Weathering the Storm: What is a Preference Demand Letter and What Do I Do With It?

03/11/2009

With the current economic downturn, your company may encounter the following unpleasant fact scenario: While going through the company’s mail, you find a demand from some person claiming to be a representative of one of your bankrupt customers threatening a lawsuit unless you return “preferential” payments made to you prior to the bankruptcy. Immediately, extortion comes to mind, and your first reaction is to simply ignore this demand because you certainly didn’t do anything wrong. Unfortunately, the demand is very real, and ignoring a preference demand will likely lead to a collectable money judgment being entered against you. To eliminate or minimize your company’s potential liability, you should know what a preference demand letter is and what to do with it.

The Bankruptcy Code provides a source of recovery for debtors or bankruptcy trustees in the form of a cause of action called a “preference.” The purpose of preference laws is to allow ratable treatment of a debtor’s general unsecured creditors and to discourage a financially distressed company from favoring certain creditors over others shortly before the company files bankruptcy. In short, bankruptcy law allows payments made to favored creditors shortly before a bankruptcy filing to be recaptured and distributed ratably to all similarly situated creditors. You may be subject to a preference if:

1.  you receive any payment or transfer from the debtor during the 90-day period prior to the bankruptcy filing;

2.  the payment was on account of an antecedent debt (not a prepayment);  

3.  the debtor made the payment while insolvent; and

4.  the payment enabled you to recover more than other similarly situated unsecured creditors would receive in a Chapter 7 liquidation.

If the payment meets these criteria, then no matter what your intent may have been with respect to that payment, the debtor or trustee will have a valid cause of action against you. The ultimate result of this cause of action may be a bankruptcy court money judgment against you, ordering the return of the payment.

Before paying all or any portion of the demand (or even worse, ignoring the demand), you should consult with your counsel. The Bankruptcy Code provides several defenses that, in many cases, will defeat or at least minimize your liability for the preference. For example, you may have a complete defense to the preference if you were paid within the normal range of historical payment dates between the parties or if the payment was made within industry-standard payment terms (otherwise known as the “Ordinary Course of Business” defense). You may also have a complete or partial defense to the preference if you continued to provide goods or services to the debtor after the payment at issue (the “Subsequent New Value” defense). Through negotiation and proper strategy, a company often can eliminate or at least reduce its exposure and the costs associated with preference litigation.

Remember to always notify your legal department or outside counsel at the first sign of a dreaded preference demand letter.

For more information on the Restructuring, Workouts and Recapitalizations group and its members, go to Restructuring, Workouts, and Recapitalizations.

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