Imagine, if you will, that your best customer went out of business a year or so ago. Your sales took a big hit and your company is just starting to recover from the revenue loss. Now imagine you open a letter from a Wilmington Delaware attorney demanding you pay back $100,000 that she claims your company received within 90 days of the bankruptcy filed by that customer. This is a preference action and how you deal with it will determine how much, if any, of that $100,000 you will have to repay.
"Preference" is a term used in bankruptcy to describe monies paid to creditors by a soon-to-be bankrupt company shortly- before it files for bankruptcy. Preferences were deemed to create unequal treatment between the creditors of the bankrupt business. The thought was that the bankrupt would pay off certain creditors in order to obtain from those creditors some sort of favorable or preferential treatment after the bankruptcy concluded.
In order to discourage these preferential payments by bankrupts, Congress created what it considered to be a "bright-line" test of whether payments were preferences. Under this bright-line test Congress conjured, generally, any payments made to creditors within ninety (90) days of the filing of bankruptcy by a bankrupt company are presumed to be preferential and therefore have to be returned by the creditor.
Any successful defense of a preference claim will require you to prove such things as the amounts of payments you have received from the bankrupt -- not just during the 90 days prior to filing of the bankruptcy -- but during the entire history of your company's dealings with the bankrupt. You will need accurate dates: of when product was delivered; when the bankrupt company was invoiced for those sales; when payments were received on each of those sales; and when those payments were deposited into your company's bank.
You will also need copies of documents supporting these transactions, including contracts, terms and conditions of sale, security agreements, invoices, paper payments, electronic payments and correspondence, and notes of communications between your company and the bankrupt.
All of this information will be essential in establishing to the law firm or, if things do not go well, to a bankruptcy court, that your company does not have to repay the $100,000 the attorneys are claiming. In other words, your documentation is essential to your defense against this claim.
What defenses are available to your company?
There are three major defenses available in preference actions, and a few esoteric ones. The big three are, in order of greatest applicability:
- The payments were made in the ordinary course of business;
- The payments made as a result of your company providing "New Value" to the bankrupt; and
- The payments constituted "substantially contemporaneous exchanges of equal value."
1. Payments made in the ordinary course of business.
This defense is the most frequently employed and can be established under two distinctly different approaches -- the payments were ordinary as between the creditor and the bankrupt, OR, they were ordinary according to industry standards.
The first approach requires the creditor to prove that the payments which it received within 90 days of the bankruptcy filing were paid pursuant to normal terms of business between the creditor and the bankrupt customer. For example, say that in the five years preceding the 90 day window, the customer was invoiced two days after delivery and paid the invoice, on average, 62 days after the date of the invoice. Likewise, during the 90 day preference window, every one of the 35 invoices at issue were contemporaneously invoiced and then paid on the 62nd day after each invoice date. Additionally, there was no specific written contract between the parties requiring payment any earlier than 62 days, and there was no "coercion" of the bankrupt from the creditor to collect these 35 invoices. Under these "perfect" facts the creditor would likely beat a preference claim and could retain the monies it was paid.
Industry standards: If you, as creditor have an insufficient payment history with the bankrupt or if the payments during the preference period do not match the rest of the payment history of this customer, you may rely upon the payment history of your industry as a whole to establish that the payments made during the preference period are payments in the ordinary course of business. For example, if, in the construction industry, subcontractors pay suppliers, on average in 93 days after the date of the invoice and during the preference period, a bankrupt subcontractor paid its supplier in roughly the same amount of time, then this defense would be viable - - if the supplier is able to prove that this industry standard exists.
New Value: How it works is thus: during the 90 preference period, the soon to be bankrupt customer pays your company $1,000. After this payment is made, your company sells another $1,000 worth of goods/services to the customer on credit. This fact pattern is repeated 12 times over the course of the 90 days and finally guillotine falls.
2. Payments made as a result of creditor providing "New Value."
New Value is a concept that was designed to encourage businesses to continue to extend credit to financially troubled companies in hopes that these new extensions of credit would enable a troubled company to overcome its financial obstacles and avoid bankruptcy. How it works is thus: during the 90 preference period, the soon to be bankrupt customer pays your company $1,000. After this payment is made, your company sells another $1,000 worth of goods/services to the customer on credit. This fact pattern is repeated 12 times over the course of the 90 days and finally guillotine falls. Even though the bankrupt paid your company $12,000 over the 90 days, your company would not have to return any of it, because each time it was paid you thereafter extended credit equal to, or greater than, the amount of the payment. Of course, your company may end up writing off the last $1,000 in credit you extended to the bankrupt.
This defense recently received a shot in the arm by decision from the United States Court of Appeals for the 11th Circuit (Alabama, Florida and Georgia) which ruled in the case of In re: BFW Liquidation, LLC that the New Value defense may be employed even though the credit granted to the bankrupt in exchange for a payment from the bankrupt was paid during the 90 day window. The Bankruptcy Trustee that sued the creditor (Blue Bell Creameries, Inc.) argued that the new value defense is lost if the new credit extended is paid off. The Court of Appeals soundly rejected that argument and held that only the last payment made to pay off the new value credit would be a preferential transfer that the Trustee could seek to recover.
3. Payments that constitute "substantially contemporaneous" exchanges of equal value.
This defense is the opposite of a new value defense and involves the virtual immediate repayment of any credit extended or sale made. For the most part, this defense is employed when the customer is on a COD basis and payment for product is made at the same time it is delivered.
If your company holds a senior priority security interest against certain assets of the bankrupt, then to the extent of its security interest, the payments it received during the bankruptcy period are offset by the value of the security interest it holds.
Other Defenses.
Lesser known defenses may be available. For example, if the monies are trust funds that were paid to a creditor pursuant to a trust arrangement, then they are likely not property of the estate, and therefore cannot be part of a preference action. This defense generally works when the monies are paid as part of a construction project that is covered by a Construction Trust Fund Statute.
Secured claims. If your company holds a senior priority security interest against certain assets of the bankrupt, then to the extent of its security interest, the payments it received during the bankruptcy period are offset by the value of the security interest it holds.
Were the payments your company received from the bankrupt business customer less than $6,425.00? If so, a preference claim cannot be made.
Were the payments your company received from the bankrupt business customer more than $6,425.00 but less than $12,850.00? If so, a preference lawsuit can only be filed in the federal district in which your company is located.
Final Thoughts: Proactive Avoidance of Preference Actions
What can you do to avoid these strong arm actions by trustees? As was stated at the outset: stellar record keeping that can be easily/reliably accessed is the first step in fighting these claims. Without it, you are fighting an uphill battle because any payments you received are automatically presumed to be a preferential.
Careful monitoring of credit to troubled accounts. If you think a customer might be on the brink, consider agreements where new credit is extended only after payment of an equivalent amount is paid by the customer. Consider obtaining personal guarantees from principals of the business. Consider placing the customer on a COD basis. Investigate the possibility of obtaining a security interest in the goods you are selling to the troubled customer or in other unencumbered property it might own.
Also: Investigate the possibility of receiving payment from third parties, such as the end user of the product you are providing. A good example of this is a Joint Check Agreement which requires the end user to pay the amount due directly to your company, thereby keeping your money out of the hands of insolvent middleman. Finally, discuss with a Creditors' Rights attorney your options should a big customer file or be on the verge of filing a bankruptcy.
Douglas H. Seitz is Partner, Wright, Constable & Skeen, LLP, 7 Saint Paul Street, 18th Floor, Baltimore, Maryland 21202. He can be reached at 410.659.1358 or dseitz@wcslaw.com.
