Bankruptcy Preference Actions and the Preference Defense

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 What Is Bankruptcy?

Bankruptcy is a legal process that is initiated when a person or business cannot meet their financial obligations. Through the legal process of bankruptcy debtors will liquidate their assets or restructure their finances to fund or eliminate their debts that they are unable to pay. There are different types of bankruptcy, all of which are defined and governed under federal law. Consumer bankruptcy occurs when an individual that cannot pay back their debts that they have incurred for their personal needs files for bankruptcy.

Once the consumer bankruptcy process is completed, the debtor that files for the bankruptcy would no longer be liable for the debts that they incurred, minus certain debts that are not dischargeable. Additionally, at the completion of the proceedings the bankruptcy court would enter an official discharge order that releases the debtor from their debts. This would then give the debtor a clean financial slate.

However, the bankruptcy itself would remain on their credit report for up to ten years. Also, filing for bankruptcy can have other lasting consequences on the debtor. As such seeking bankruptcy should be reserved as a last resort for times of extreme financial hardship.

What Are the Different Types of Bankruptcy?

As mentioned above, there are three main types of bankruptcy in the United States: Chapter 7, 11, and 13. Chapter 7 Bankruptcy, also commonly referred to as “liquidation bankruptcy,” allows individuals to discharge all of their debts that can be legally discharged. However, there are specific rules in terms of who is able to qualify and file for Chapter 7 bankruptcy.

In order to be eligible to file for a Chapter 7 bankruptcy, a debtor’s income must be either equal to or below the median income in their state. This means that each state will have a different income requirement for Chapter 7 bankruptcy. If the debtor’s income is above the requirement for their state, the court may apply a “means test” based on their previous six months of income.

If they are eligible, and they initiate a Chapter 7 bankruptcy filing, the court will issue an automatic stay for the filer. The automatic stay will prevent creditors from attempting to collect on the debts the filers owe. Automatic stays also serve to prevent or pause the following actions against the bankruptcy filer:

  • Pending lawsuits;
  • Wage garnishments;
  • Filing of liens against the filer; or
  • Seizure of the filer’s property.

Chapter 13 Bankruptcy is commonly referred to as “wage earner’s bankruptcy” and is a way for a debtor to restructure their debts to be able to afford payments. Chapter 13 is generally reserved for those who have incomes higher than their state median, but also wish to keep their property intact. Under Chapter 13 bankruptcy some debts may be eligible for discharge, while others will require payment in full through a payment plan. Typical payment plans are anywhere between three and five years.

An individual is eligible for a Chapter 13 bankruptcy filing if they meet the following requirements:

  • They’re either an individual or married couple;
  • As of April 2022, Their total secured debts are equal to or less than $1,395,875.00;
  • As of April 2022, their total secured debts are equal to or below $465,275;
  • They have not had a bankruptcy petition dismissed within the last 180 days due to failure to appear or comply with the bankruptcy court; and
  • They receive credit counseling through an approved counselor within 180 days from the date that their petition is filed.

Chapter 13 bankruptcy differs from Chapter 7 bankruptcy in that the borrower attempts to keep their property, and is also required to continue to make payments. Similar to Chapter 7, Chapter 13 bankruptcy can also affect an individual’s credit for up to ten years after filing. Finally, during the Chapter 13 bankruptcy payment plan process, debtors must also adhere to a strict budget without lines of credit. Because of this fact, many borrowers tend to drop out of the payment plan.

The last of the three main bankruptcy forms is Chapter 11 bankruptcy. This bankruptcy is also known as “reorganization bankruptcy” and is a type of bankruptcy that is available to individuals, corporations, and partnerships. With Chapter 11 bankruptcy, there are no limits on the amount of debts that can be involved in the bankruptcy process.

As such, this form of bankruptcy is the most common choice for large businesses seeking to restructure their debts in order to become profitable again. It is important to note that Chapter 11 bankruptcy is generally more expensive to debtors than the other chapters. Further, the rate of successful business reorganizations is generally very low.

During some bankruptcy proceedings there are cases that arise where a debtor may be sued by creditors. Further, there are also circumstances wherein a debtor may file a lawsuit against one of the creditors involved in the bankruptcy proceedings.

