Is The Bankruptcy Trustee Demanding That You Return Your Last Progress Payment? What A Contractor Should Know About Preferential Payments

Is The Bankruptcy Trustee Demanding That You
Your Last Progress Payment?
What A Contractor Should Know About
Preferential Payments

By
William C. Last, Jr.
Attorney At Law

Since the economy has weakened, there has been an increase in the number of businesses that are seeking bankruptcy protection. As a result, sooner or later, you may receive a letter from the trustee for one of your now bankrupt clients that demands that you return the last progress payment you received from that client before it filed for bankruptcy.

The bankruptcy laws are at times confusing and intimating. They are even more so when you finally decide to write off the bankrupt's client's bad debt and then receive a letter from that client's bankruptcy trustee that demands you return the last progress payment you received to bankrupt client's estate as a "preferential payment."

Since the trustee is not always entitled to the return of such a payment, it is important to understand what constitutes a preferential payment and your defenses to a claim that you have received one. After discussing a few basic bankruptcy concepts, this article will explain what is a bankruptcy preferential payment and how you can defend against such a claim.

Basic Bankruptcy Concepts

The two primary goals of the federal bankruptcy statutes are: (1) providing an orderly manner for converting the assets of the debtor into cash so that the creditors can be paid in accordance statutory priorities; (2) providing a fresh start to the debtor by relieving the debt and allowing the debtor to keep certain assets that are exempt from bankruptcy. In addition, if the debtor can reorganize or develop a plan to pay its creditors, there are bankruptcy proceedings that will allow such a plan to be formulated and implemented.

There are two basic types of bankruptcy proceedings. One proceeding, commonly referred as a Chapter 7, provides for the orderly liquidation and distribution of the debtor's assets. The other proceeding, commonly referred to as a Chapter 11, allows a debtor to continue ongoing business operations while a reorganization plan is developed.

In a Chapter 7 proceeding, a trustee is appointed to oversee the liquidation/distribution process. The trustee is responsible for collecting the assets, liquidating the assets, and then distributing the proceeds. The distribution generally is in accordance with specific classes of claims.

In a Chapter 11 proceeding, the debtor can remain in possession of the bankruptcy estate ("debtor in possession") or, alternatively, the court can appoint a trustee. Within a fixed period of time after filing a Chapter 11 petition, the debtor is required to file and serve a written disclosure statement and a plan of reorganization. The plan includes a classification of the claims and specifies how each classification will be treated under the plan. The creditors are then allowed to vote to accept or reject the plan.

What Is A Preferential Payment?

Quite simply, a preferential payment occurs when a debtor makes a payment in preference to one creditor(s) over another class of creditor(s). Bankruptcy Code §547 is intended to prevent an insolvent party from making payments to a certain creditor shortly before filing bankruptcy. The preferential rules are intended to create equality amongst unsecured creditors.

For example, a typical preferential payment scenario could be: (a) you are an electrical contractor who performed electrical work for an owner. Long after the owner was supposed to pay you for the work, they finally make a past due payment of the balance due. The payment is made within 90 days before the owner files for bankruptcy protection. The owner does not make similar payments to its other creditors. Since you may have received more than you would have received from bankruptcy court in a distribution of assets, the bankrupt owner's trustee may have the legal right to recover the payment you received as a preferential payment.

Unless the payment is subject to a defense, a preferential payment or transfer occurs when: (1) there is transfer of property of the debtor to, or for the benefit of a creditor; (2) the transfer was for a pre-existing debt owed by the debtor before such transfer was made; (3) the transfer was made while the debtor was insolvent; and (4) the transfer was made on or within 90 days before the filing date of the bankruptcy petition. The time of the transfer is extended to one year for an insider. In addition, the preferential transfer must result in the creditor receiving more than it would have received if the case were a Chapter 7, or if the transfer had not been made.

Due to the complexity of preferential payments and the statutory exceptions, if you are confronted with a preferential payment claim, or a transaction that may lead to such a claim, you should immediately consult a qualified attorney.

What Happens If I Received a Payment from a Bankrupt Entity Within 90 Days of the Filing?

The bankruptcy trustee has the duty to review the bankruptcy estate to determine if there were improper transfers. Thus, once a trustee is appointed for a bankrupt party, it is not uncommon for the trustee to send letters demanding return of all the sums any creditor received from the now bankrupt party within the 90 day period before the bankruptcy petition filing. It is the goal of the trustee to recover preferential payments so that they can be recaptured for the bankruptcy estate and ultimately disbursed in accordance with the bankruptcy laws.

