In a bankruptcy setting, a preference action is a type of lawsuit that is filed by a bankrupt entity against their creditor.  In a preference action, the debtor seeks to recover payments that they made to the creditor during a 90-day time frame before they filed for bankruptcy.  This is a rather unusual type of lawsuit, as most of the time it is the creditor that is suing the debtor, and not the other way around.   

As an example, suppose that a business made a sizeable debt payment to their creditor.  60 days later, the company files for bankruptcy.  A preference action would allow the business to file a claim against their debtor to recover the debt payment that they made, since it was made within 90 days of the bankruptcy filing.  Such payments are called “preference payments”.

What are the Requirements for Filing a Preference Action?

Preference actions are permitted by the Bankruptcy Code in order to prevent creditors from engaging in aggressive collection practices.  The requirements for filing a preference action are:

  • The payment was made with regards to an “antecedent” debt (a previous debt rather than a current one)
  • The payment was made while the debtor party was insolvent (had less assets than liabilities)
  • The payment was made within 90 days of filing for bankruptcy
  • The payment allowed the creditor to receive more on the claim than if the payment were made through the bankruptcy hearings

Before a preference action is filed, the debtor usually sends their creditor a “demand letter”.  This is a writing requesting that the debtor return any payments that were made within the 90 days prior to filing for bankruptcy.  If the creditor refuses to return the payments, the debtor may file for the preference action against the debtor.  

What is a Bankruptcy Preference Defense?

The Bankruptcy Code also provides defenses that may be available for creditors who have had a preference action filed against them.  There are three commonly raised defenses to a preference action:

  • “Ordinary Course of Business”:  The creditor must prove that the payments were offered in the ordinary course and terms of business between the debtor and creditor.  This means that the payments were not made under terms of coercion, or in connection with overt, aggressive collection efforts by the creditor.  Invoices and previous payment records can help prove what the “ordinary course of business” was between the parties, which may be different in each case.
  • “Contemporaneous Exchange”:  The creditor must show that they provided new services or goods at or near the same time that a preference payment was made.  The payment must be of equal value to the services or goods, and must not be intended for the payment of a previous invoice.  In other words, the payment was not actually for the purpose of satisfying debt, but for paying for the new goods or services, and thus should not be repaid to the debtor. 
  • “New Value”:  The creditor must show that services or goods were sold to the debtor after a preference payment was made.  The value of the new goods or services can be used to offset the amount of re-payment that the creditor will issue to the debtor for their preference payments.

For these types of defenses, the burden of proof rests on the creditor.  This means that it is up to the creditor to raise the defense(s), and to provide proof in support of the defense.  Proof can be supported through evidence like documents, invoices, accounting records, and witness testimony in relation to the preference payments.

Do I need a Lawyer for assistance with Preference Actions and Preference Defenses?

As with any bankruptcy-related claim, preference actions can be exceedingly complicated.  It’s always in your best interest to contact a bankruptcy lawyer if you have any issues with a preference action or a preference defense.  A competent bankruptcy attorney in your area can explain how the Bankruptcy Code works.  Many changes have been made to bankruptcy laws in the past decade, so be sure to ask your lawyer if you have any questions or concerns about new laws.