What Is a Preference Action?

As noted above, there are certain situations in which a debtor may actually file a lawsuit against one of their creditors. In a bankruptcy proceeding, a preference action is a type of lawsuit that is filed by a bankruptcy trustee against a creditor of the bankruptcy estate. A bankruptcy estate is created when a bankruptcy action is commenced and consists of all of the property and assets of the file.

In a preference action, the debtor seeks to recover payments that they made to the creditor during a 90-day time frame before they commenced the bankruptcy proceedings. Preference actions are rather unusual, as most commonly it is the creditor that is suing the debtor. The purpose of preference actions are to protect debtors from aggressive debt collection activities that may have forced the debtor into bankruptcy.

For example, suppose that a business or individual made a sizable debt payment to their creditor, as a result of threatening debt collection letters. Then, 60 days later the debtor is forced to file for bankruptcy as the sizable payment caused them to be unable to control their debts.

A preference action would then allow the business to file a claim against their creditor to recover the payment that they made, since the payment was made within 90 days of the initial bankruptcy filing. Thus, payments made within the preceding 90 days are often referred to as “preference payments”.

What Are the Requirements for Filing a Preference Action?

Once again, preference actions are lawsuits that are permitted by the Bankruptcy Code in order to prevent creditors from engaging in aggressive debt collection practices. There are certain requirements for filing a preference action, including:

  • The debt payment was made with regards to an “antecedent” debt. An antecedent debt is a previous debt, as opposed to a current one;
  • The debt payment was made while the debtor party was insolvent, i.e. when the debtor had less assets than liabilities;
  • The debt payment was made within the 90 days prior to the debtor filing for bankruptcy; and
  • The debt payment allowed the creditor to receive more on the credit claim than the creditor would have received if the payment had been made through the bankruptcy hearings.

Before a preference action is filed, the debtor typically sends their creditor a demand letter, demanding that any payments within the 90 days prior to their bankruptcy filing be refunded. If the creditor refuses to return the payments, the debtor may then file for the preference action against the creditor.

What Is a Bankruptcy Preference Defense?

The Bankruptcy Code also provides legal defenses for creditors who have a preference action filed against them. There are three common raised legal defenses to a preference action:

  • Ordinary Course of Business Defense: In order to succeed in an ordinary course of business defense, the creditor must prove that the payments made by the debtor were offered in the ordinary course and terms of business between the debtor and creditor. Creditors may typically accomplish this by providing evidence that the payments were not made under terms of coercion, or in connection with overt, aggressive collection efforts by the creditor;
  • Contemporaneous Exchange Defense: In order to succeed in a contemporaneous exchange defense, the creditor must demonstrate that they provided new services or goods at or near the same time that a preference payment was made. For example, if a payment was not actually for the purpose of satisfying debt, but rather for paying for the new goods or services, the creditor should not be forced to refund such payment. Importantly, contemporaneous exchange does not cover payments for previous invoices; and
  • New Value Defense: In order to succeed in a new value defense, the creditor must show that new services or goods were sold to the debtor after a preference payment was made. Then the value of the new goods or services can be used to offset the amount of any refund that the creditor may issue to the debtor for their preference payments.

For these types of legal defenses, the burden of proof rests on the creditor. Therefore, it is up to the creditor to raise the legal defense claim, as well as provide the proof in support of the defense. Examples of proof for the above defenses may include evidence such as documents, invoices, accounting records, and even witness testimony.

Do I Need a Lawyer for Help with Preference Actions and Preference Defenses?

As can be seen, bankruptcy law and preference actions can be exceedingly complicated. As such, it is recommended to contact a bankruptcy lawyer if you have any questions regarding preference actions or preference defenses. An experienced bankruptcy attorney can assist you in understanding bankruptcy law, and whether or not you would be successful in a preference action lawsuit against a creditor.

If you are a creditor that has had a preference action filed against you, a bankruptcy attorney can assist you in determining whether or not there is an applicable legal defense to defeat the debtor’s claim. Finally, in either scenario an attorney can represent you in court, as necessary.

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