Preference Defense: Bringing Playground Justice Into The Courtroom

There are a set of unwritten yet universal rules that every kid who grows up in the Milwaukee area seems to know. Eeny, meeny, miny, moe is the best way to select a winner. Pinky promises are akin to unbreakable contracts. And saying “no take backs” when you make a trade locks that deal into place, no matter how much the other kid later regrets their decision. These and other rules ensure justice prevails on the playground. 

As we grow up, we see echoes of these edicts in the laws that govern our lives. There is a particularly striking similarity between the playground rule of “no take backs” and preference defense actions in bankruptcy court

What Is the Preference Defense?

Having a preference defense you can assert when one of your customers files for bankruptcy is the “no take backs” of the bankruptcy world. If you do not have a defense, the bankruptcy court can claw back any funds paid to you by someone who has filed for bankruptcy if the payment was made within 90 days of the bankruptcy. Policymakers gave courts this power because they don’t want people who are planning on filing bankruptcy to pay off their favorite creditors and leave others in a lurch. This is where the term preference action comes from.

Although the power to claw back payments through preference actions was given to the courts to protect creditors from debtors who might attempt to transfer assets improperly, no wrongdoing is necessary on the part of the creditor for a preference action to be filed against them. Most preference actions are filed against a business that was just going about its business, as usual, not suspecting that its customer was in financial distress.

Fortunately, going about your business as usual may be a valid defense. The ordinary course of business defense applies when a payment subject to clawback was received in the ordinary course of business between the creditor and the debtor. To take advantage of this defense, the creditor must be able to show that its relationship with the debtor did not change in the time period leading up to the debtor’s bankruptcy filing. 

Another popular defense is the contemporaneous exchange for new value defense. It applies when the payment sent to a creditor was intended by both the debtor and creditor to be a payment for some new good or service exchanged right when new assets were transferred to the creditor. This is why a lot of contracts, and especially those with a financially troubled business partner, specify that they are cash-on-delivery (COD).

Unless you want to risk having the money you are rightfully owed clawed back by the courts when one of your customers files for bankruptcy, it is a good idea to talk with an experienced bankruptcy attorney about what options are available to you in case you are served with a preference action. It is understandably frustrating to pay someone to protect the money that is rightfully yours, but it is better to pay a little extra than to pay it all back to a court, and that is what may happen unless you call “no take backs.”