Recovery of Payments Made to Business Creditors Within 90 Days of Filing, or to Family or Friends Within One Year of Filing, and Defenses thereto Under the Small Business Reorganization Act.

In this building block blog we discuss what are known as preference payments and the rules for when these payments can be “clawed back” from the creditor who received them.  Returned preference payments would then, in turn, be used to fund the reorganization plan.

When must a payment be further analyzed to determine if it is a preferential payment?  A potential preference payment is any payment made to a non-insider creditor within 90 days of filing the petition. As to friends and family, so-called insiders, it is any payment made within one year of filing.

But just because a payment was made within the 90 day or 1 year limits does not automatically make it a preferential payment. For a payment to meet the definition of a preferential transfer a number of other conditions have to be met.  And even if all of these conditions are met, the creditor can still argue that it has defenses allowing them to keep the money paid even though the payment was a preference.

The basic elements are as follows:                 

1. There was a transfer within the 90 day or one-year timeframe to or for the benefit of the creditor.
2. The amount paid was more than $5850 if a business debt or more than $600 if a consumer debt.
3. The payment was on account of an antecedent debt.
4. The payment was made while the client was insolvent. Insolvency is assumed if the payment was made within 90 days of filing.
5. The payment allows the creditor to receive more than it would have had the client’s assets been liquidated as part of a Chapter 7 proceeding.

Establishing whether the payment was a preference is rather mechanical and relatively easy to establish. Take a large payment to American Express, for example. $50,000 paid on February 1 on a pre-existing credit card debt. A few weeks later, on April 1, the SBRA action was filed. I did not go to Harvard, but I do know that April 1 is less than 90 days from February 1.  Payment was made on an existing credit card balance. Here, so long as the debtor was actually insolvent 60 days prior to filing, which is almost certainly the case, we are dealing with a preferential payment.

Whether the creditor has to disgorge the monies received, the preferential payment, revolves around whether the creditor can avail itself of one or more of five principal defenses. Proving that one of these principal defenses applies is complex, can be time-consuming, fact intensive and since these things are all done within the context of litigation, very expensive for the creditor and client, alike. The principal defenses are as follows:

1. The new value defense.
   1. Here, if the creditor receives a $20,000 preferential payment on day one and the client uses $10,000 of the remaining credit line on day 20, the preferential payment is only $10,000.
2. The ordinary course of business defense.           
   1. If the preferential payment was made consistent with the parties prior course of dealing or consistent with common industry practice this defense will apply.
3. The contemporaneous exchange defense.
   1. If the payment was cash on delivery for goods or services provided, or the payment was made shortly after so as to functionally be a cash on delivery transaction, this defense will apply.
4. The floating lien defense.
   1. If the value of the creditor’s collateral under the floating lien, typically a UCC one lien, has not increased during the preference period, the creditor may avoid having to return all or part of an alleged preference.
5. The purchase money security interest defense.
   1. If the monies received by the creditor were funds:
      1. loaned to purchase a specific item, and
      1. there is a security agreement describing the property, and
      1. the debtor does in fact purchase the item in question, and
      1. the creditor perfects its security interest, the creditor can avoid having to return the money.

Now let’s look at changes made by the SBRA to the law applicable to preferential transfers.  The SBRA did not modify the substantive law related to transfers made within 90 days or one year. The elements are what constitutes a preferential transfer, and the elements are what constitute a defense, had not changed. But certain procedural and pleading rules were modified.  And those changes make it less likely that a creditor who has received a preferential payment will have to give it back.  And, remember, by creditor that could also mean a family member or friend who the client paid within one year. As a result, the changes made to the procedural and pleading rules could very well provide ample excuse for the client not going after monies paid to a family member or friend which, understandably are loath to do no matter how desperately they need to reorganize the business to keep the business from going under but also from keeping the business going under could take them under since almost all business debts are personally guaranteed by at least its owners. The changes are as follows:

• First, if the amount that constitutes the preferential payment is less than $25,000, the legal action to get the money back has to be brought in the judicial district where the creditor resides or has their principal place of business. If the SBRA action is in San Diego and the creditor lives in New York, the cost of bringing the preference action may not make financial sense given the significant added expense of litigating cross-country.
• Second, before bringing the preference action, the client must take into account the circumstances of the case and any known or reasonably known affirmative defenses. The days of blanket suing any creditor who received preference payments are over. The due diligence analysis could justify not pursuing the monies.

The existence of preferential payments can complicate the reorganization process especially where the preferential payment was made to a friend or family member. The client is in a bit of a dilemma. Reorganizing the business may require a friend or family member to disgorge monies received within one year. But not reorganizing the business would lead to business failure and, in most cases, creditors executing on personal guarantees which might push the client into a personal bankruptcy to wipe out the personal guarantees or, if the client has significant assets, the client’s financial ruin as the holders of the personal guarantees Sue, obtain judgments and then execute on the client’s personal assets – home, bank accounts, vehicles, jewelry, inheritances, property settlement agreements and more– in order to satisfy the judgments.

The client does have some maneuvering room. What planning options does a client have?

• First, wait until after the preference period expires to file the bankruptcy case; or
• File the bankruptcy case, recover the preferential payments from friends or family, and repay those monies later after the business is reorganized. Nothing prevents a client from voluntarily repaying debt.
• Decline to seek recovery of the preferential payments on the grounds that the due diligence analysis supports not doing so because the cost of recovering the preferential payment outweighs the benefit.
  • Note, however, in an SBRA case, the subchapter five trustee or the United States trustee can, on their own, seek through legal action a recovery of the preferential payment.
• Agree through the reorganization plan to repay some portion of the preferential payment into a pool for unsecured creditors. In other words, settle. The creditor, or pool of creditors who would share in monies recovered, agree to get something in exchange for waiving their objection to confirmation of the plan on the grounds that the plan does not include preferential payment monies that could have been, arguably, recovered had the client chosen to do so.

In sum, payments made within 90 days to trade creditors or one year to family members or friends have to be disclosed on the bankruptcy petition. Whether action to recover the funds is brought has to be carefully considered. Payments to family or friends are the real dilemma. In the end, however, if the option to pursuing a family member or friend for preferential payments is the client’s and his or her family’s financial ruin, sometimes what has to be done has to be done, no matter how uncomfortable that is. But, again, as we discussed, the client has a number of viable strategies to deploy before the doomsday scenario comes into play.

To find out more about other powerful tools available under the SBRA to protect a business you enjoy and a way of life that you have worked hard to achieve, sign up to attend one of our webinars or call to schedule an appointment to discuss the particulars of your case. The initial consultation, up to one hour, is at no charge. The webinars are free, and include a 20 minute question and answer session at the end.  We would also refer you to the blog and video blog sections of our website for discussions on other topics and points of interest, including case studies where we apply the individual principles covered in these building block videos to real life fact patterns.