Defenses to Preference Claims in Bankruptcy for Texas Small Businesses

Stressed small business owner

There are a number of challenges facing small business owners in Texas which, some of which can affect a business’s survival: severe weather events causing property damage; unjustified online reputational harm; and all kinds of legal claims from every angle. Many of those risks can be managed with insurance. One that typically is not covered by insurance, however, is when a substantial customer unexpectedly goes bankrupt. If you provided goods or services on credit that means you likely will not be paid for the full value. Just as bad, if you did receive payment in the 90 days prior to bankruptcy, you can expect to receive a letter from a bankruptcy trustee demanding to claw it back as a “preference”, aka a preference claim, or even alleged to be a “fraudulent transfer.”  

In already challenging economic times, being subject to a bankruptcy adversary proceeding that seeks to recover the money you were paid years prior can cause crippling financial problems for a small business owner. If you received a demand letter claiming a preferential transfer, avoidance action, or fraudulent transfer under Sections 547 or 548 of the Bankruptcy Code, you may need an experienced attorney to help advocate for your rights. Contact Wright Commercial Litigation to schedule a consultation and learn more about the legal defenses available to you. 

What Is a Preference Claim in Bankruptcy?

A preference claim is a way for the trustee of a bankruptcy estate (or “debtor in possession” and sometimes an unsecured creditors committee) to recover payments made by the debtor in the 90 days before a bankruptcy in order to gather money for a more equitable redistribution to all unsecured creditors. That process is governed primarily by Section 547 of the Bankruptcy Code (11 U.S.C. § 547) and has the general purpose of preventing a debtor from acting in favor of certain vendors shortly before bankruptcy while also preventing a shrewd creditor from taking advantage of a struggling debtor to extract payments or other terms that essentially makes bankruptcy more likely. The touchstone is supposed to be fair for all similarly situated.

However, it certainly does not feel fair to the small business owner who is subject to a preference action merely because they got paid for goods or services in the applicable 90-day window—usually with no idea their customer was struggling or about to end up in bankruptcy—which is made possible because a preference action does not require showing bad intent, knowledge of the debtor’s financial condition, or anything else.

Rather, preferential transfers are defined by 11 U.S.C. § 547(b) to be simply any transfer of “an interest of the debtor in property” that was done:

(1)         to or for the benefit of a creditor;

(2)         for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3)         made while the debtor was insolvent;

(4)         made—

(A)          on or within 90 days before the date of the filing of the petition; or

(B)           between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5)         that enables such creditor to receive more than such creditor would receive if—

(A)          the case were a case under chapter 7 of this title;

(B)           the transfer had not been made; and

(C)           such creditor received payment of such debt to the extent provided by the provisions of this title.

As you can see, there is no intent required. It is very easy then for a trustee to show those five elements (particularly since the Code presumes insolvency in the 90 days before bankruptcy) and, even if an element is missing, an avoidance action can still be brought under Section 548 of the Bankruptcy Code for either a constructive or actual “fraudulent transfer.”

As a result, bankruptcy trustees regularly assert avoidance actions automatically against virtually every creditor who received payment (or payments) in the 90 days before bankruptcy that meet or exceed the minimum threshold of $5,000 in total. See 11 U.S.C. § 547(c)(9) (providing a trustee may not avoid transfers less than that, in aggregate, as a preference). That can be very frustrating to the small business owner who did nothing wrong other than get paid for goods or services provided to a customer who ended up in bankruptcy. 

Fortunately, there are several defenses one can use to fight a preference claim and keep much of the money paid. That qualification of “much” is necessary, as it is difficult to keep all the money paid since there usually is no right to recover attorney’s fees in defending a bankruptcy avoidance action. That means an unscrupulous trustee or their counsel can leverage such costs to extract at least some amount in the settlement because they know a creditor will have to pay attorney fees otherwise and often incur the expense of doing so far from their home office location. It is important then to have a cost-effective attorney knowledgeable of all the possible defenses and tactics to at least help minimize the overreaching.

