Minimizing Your Exposure to a Bankruptcy Preference Claim

Understanding Bankruptcy Preference Claims

What is a bankruptcy preference claim? The following scenario describes it perfectly: you have been doing business with a customer for quite a while. The customer is starting to get slower on payments but assures you that your invoice will be paid. The next thing you receive in the mail is a notice that the customer filed for either a Chapter 7 or Chapter 11 bankruptcy case. Under Section 547 of the Bankruptcy Code, any payment made to you by the customer within 90 days before the filing of the bankruptcy case is considered a preferential payment that can be recovered by the Bankruptcy Court. How can this be? You delivered products or services to the customer. The invoices were correct, and the products or services you sold were not defective; yet, you might have to return the amount paid on a perfectly legitimate debt. Why?

This is perhaps the worst section of the Bankruptcy Code from a policy perspective. What could possibly be the reason behind requiring a seller to return a perfectly legitimate payment? The rationale is that savvy creditors who are aware a company might be insolvent will be much more aggressive than creditors who are not in the know. This gives them the opportunity to effectively take advantage of the situation to the detriment of the unknowing creditors. Creditors who pressure debtors owing them money to make payments during the 90-day period leading up to bankruptcy may be required to return these payments to the bankruptcy estate for equitable distribution among all creditors. There are two major problems with this policy: first, it does not matter whether the creditor knows the debtor is insolvent; second, the funds recovered from those who received these payments prior to bankruptcy are almost never equitably distributed among the other creditors. Rather, they typically go to pay professional fees and only a small portion may end up in a pool of funds for distribution to all creditors.

Is there anything you can do to minimize your exposure to being sued by the bankruptcy estate to recover a preference? The answer is yes. There are multiple techniques. Some are practical and some may not be, but I will list them all here in order of their significance.

The “Ordinary Course of Business” Defense

The first defense to a preference claim is called the “Ordinary Course of Business” exception. In other words, if the payment was made in the ordinary course and not because you pressured the debtor while it was insolvent, then you have a defense to a preference claim. The almost safe harbor for the “ordinary course” defense is that the invoice was paid according to its terms. Most invoices contain 30-day payment terms. If, historically, the debtor made payments to your company within 30 days of invoicing and the last payment before bankruptcy was made within 30 days, you should have a good defense. But how many companies really pay within 30-day terms? Not many, especially if they are experiencing financial difficulty. Will it be

considered a preference if you have 30-day payment terms and you call the debtor in 20 days, ask for payment, and payment is received within 30 days? No, this is perfectly acceptable.

What if your invoices say payment is due within 30 days, but for the last three years, the customer has paid within 60 days? This, too, is considered in the ordinary course of business. The problem comes when, each month, the customer becomes later and later on the most recent invoices; then, when the customer finally makes a payment, you apply the payment to an old invoice from something like 120 days ago. This will not be considered in the ordinary course of business. Is there anything you can do to avoid this result? Yes, but it is not easy. Let’s assume you have the situation in the previous sentence. If you apply the most recent payment to the most recent invoice, you can argue that the payment was made in the ordinary course as it was made according to the invoice terms. This is not a one hundred percent fix, but it gives you a leg to stand on.

The “Contemporaneous Exchange of Value” Defense

Are there some other good strategies? Yes. Another defense to a preference action is called the contemporaneous exchange of value. Stated another way, this is a COD sale. But this only works if your customer does not have another source of supply willing to extend credit. If it does not, you can also ask for some additional funds to cover the old invoices. Even though this might be exposed to a preference claim, it will be much less than if you sell a new product, receive payment, and apply the payment to the oldest invoice.

These are the most practical ways to minimize preference exposure. There are some others, but they are difficult. First, you can enter into a supply agreement which provides you with a security interest in the buyer’s assets, as payments on secured claims are not preferences; however, you must have filed the UCC-1 prior to 90 days before the bankruptcy case; second, you can require an up-front deposit before shipping. Up-front deposits are, by definition, not preferences which are payments on antecedent debts; third, you can require a Letter of Credit from a bank to secure payment of your invoice. This is done primarily in international transactions. It is not a preference because the payment is made by the issuer of the Letter of Credit, not the Debtor.

The best practice is to keep a sharp eye on your customer’s payment trends and, if it looks like the situation is deteriorating, take the steps noted above.

To work with attorneys who understand how to keep you protected, give us a call or contact us through our website: (281) 829-1555. Doré Rothberg – Houston & Fort Worth Law Firm.