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Payments to Creditors Ahead of Schedule May Constitute Avoidable Preferences

A recent decision by Judge Stuart M. Bertnstein of the Bankruptcy Court for the Southern District of New York in the case of M. Fabrikant & Sons, a jewelry retailer, could make it more difficult for a creditor to defend against an action to avoid pre-petition payments as preferences in the case where the payments were made early or on time.

Under Bankruptcy CodeSection 547, payments to creditors made by the debtor within the 90 days preceeding bankruptcy that are deemed to favor one creditor over another can be reversed.  A common defense to a preference action is the “ordinary course of business” defense under Section 547(c)(2).  In order to prevail, the creditor must show that the debt was incurred in the ordinary course of business and either:  (1) the payment was made in the ordinary course of business between the debtor and the creditor; or (2) the payment was made according to ordinary business terms.

In the typical case, a debtor rushes to pay several old invoices, sometimes in order to curry favor with a trade creditor or satisfy the demands of an insider, and the payments are subject to avoidance in order to place the recipient on equal footing with other creditors.  In M. Fabrikant & Sons' case, although the debtor made payments for jewelry purchased from Gramercy on average 65 days after the invoice, the debtor made a certain payment 30 days after the invoice (and another payment 95 days after the invoice).  Significantly, the 30-day payment was consistent with the payment terms provided in the invoice.  Nevertheless, the court found that the payment constituted an avoidable preference because it was inconsistent with the debtor's practice of paying the invoices late.

Creditors and their attorneys should keep this case in mind when defending a preference suit.  If a creditor paid some invoices late and others on time or early, it will be necessary to carefully present the facts to harmonize the payments with the debtor's practices.

By Reno F.R. Fernandez III