Your bankrupt customer owes money, but now wants payments returned. What's next?

Several defenses may apply to insulate the transfers from recovery by the trustee

When a customer files for bankruptcy, the harsh reality is that the money that the customer owes your company may never be repaid, or recovery may be mere pennies on the dollar. Painful as it may be to write off such a debt, it pales in comparison to the distress of being ordered to return payments that your customer did make, payments that the customer indisputably owed to your company. Yet such a scenario is fully contemplated by the Bankruptcy Code, which permits the bankruptcy trustee to recover “preferential transfers” to creditors under certain circumstances.

The policy rationale behind the preference statute is to prevent a troubled company from making pre-bankruptcy payments to certain favored creditors, thereby leaving less for distribution in bankruptcy to similarly situated creditors, and to discourage aggressive collection tactics against financially distressed companies. As applied, however, the statute goes far beyond these policy objectives. Intent is not an element—if a payment falls within the applicable preference period, and no defenses apply, the payment may be recovered as a preference. While the potential for preference liability is an unavoidable reality of doing business, there are steps you can take after being served with a preference action—or better yet, before your customer ever files for bankruptcy—to reduce your exposure.

Section 547 of the Bankruptcy Code permits the trustee to recover certain payments made by the debtor to a (non-insider) creditor within 90 days before the date of the bankruptcy filing. Specifically, the trustee may avoid any transfer:

1. Made to or for the benefit of a creditor;
2. Made for or on account of an antecedent debt;
3. Made while the debtor was insolvent;
4. Made within 90 days of the filing of the bankruptcy petition;
5. That allows the creditor to receive more on its claim than it would have received in a chapter 7 liquidation case if the payment had not been made and the claim paid through the bankruptcy proceeding.

Assuming that the targeted transfers satisfy each of these elements, several defenses may apply to insulate the transfers from recovery by the trustee.

The contemporaneous exchange defense protects payments made at or near the same time that the creditor provided equal value in goods or services. A COD transaction is the classic example. However, recent cases have extended the contemporaneous exchange defense to certain credit transactions, so it is worthwhile to analyze its potential applicability even in situations that do not seem as patently “contemporaneous.”

The ordinary course of business defense prevents recovery of payments made in the parties’ ordinary course of business, or according to ordinary business terms. This defense requires the creditor to show that the targeted payments were made in accordance with the parties’ historical invoicing and payment patterns (the “ordinary business terms” alternative is generally more difficult to prove and is typically used either as an alternative or backup defense).

Finally, under the new value defense, a creditor that can show that it delivered new goods or services to the customer after receiving alleged preference payments may be able to set off the value of such new goods and services against any preferential payments. The three defenses, taken together, operate to protect routine and ordinary business transactions from avoidance, and to encourage creditors to continue to deal with troubled businesses.

After a significant customer files for bankruptcy, it is useful to conduct a preference audit to determine the extent of potential preference liability and the applicability of the major defenses. The trustee will typically begin the preference recovery process by sending a demand letter, so being positioned to respond to the demand quickly, before a lawsuit is filed, can substantially reduce litigation costs. The company should review all payments made by the customer within the 90 day preference period.

The new value defense will allow the company to set off the value of any goods shipped to the customer during the preference period against payments received from the customer during the same period, thereby reducing the total preference liability. To evaluate applicability of ordinary course defense, the company should compare the customer’s historical payment patterns with the payments made within the preference period. For example, if the customer typically pays invoices between 30 and 45 days, payments made during the preference period within 30 and 45 days after the invoice date may be protected as having been made in the ordinary course, whereas payments made 7 days post-invoice are more likely to be viewed as outside of the ordinary course and therefore preferential. Finally, any payments made contemporaneously with the shipment of goods may be protected by the contemporaneous exchange defense.

A company can implement certain practices before a bankruptcy case is filed to minimize its preference exposure. Establishing a solid baseline of dealing with customers and operating within those parameters, even as the customer’s financial condition deteriorates, increases the chances that payments made during the preference period will be considered ordinary course. Any changes to baseline dealings should be made with the other defenses in mind. For example, requiring the same customer to pay cash in advance will take the payment outside of the scope of the trustee’s avoidance powers altogether, since such payment will not have been made “for or on account of an antecedent debt.” Similarly, requiring the customer to pay cash on delivery will trigger application of the contemporaneous exchange defense.

On a final note, clients often ask if they should accept a large payment from a financially distressed customer in danger of bankruptcy, given that such a payment would likely to be targeted as a preference. The answer is a resounding yes. Money in hand is always preferable to a claim in bankruptcy. The trustee may never pursue the preference claim at all, and any asserted claim can likely be settled for something less than the total amount of the payment. In either case, the company is in a far better position than it would be had it not accepted the payment.

Republished with permission. This article first appeared in Inside Counsel on June 16, 2015.