What are the Defenses Against a Preference Claim?

There are several arguments that a small business in Texas can make to minimize or defeat preference claims asserted by a bankruptcy trustee or debtor in possession. First, a small business can establish the trustee will not be able to meet its own burden of proof regarding the elements of a preference claim. The Small Business Reorganization Act (SBRA) of 2019 made some tweaks to the Bankruptcy Code that can help in that regard, which is discussed first below and then the other more traditional affirmative defenses.

Failure of a Trustee to Conduct “Reasonable Due Diligence” into Defenses

In 2019, Congress added a new element to a trustee’s burden of proof that requires “reasonable due diligence” and “taking into account a party’s known or reasonably knowable affirmative defenses under subsection (c)” before bringing an adversary proceeding. See Pub. L. No. 116-54 § 3(a) (codified at 11 U.S.C. § 547(b)). Courts have recognized the purpose of that “due diligence” requirement was to discourage the practice of trustees bringing preference claims blindly against everyone who received a payment in the 90 days before bankruptcy without regard to “obvious” defenses, such as “ordinary course of business, contemporaneous exchange, or new value.” In re Art Inst. of Phila. LLC, No. 20-50627 (CTG), 2022 Bankr. LEXIS 68, at *49-50 (Bankr. D. Del. Jan. 12, 2022). One court has found it to have real teeth by creating a new condition precedent—i.e., a “statutory prerequisite to litigation”—that must be satisfied for a claim to be brought. See In re ECS Ref., Inc., 625 B.R. 425, 453-57 (Bankr. E.D. Cal. 2020) (analyzing plain language, legislative history, and analogous case law).

It is therefore possible to attack a trustee’s complaint if it failed to plead (and ultimately prove) doing reasonable due diligence into obvious affirmative defenses available to a small business.

Venue for Small-Dollar Preference Actions

Something that has been around longer and was only amended by the SBRA in 2019 was a provision that is supposed to help small businesses by requiring non-consumer debts less than $25,000 be litigated only in the district where the small business resides rather than, as often the case, some far-flung state (Delaware often) halfway across the country where the debtor’s bankruptcy was filed. See 28 U.S.C. § 1409(b). 

However, there is a split of authority in courts across the country as to whether that provision actually applies to a preference action due to the technical language used in the statute not including a bankruptcy term of art that has developed around the specific phrase “arising under” versus “arising in” or “related to” a bankruptcy proceeding, even though the recent legislative history of the provision strongly indicates Congress has always expected and intended for the limitation to apply specifically to preference actions.

It is thus unclear if a particular court will or will not give effect to the intent of the small-dollar venue provision, but it is an argument that should be considered and often be made since there is a split of authority, so long as your federal circuit has not ruled conclusively otherwise.

The Ordinary Course of Business Defense

One of the most common defenses otherwise available to a small business dealing with a customer who made payments within 90 days of its bankruptcy is the ordinary course of business defense under Section 547(c)(2). That provision exists to induce creditors to continue dealing with a distressed entity on ordinary terms so as to hopefully help it stave off bankruptcy, without the worry of a subsequent trustee trying to disgorge it all as a preference. See Barnhill v. Johnson, 503 U.S. 393, 402 (1992). The Code thus states a trustee may not avoid a transfer:

(2)   to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms;

That creates two ways to establish whether payments were made in the ordinary course of business: by comparing those in the 90-day window to the history of payments between the creditor and debtor in a longer time period to see what was ordinary or not, and otherwise by looking at the standard terms of payment more broadly in the industry. Helpful information about the debtor’s payment history may be gathered from the Statement of Financial Affairs filed early in the case by the debtor.

There are several different factors that can be relevant to this defense but the typical analysis involves calculating the number of days between the invoice and each related payment in the two different time periods to determine what, if anything, was outside the normal course of business.

The Subsequent New Value Defense

The other most frequently-invoked affirmative defense to preference claims is that which exists for subsequent new value. A preference claim can be reduced by the amount of “new value”—meaning additional goods or services provided on an unsecured basis—that the small business continued to provide after receiving payment for past goods or services.

