New bankruptcy law eases creditors' burden in preference cases

Doing business with a company that files for bankruptcy can create hardships for your business.

If a debtor files for bankruptcy, any payments made to vendors within the 90 days prior to filing are at risk for a demand to return the payments. This is called a preference demand.

Advertisement

Most typically, preferences impact vendors who invoice customers when they deliver goods and receive payment sometime after delivery. If the vendor receives the payment within 90 days of the customer's bankruptcy filing, the vendor is at risk for a "preference" and will be asked to return the payment to the bankruptcy estate.

Making demand for return of preferences is required under the Bankruptcy Code. If a preference demand is not settled, the debtor sues the creditor within the bankruptcy case. Once recovered, the preferences are split among all of the debtor's unsecured creditors in proportion to the size of their claims in the bankruptcy case.

Preference recoveries are intended to make all unsecured creditors share the burden of bankruptcy evenly. Unfortunately, most preference defendants are also owed money at the time a bankruptcy is filed, and return of a preference only increases the loss for the preference defendant. Preference demands feel unfair and can cause serious problems with the business' cash flow.

On April 20, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. For businesses faced with preference demands, the new bankruptcy law offers some relief. With limited exceptions, the changes in the law related to preferences will go into effect on Oct. 17.

Under the amendments, preference actions cannot be brought in amounts less than $5,000, and an action seeking collection of a business debt of less than $10,000 can be brought only in the district in which the creditor resides. These provisions will have the effect of eliminating or curtailing smaller preference demands.

For larger preferences, there is also some relief. Under the old law, a creditor could assert the "ordinary course of business defense" to avoid paying the preference back to the bankruptcy estate. The creditor had to prove that the payment was in the ordinary course of business of the debtor, the creditor and the industry as a whole. The burden on the creditor was very difficult and, as a result, the defense was not successful very often.

Under the new law, the rules for the ordinary course of business defense have been relaxed. Creditors must prove either the payment was ordinary between this debtor and this creditor; or the payment was made according to ordinary business terms in the industry.

This provision went into effect on April 20, and preference cases are settling more quickly as debtors realize that creditors will have an easier time proving this defense.

In addition to the preference changes, the new law includes additional revisions for commercial real estate transactions, protections for trade reclaiming creditors, and many changes for debtors in bankruptcy.