The anatomy of a preference claim: Building your best defense as a trade creditor

No matter how sound your credit policy or how thorough your practice, bankruptcy can strike without warning. One day your customer is current and the next, they’ve filed. And when they do, the payments you worked hard to collect could be at risk of being clawed back through a preference claim.  

Why it matters: Defending against a preference is not only possible—it can be cost-effective, especially when compared to other types of litigation. Trade creditors who understand the process and work closely with legal counsel are better positioned to protect their bottom line.  

What is a preference claim? 
Under Section 547 of the Bankruptcy Code, a preference is a cause of action that arises at the moment a debtor files for bankruptcy. The elements of a preferential transfer are as follows:  

• Payment or transfer of property to or for the benefit of a creditor  
• On account of an antecedent debt (meaning a cash-in-advance payment cannot be recovered as a preference)  
• Made while the debtor is insolvent  
• Made on or within the 90 days before the filing of the petition (or one year before, if the recipient is an “insider” of the debtor) 
• The creditor receives more than it would under a hypothetical Chapter 7 liquidation 
• If the creditor did not fare better than it would have had the allegedly preferential transfer not been made, no preferential treatment is applied  
• The trustee also bears the burden of proof in satisfying the due diligence requirement under the Small Business Reorganization Act (SBRA)  

In some cases, the first time a creditor may learn of a preference claim is through the commencement of formal litigation (e.g., the filing of a complaint or demand for discovery). But in many cases, a creditor will be notified of a preference claim through an informal demand letter sent (typically through counsel) by a trustee (in some cases referred to as bankruptcy trustee, debtor-in-possession or bankruptcy estate fiduciary). This letter demands the return of payments received within 90 days before the bankruptcy filing, often initiating a negotiation process that can escalate to litigation if the preference claim isn’t settled or otherwise resolved through informal negotiations.    

Received a demand letter? Here’s how to respond 
Upon receipt of a preference demand letter, creditors are strongly advised to respond promptly to avoid default. Seeking legal counsel immediately and gathering appropriate documentation, including invoices, payment history and correspondence, is essential to substantiating primary defenses against the claim.  

Preference demands typically require proof of payment made by the debtor. Creditors should check their internal records for (and, if necessary, request that the trustee provide) a list of all payments relating to the claim, including copies of cancelled checks and proof of wire or Automatic Clearing House (ACH) transfers, with remittance instructions. The creditor may obtain notices of non-sufficient funds (NSF) or return-to-maker checks. If funds were not received, then the funds cannot be recovered, and the creditor can request that the trustee or debtor withdraw the demand.   

Confirming the date when each payment cleared from the debtor’s account is just as important—if a payment was received before the 90-day preference period (e.g., 91 or more days before the bankruptcy filing), it cannot be recovered as a preference.   

Additionally, a lawsuit to recover a preference claim must be filed within two years after the debtor filed for bankruptcy. Creditors should be mindful of this two-year statute of limitations. It will give a sense of how much time there may be to negotiate before a complaint is filed or whether the claim can be pursued in the first instance. If the two-year limitations period passes, the preference claim cannot be pursued.     

Failure to respond to a preference demand letter allows the bankruptcy trustee to assume an absence of viable defenses against the preference claim and thereby satisfy SBRA’s due diligence obligation. The trustee may then file an adversary proceeding seeking the entire amount of payments received within the 90 days before the bankruptcy filing.  

The Federal Rules of Civil Procedure require plaintiffs to file lawsuits in the district where the defendant resides when the gross amount of the claim is less than $27,750 (subject to adjustment for inflation). A number of courts have held that this venue limitation does not apply to preference actions.  Nonetheless, creditors should be mindful of this venue limitation as it may provide some leverage when negotiating preference demands that fall under the applicable minimum.  

Most importantly, creditors should determine whether they can actually be sued in the first place. For bankruptcy cases filed on or after April 1, 2025, the trustee cannot file suit if the aggregate claim is less than $8,575—though demand letters may still be sent regardless. In fact, demand letters are often sent without considering all potential defenses (despite the due diligence requirement discussed above). Never assume a preference claim is valid just because a demand letter was sent. 