Section 547(c)(4) articulates this defense by stating a trustee may not avoid a transfer made:

(4)   to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor —

(A) not secured by an otherwise unavoidable security interest; or

(B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor;

The idea is that a business should receive a dollar-for-dollar credit against whatever is allegedly taken from the bankruptcy estate by way of preferential payment by that subsequently replenished to the estate in the form of new value in goods or services, to the extent it remained unpaid at the time of bankruptcy filing. (Note that post-petition payments typically do not affect this credit/defense). 

Calculating the credit can involve complicated assessments of when value was provided—continuously, only at the moment of invoice, earlier before invoice, or sometimes even after the invoice—that can impact how much is allowed by the defense. There are also interesting factors to consider with the administrative priority status given for goods received by a debtor in the ordinary course within 20 days of a bankruptcy filing. See 11 U.S.C. § 503(b)(9).

The Contemporaneous Exchange of Value Defense

Somewhat less common than subsequent new value or ordinary course of business is the defense that small businesses can assert by demonstrating a payment was for a contemporaneous exchange of new value. This defense is found in Section 547(c)(1) of the Bankruptcy Code and states that a trustee may not avoid a transfer made:

(1)   to the extent that such transfer was—

(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange;

In this type of defense, the small business needs to prove it and the debtor originally intended the payment to be a contemporaneous exchange and that did in fact substantially occur. The typical example of this type of transaction is one for cash-on-delivery of goods. The law does not foreclose it from applying to what is otherwise a credit-type of relationship and the payment does not have to actually occur at the exact same time since it requires only a “substantially” contemporaneous exchange. Payments up to 2-3 weeks later have been found to fall within the defense so long as the parties intended a contemporaneous exchange.

The Critical Vendor Defense To a Preference Claim

Another type of defense that can sometimes be asserted applies to creditors who are, in the days after a bankruptcy filing, granted status as a “critical vendor” that allows the debtor to continue using and paying that business even after the bankruptcy started. 

A small business can argue that a preference claim against it must fail because the bankruptcy court has already granted it authority to be paid. This defense is typically premised though on the basis that the trustee cannot prove one of the necessary elements of a preference claim; namely, that the transfer enabled the small business to receive more than it would have otherwise received in a bankruptcy. Its success can depend on whether the debtor was required to pay the small business’s claim or merely had discretionary authority to do so.

The Statute of Limitations

An important defense to always consider for any type of legal claim is the statute of limitations. Under Section 546(a) of the Bankruptcy Code, the limitations date for a preference action under Section 547 (or a fraudulent transfer under Section 548) is the earlier of either:

(1)   the later of—

(A) 2 years after the entry of the order for relief; or

(B) 1 year after the appointment or election of the first trustee under section 702, 1104, 1163, 1202, or 1302 of this title if such appointment or such election occurs before the expiration of the period specified in subparagraph (A); or

(1)   the time the case is closed or dismissed.

Most trustees and their counsel in a larger bankruptcy proceeding will be sure to bring avoidance actions before that statute of limitations. However, if they do so without conducting the “reasonable due diligence” required under Section 547(b), they may end up barred from maintaining a claim thereafter since some courts have found that due diligence aspect to be a condition precedent to even bringing a proper adversary proceeding.

Discuss Your Preference Claim Case with an Experienced Commercial Litigation Attorney

If you are a small business owner in Texas and you received a demand letter or adversary proceeding complaint, it is important to discuss your case with an attorney so you can understand your legal rights and possible defenses to a preference claim or other avoidance action that can be asserted by a bankruptcy trustee. 

Wright Commercial Litigation is a boutique law firm itself that helps other small businesses in Texas with all kinds of commercial disputes, including preference claims, fraudulent transfer allegations, and others that can be asserted in bankruptcy adversary proceedings. Contact the firm to schedule an initial consultation and learn more about your options.