If you fail to respond to a demand by a bankruptcy trustee for the return of a "preferential payment," the trustee may initiate litigation to obtain the recovery of the sum demanded. Since there are defenses to a preferential payment claim, it is important that you timely respond to a demand to return a payment as a preference and to assert applicable defenses.

How Can I Defend Myself Against A Preferential Payment Claim?

There are a number of defenses to preferential payment claims. While there are seven key defenses, only three usually are applicable to construction industry related transactions. These three forms of transfers under Bankruptcy Code §547 are:

(1) A transfer that was intended by the debtor and the creditor to be a contemporaneous exchange for new value given to the debtor, if it was in fact a substantially contemporaneous exchange.

Example: An example of this defense is when the electrical contractor agrees to perform new work for an insolvent owner in exchange for immediate payment.

(2) A transfer is made (a) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; (b) made in the ordinary course of business or financial affairs of the debtor and the transferee; and (c) made according to ordinary business terms.

Example: An example of this defense is when the electrical contractor performs work for the insolvent owner, who then pays the electrical contractor in accordance with their past billing and payment history as they relate to their business practices. The main factors in determining if the transfer was "ordinary" in relation to past practices are: (1) the length of time during which the transactions occurred, compared to prior transactions; (2) whether the payment amount and form was different than the prior transactions; (3) whether or not the transaction in question was unusual in context of the usual payment and collection activity between the parties; and (4) whether or not the creditor took advantage of the debtor's poor financial condition.

(3) A transfer that to a creditor when there is a history of frequent sales to the debtor and periodic payments on account given in exchange for a subsequent unsatisfied new value that is given to the debtor by the creditor.

Example: An example of this defense is when the electrical contractor, who has a history of performing certain small jobs for the owner that are billed on an open account, receives payment of a past due from the insolvent owner, within the 90 days of the bankruptcy filing, payment of a past due invoice in the amount of $20,000, and then performs new work, valued at $10,000, that remains unpaid at the time of the bankruptcy filing. For the purposes of this example, the $10,000 for the new work could be offset against a claim that the $20,000 payment was a preferential payment that must be returned. This "subsequent advance rule" requires the following: (1) there must be new value after the payment in question is made; (2) the new value must be unsecured; (3) the new value must remain unpaid at the time of the bankruptcy petition filing.

As previously stated, there are other exceptions. When the nature of a payment is disputed, the trustee has the burden of proving the transfer was a preferential payment/transfer ("avoidable transfer"), and the creditor, or other party in interest against whom recovery ("avoidance") of the payment/transfer is sought, has the burden of proving defense(s) to the transfer ("non-avoidable transfer").

Practical Suggestions

If you receive a preferential payment demand letter from a bankruptcy trustee, you should immediately consult an attorney who is familiar with defending against such claims. Before you send a check in response to the trustee's demand, determine if what the debtor paid to you is a preferential payment/transfer, and/or if there is a defense to the claim under law. If you need more time to investigate the facts surrounding the payment, or have difficulty in immediately locating competent counsel, do not hesitate to write a letter to the bankruptcy trustee and request an extension of time to respond to demand.

If you have a client that is not paying you, and may be insolvent, always try to structure your efforts to collect the debt and any payment received so that payment will fall within one of the defenses to a claim that the payment is a preferential payment/transfer. Generally, always try to request payment before you provide the goods and services. If that is not practical under the circumstances, be sure that any additional goods and services provided to such a client are paid for in accordance with the ordinary course of the client's business and paid pursuant to your ordinary business terms.

Even if you have received payment, which is a preferential payment under law, it still may be possible to negotiate a lower payment with the bankruptcy trustee. It is important to discuss all your options with an informed and knowledgeable counsel.

This article, 8 2004, was written by William C. Last, Jr. The quoted text and other parts of the article are from SB 800. Parts of the article are from the Civil Code section 1375. Mr. Last is an attorney who has been specializing in Construction Law for over eighteen years. Mr. Last also holds a California A&B contractors license. If you have any questions Mr. Last can be contacted at 415-764-1990 or 650-425-7679 or by e-mail at wclast@lastlawfirm.com. He has other articles on his web site: lhfconstructlaw.com. This bulletin is published periodically to provide general information about current legal issues. If you have a specific legal question or need legal advice, you should contact an attorney