is reached, suit will be filed.

What most Preference Action defendants do not know is that there are a number of potential defenses to these cases. Without proper legal advice, such a defendant may be tempted to try to resolve the case quickly to avoid the legal fees and uncertainty of the bankruptcy court. Many probably feel that the trustee knows bankruptcy law and wouldn't bring the action without a basis, but they don't know about the defenses or the fact that those bringing these suits usually do not investigate the possible defenses at all. There are a number of real defenses that every defendant should investigate. If the payments were made in the "ordinary course of business," as that term is defined in the statute (which is not nearly as inclusive as most business persons would assume to be the case), they need not be repaid. To the extent that the defendant provided "new value" after the payment in question, that new value can be effectively set off against the payments made, lessening or completely eliminating the Preference claim. If the payment was part of a "contemporaneous exchange," in which the bankrupt entity received fair value at about the same time the payment was made, the payment is not considered to be a preference, and the defendant will prevail. These are the main defenses that anyone sued for a Preference should investigate, but there are others as well.

The best thing about the preference defenses is that, with the proper information, a good lawyer can analyze the availability of any of them in a short amount of time. I would estimate that, in most cases, once all the relevant financial information is provided, it will take less than 2 hours to determine, with reasonable precision, what defenses are available and in what amounts. Because the lawyers bringing these cases generally understand the defenses (even though they do not investigate them unless the defendant raises the issue first), the two lawyers can and do settle most of these cases fairly promptly, once the relevant facts are known. The message here is that no one should be afraid when a preference demand letter is received. One should find a good lawyer familiar with preference litigation, get them the demand letter and the information they request, and then make an informed decision about how to proceed. The relatively small investment in attorney's fees to make this initial analysis will be money well spent.


David J. Hutchinson is an attorney with The Law Office of David J. Hutchinson in Ann Arbor, a firm focusing on general civil litigation, including bankruptcy, family law, and real estate.

Published: Fri, Dec 04, 2015