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New Bankruptcy Law Aids Trade Creditors When Resisting Preferential Transfer Claims

NAW Legal Advisory - May 2005

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was signed into law by President Bush on April 20, 2005. This legislation contains the most significant changes to federal bankruptcy law since the enactment of the Bankruptcy Code in 1978, including important changes to the law’s preferential transfer provisions.

Background

Federal bankruptcy law has permitted the trustee for a bankrupt company or person to recover certain “transfers” made by the bankrupt within the 90 day period before the bankruptcy petition is filed for a debt existing at the time of transfer. A transfer includes a payment made by the bankrupt to pay off a bona fide debt. “Recover” means the company that received payment has to give the money back to the trustee, even though by contract the payment was due and owing.

These payments are known as preferential transfers. They are considered preferential because a financially troubled company tends to pay only certain (i.e., preferred) unsecured creditors, to the detriment of the remaining creditors. By recovering these preferred payments, the trustee is then able to make an equitable distribution to all unsecured creditors.

To illustrate, here’s an example: Wholesaler-distributor (“WD”) sells $10,000 worth of product on open account to Customer (“C”) and the product is delivered on 8/15/04. Payment is due within 30 days of delivery (by 9/15/04). C pays WD late, with payment received by WD on 11/1/04.

On 12/31/04, C files a petition in bankruptcy. The bankruptcy trustee will (in fact, has a fiduciary duty to) examine each payment made by C during the last 90 days preceding the petition date (i.e., all payments from 10/1/04 to 12/31/04) and seek recovery of preferential transfers. In our example, generally the trustee is entitled to recover C’s $10,000 payment made to WD (there are a few defenses) because:

  • WD received the payment within the 90 day period,
  • The payment was for an antecedent (existing on the date of payment) debt owed to WD, and
  • The payment was not made in the ordinary course of business, when due (payment was due on 9/15 and was made 45 days later).

In our example, if WD received the $10,000 payment within the agreed-to terms (30 days from delivery), and those terms are customary in the industry, the trustee would likely not be able to recover the $10,000. Of course, companies in financial trouble generally only pay select debts on time within terms.

New Bankruptcy Law

The new law amends the Bankruptcy Code’s preferential transfer provision in three important areas:

  • In defending against a preference claim the creditor now needs to prove either (1) the payment was made in the ordinary course of business of the creditor and debtor, or (2) the payment was made according to ordinary business terms in the industry generally. Under existing law, the creditor had to meet both tests.
  • Under the new law, the trustee may not recover preferential transfers to a creditor aggregating less than $5,000.
  • Under existing law the trustee typically filed, or threatened to file, a suit (called an adversary proceeding) against a creditor in a distant bankruptcy court to recover a small preference payment. The creditor would often elect to settle rather than incur defense costs. Under the new law, with some limited exceptions, these suits seeking to recover less than $10,000 may be filed only in the federal district court where the creditor is located.

Effective Date

Generally the effective date of these changes (and others) to the Bankruptcy Code is 180 days after enactment, which is October 17, 2005.