Sidestepping a Preference Lawsuit
Frederick J. Petersen
Regardless of how cautious or financially secure a company may be, there is little it can do to prevent one of its customers from seeking bankruptcy protection. When a customer files bankruptcy, the first response is to assess how much is owed by the insolvent company. As if not disruptive enough that payment may not be made for goods and services provided to the bankrupt company, another bitter pill must be swallowed when served with a lawsuit to return some of the few payments received from the bankrupt customer.
More than 50,000 lawsuits were filed last year to recover "preferential payments." Preference is a mechanism of the Bankruptcy Code, designed to prevent a failing company from favoring certain creditors, and to prevent certain creditors from taking advantage of a failing company and taking more than its "fair share" of the debtor's assets. The Bankruptcy Code allows, and imposes an affirmative duty on, a bankrupt debtor to recover preferential payments made to creditors.
The Bankruptcy Code defines a preferential payment as: (1) a transfer of the debtor's interest in property, (2) to or for the benefit of a creditor, (3) for or on account of an antecedent debt, (4) made while the debtor was insolvent, (5) on or within 90 days prior to the bankruptcy filing, and (6) that enables the creditor to receive more than such creditor would receive in a Chapter 7 case if the transfer had not been made.
For instance, if a customer is behind in paying a company's invoices, and agrees to pay an extra $1,000 per week until caught up, but files for bankruptcy within 90 days of one of the extra payments, the extra payment may be a preference. Similarly, if a customer is late in paying an invoice, and agrees to transfer a piece of equipment to satisfy the obligation, but files for bankruptcy within 90 days of the transfer, it may be a preference.
In the creditor's defense, even if the elements of a preference are met, a transfer is generally not preferential if: (1) the payment was made in the "ordinary course" of business with the debtor, (2) the creditor supplied "new value," of any type, to the debtor, subsequent to the transfer, or (3) if the transfer was part of a contemporaneous exchange.
For instance, if an invoice calls for payment within 30 days of its issuance, but the customer regularly pays 65 days after the invoice date, payments made during the 90 days prior to bankruptcy 65 days after the invoice date are likely in the "ordinary course" of business and not preferential. Also, if after receiving a preferential payment, another delivery worth more than the payment is made, but not paid for, the prior payment is not recoverable as a preference.
Unfortunately, there is no definitive way to prevent being a defendant to a preference lawsuit. Sometimes, even if a party has a complete defense to a preference claim, it may still be sued because the debtor has not completed an analysis of potential defenses.
Generally, however, to protect one's self from a preference lawsuit, a party should be aware of the preference defenses, and attempt to make sure transactions with a troubled customer fit into one of the categories. Companies should keep a very close watch on their customer receivables. If a party stops paying according to ordinary business terms, the customer account should be flagged to make sure future payments are timely made. Also, if a customer is unable to pay invoices on time, or there is some indication the customer is approaching insolvency or bankruptcy, the customer may need to be placed on COD, so that any additional payment is part of a contemporaneous exchange.
In certain transactions, there are additional safeguards that can be instituted. For example, extending additional credit or continuing to do business with a troubled customer may
be new value if documented correctly. Any safeguards, however, must be negotiated before the customer files for bankruptcy protection to be an effective defense to a preference lawsuit.
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