Dealing with a customer's bankruptcy:
Defending against a preference claim (Part II of a series)

Economists agree that the current recovery is anything but robust. As a result, chances are good that many vendors will experience customer bankruptcies. In a recent issue of Legal Insights, we outlined some preliminary considerations if a customer was heading for, or had actually filed, a bankruptcy case. In this issue, we examine how to navigate one of the more common challenges that a seller may experience in a customer bankruptcy: defending against preference claims to recover payments made by the debtor prior to filing bankruptcy.

DO I REALLY HAVE TO RETURN THE MONEY?

Bankruptcy law honors the maxim that "equality is equity" by favoring a distribution of a bankrupt's assets to unsecured creditors in proportion to the amounts of their claims. Bankruptcy law seeks to impose this policy not only during the pendency of a bankruptcy case but also retroactively for the 90-day period immediately before the case is filed by giving the Chapter 7 bankruptcy trustee or the Chapter 11 debtor-in-possession the power to avoid, or set aside, preferences, or transactions that took place during that 90-day period. For suppliers that received payment of an overdue receivable from the debtor during such period, this means that the bankruptcy trustee may sue to recover the payment for redistribution to all creditors.

According to the rationale embodied in the U.S. Bankruptcy Code, if such transactions were not set aside, the creditors that acted aggressively and improved their financial positions during that 90-day period would fare better than those that continued to extend business credit to customers when the customers needed it the most.

Under the Bankruptcy Code, a transaction can be set aside, and the money recovered, if the transaction exhibits seven elements. It must be (1) a transfer (such as a payment of money or the granting of a lien on the debtor's property as collateral), (2) of an interest in property of the debtor (typically money or other assets), (3) to or for the benefit of a creditor, (4) for a pre-existing debt, (5) made while the debtor was insolvent and (6) made within 90 days before the bankruptcy filing (or one year, if the creditor is a related party known as an insider), and it must (7) enable the creditor to receive more than it would otherwise receive in a Chapter 7 liquidation.

A common example of an avoidable preference is a debtor's payment of a past-due account payable.

AVOIDING AVOIDABLE PREFERENCES

Even if each of the seven elements is present, a supplier may still be permitted to retain the prefiling payment under one or more of the 10 statutory exceptions to preference avoidance. In simple terms, the most commonly invoked exceptions provide that a transfer may not be avoided if:

  • The supplier provided "new value" in exchange for the payment.
  • The transfer was a payment that was made in the ordinary course of business of the supplier and the customer/debtor or made according to ordinary business terms in their industry.
  • The transfer resulted from a floating lien on inventory or receivables, and there was no "improvement in position" during the preference period.
  • The transfer was of less than $6,225 and the case was not a consumer case.

In addition, although not technically a defense to a preference claim, if a trustee seeks recovery of an amount less than $12,475, the preference lawsuit must be brought in the judicial district where the defendant "resides." In the case of a corporate defendant, this is where the corporation has its principal place of business. Congress intended this venue limitation to protect creditors from preference "strike suits"—lawsuits brought in remote locations that therefore cost more to defend than the actions seek.

Successfully defending against a trustee's preference claim almost always requires a detailed analysis of the specific history of commercial dealings between the two parties, as well as an understanding of how bankruptcy courts have ruled in factually similar cases and in the particular judicial district in which the claim arises. Therefore, engaging an experienced bankruptcy or creditor's rights lawyer is a must if you receive a demand letter or are sued to recover a preference.

STEPS TO TAKE IN ADVANCE

In addition, there are steps that a supplier may take in advance to significantly improve its likelihood of success when facing a preference claim:

  • Maintain accurate and complete records of all transactions with each customer (including dates of shipment of goods, invoices, copies of checks and dates of receipt, deposits and bank payments of checks and all written and e-mail correspondence) for at least 15 months (a period of at least three years would be even better).
  • Apply any payment on account to the oldest unpaid invoice, even if the customer identifies a different invoice.
  • Limit overdue receivables for out-of-state customers to less than $12,475, in order to take advantage of the venue rule.
  • If you need to tighten credit on a customer, be definitive and set forth the new credit terms in writing.
  • Be aware that "dunning" letters may increase preference exposure.

Watch future issues of Legal Insights for other ways to maximize your recovery if your customer files for bankruptcy, including filing a reclamation claim, requesting to be treated as a critical vendor in a Chapter 11 bankruptcy case and filing a timely and effective proof of claim.

—Bruce L. Waterhouse Jr.
waterhouse@nicola.com