Although the number of commercial bankruptcy filings has dropped, the number of lawsuits arising out of these bankruptcies is on the rise.  These lawsuits are called “avoidance actions” because they seek to avoid or “unwind” transfers to third parties.  The most common avoidance actions are “preference” actions, filed against unsecured trade creditors to recover alleged “preferential payments” made by the debtor.

A “preference payment” is a transfer of value (usually a payment) by a debtor to a creditor on account of an existing debt  that is made within 90 days before the debtor files for bankruptcy.  If the debtor can demonstrate that a preference payment was made, it may attempt to recover that payment from a creditor.

There is no doubt that on their face preference actions conflict with modern business practices.  They arise when: (i) a trade creditor supplies goods or services to a company; (ii) the goods or services provided are accepted by the company;  (iii) the company pays for the goods or services; and (iv) the company files for bankruptcy within 90 days after making the payment.  As a result, the company (now the debtor) has a claim against the trade creditor to recover the full amount of the payment it made to the supplier.

By way of example, in the recent case of Ames Merchandising Corporation v. Cellmark Paper Inc., 450 B.R. 24 (Bankr. S.D. N.Y. March 28, 2011), the debtor filed a preference action to recover $1.9 million it paid to Cellmark Paper, Inc. before filing for bankruptcy.  The debtor clearly accepted and used Cellmark’s products, and owed the money it was suing to recover.  Nonetheless, after the bankruptcy court broke down the five elements of a preference action, it ruled in favor of the debtor and ordered Cellmark to return the $1.9 million in payments it received from the debtor during the 90-day “preference period.”

It makes no sense -- until you consider the public policy behind the Bankruptcy Code and avoidance actions in general.  The policy is that during the period in which a debtor is running short of cash, no single party should be “preferred” over another.  The preference statute allows a debtor to recover these transfers so that it can redistribute the recovered assets on a pro rata basis to all similarly situated creditors; thus preventing any “favoritism.”