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A Customer in Trouble

Imagine the following scenario: One of your customers has fallen behind on its payments. You start making phone calls. A couple of weeks later, the customer sends you a check for everything it owes. You cash the check and – whew! – it clears. Shortly after, the customer stops ordering and maintains no further contact with you. You later hear through the grapevine that this customer declared bankruptcy. The permanent loss of this trade hurts, but you console yourself that at least your company was paid.

Sometime later, you get a letter from a lawyer who represents the estate of that now bankrupt customer. The letter demands your company return the money the bankrupt customer paid you on its delinquent account. It threatens a lawsuit if you refuse to do so. And the court in which the lawsuit might occur is in the customer’s hometown – halfway across the country. Do you have to pay that money back?

The Preferential-Payment Rule

Section 547 of the Bankruptcy Code is commonly called the preferential-payment rule. This statute provides that when a debtor makes a payment to a creditor and the debtor files bankruptcy within 90 days of that payment, the Bankruptcy Court can force the creditor to pay that money back to the debtor for distribution to all of the debtor’s creditors.

The idea behind Section 547 is that it is not fair when a troubled company selectively prefers to pay only certain creditors in the slide into bankruptcy. Some creditors might get most or all of what they are owed, while other creditors might get nothing. The purpose of Section 547 is two-fold: (1) it discourages aggressive creditors from racing to the courthouse to sue a faltering debtor; and (2) it promotes fairness and equality by evening the distribution of whatever money is left under supervision of the Bankruptcy Court.

Section 547 defines a preference payment as:

• Payment made on an antecedent debt (meaning a debt incurred before the time of payment);
• Payment made while the debtor was insolvent (a company can be insolvent before it files for bankruptcy);
• Payment made to a noninsider creditor, within 90 days of the filing of bankruptcy (when the creditor is an “insider” of the debtor-owners, relatives, officers, directors, and similar persons and entities-the time period increases from 90 days to one year);
• Payment made that allows the creditor to receive more than it would have received had the payment not been made in advance of, but paid through the bankruptcy proceeding.

To recover a preference payment, the debtor-in-possession (DIP) or trustee for the debtor’s bankruptcy estate must prove all of these elements. If it can, then the payment is “avoided” and must be returned, unless a defense applies. Preferential payments are avoidable even if there is no dispute as to the goods sold or the services rendered. Return of money may be demanded even if there was never any intent to make or accept a preferential payment.

Under the Bankruptcy Code, a DIP or trustee for the debtor’s bankruptcy estate usually has two years from the filing of bankruptcy to file preference suits. Preference suits are litigated in the same place the debtor filed bankruptcy, which could be a distant court.

Defenses to the Rule

Section 547 contains several statutory defenses to a preference suit. Three of those defenses are particularly applicable to business transactions.

First, money paid by the debtor in a “contemporaneous exchange for new value” may not be avoided as a preference. If the payment is for something new and not an old debt, it may not need to be repaid by the creditor. For example, if a customer orders 1,000 widgets and pays on the spot, that payment is for new value.

Second, payments made “in the ordinary course of business” and “according to ordinary business terms” may not be avoided. If a customer orders 1,000 widgets every month and always pays in 30 days, and those terms are typical for the industry, then any payments of that type within the 90-day preference window are probably defensible.

Third, a “subsequent transfer of new value” may offset or negate the obligation to repay an already-made preference payment. For example: a customer makes a $10,000 payment to a creditor for old debt that is not in the ordinary course of business – a clear preference payment. But after that payment, the creditor shipped the debtor $5,000 worth of widgets. The debtor goes bankrupt without paying for the new widgets. The creditor can offset the $5,000 value of the widgets against a demand for the return of the entire $10,000.

Risk Reduction

There are steps a business can take to reduce the risk of preference demands. For example, using an established collection policy and schedule can keep payments within the “ordinary course” defense. Likewise, continue to demand and accept payments according to any contractual terms and in accord with the payment history for that customer. Unless authorized by contract, shortening the payment cycle or demanding “catch up” payments could later lead to preference claims.

Preference payment claims can seem manifestly unfair. This rule can be problematic for companies that received payment, disbursed it to their own creditors, and now no longer have the funds to pay the Bankruptcy Court. A company may have gone out of business still owing you money, and now – years later – the Bankruptcy Court wants to recoup the money they did pay you. There are steps you can take to protect your interests and reduce the risks against those demands. Preparation is the best defense.