Preference Defenses 
Assuming a payment meets all the elements of a preference claim, there are several defenses available to creditors. The three most prominent ones are the contemporaneous exchange defense, the subsequent new value defense and the ordinary course of business defense.  

The contemporaneous exchange defense applies when a payment was intended to be and actually was a simultaneous exchange for new value provided by the creditor, such as a cash-on-delivery transaction. This defense eliminates preference liability entirely for that transaction.  

The subsequent new value defense provides a dollar-for-dollar reduction in preference liability for any credit extended to the debtor after a preference payment was received. For example, if a creditor received a $10,000 payment on the 87th day before a bankruptcy filing and then sold $10,000 worth of goods on credit on the 85th day (i.e., after the payment), the preference liability on that payment would be reduced to zero. “Creditors who continued doing business with the debtor during the 90-day period often find this to be their strongest and most straightforward defense,” said Michael Papandrea, Esq., partner at Lowenstein Sandler (Roseland, NJ).  

The ordinary course of business (OCB) defense can be proven in one of two ways. The first is the “subjective” OCB defense, which compares the timing and manner of preference payments against the historical payment practices between the creditor and the debtor. To analyze this defense, professionals (and courts) will typically analyze the timing and manner of payments made in the two-year period leading up to the beginning of the preference period to establish certain historical baseline(s). Shortly after, they’ll review the preference period payments to see if they fall within that baseline (if a payment falls within historical baseline, then it is protected by the subjective OCB defense).   

The second is the “objective” OCB defense, which compares the preference payments against industry payment practices, regardless of the past practices between the parties. “Notably, NACM played a key role in allowing creditors to prove either the subjective or objective defense as part of the 2005 amendments to the Bankruptcy Code giving trade creditors a meaningful advantage over trustees who may not have access to the same industry data,” said Bruce Nathan, Esq., partner at Lowenstein Sandler (New York, NY).  

One important caveat to consider: collection pressure applied during the 90-day preference period, such as repeatedly calling the debtor’s CFO, modifying credit terms or halting shipments, can potentially negate a creditor’s OCB defense, particularly when the defense is based on the creditor’s and debtor’s prior history (i.e., the subjective OCB defense). “Trade creditors should remain mindful that their actions and communications during the months leading to a potential bankruptcy filing may be subject to scrutiny in the preference context, and avoid generating evidence of non-ordinary conduct,” said Papandrea.  

Minimizing Preference Risk 
Preference claims can often be settled or otherwise resolved without significant litigation, typically making them more cost-effective to defend than other types of causes of action—particularly when considering the savings arising from asserting a rigorous defense.   

“Many litigators, especially those who work for larger companies with extensive in-house legal departments, might assume that preference claims are just as expensive and time-consuming as other types of litigation,” Papandrea said. With most preference claims, however, creditors (or, their counsel) can quickly determine how strong their defenses are and predict the outcome, or even fully resolve the claim, at a significantly lower cost. “Even on a relatively low-dollar preference claim, there’s usually value in retaining counsel to defend against it.”  

For troubled customers, the creditor may choose to continue extending terms or modifying existing terms, all while managing accounts receivable (AR) and potential risk exposure. “The possibility of a preference claim down the road shouldn’t dictate every decision credit professionals make, but they should certainly exercise caution when a customer seems to be heading toward bankruptcy, since any payment made by the customer during this time may be at risk of being clawed back,” said Papandrea.  

To the extent possible, a credit professional can try to structure their relationship with customers to minimize preference risk. “When collecting during a potential insolvency scenario, holding a security interest, such as a deposit or letter of credit, can provide a defense to a preference claim,” said Papandrea. “A switch to cash-in-advance also gives you an immediate defense, if you have the ability to make that switch from both a legal and business perspective.”  

The bottom line: The best defense against a preference claim is a good offense. What you do before your customer files for bankruptcy will determine how successfully you defend against any potential preference exposure. Stay informed, act strategically and don’t wait for a demand letter to start preparing.