What, You want ME to pay YOU?

Vermont businesses have been increasingly subjected to suits and threats of suits by bankruptcy estates seeking to recover preferential transfers. The policy of preferences, although sound in theory, often has harsh and illogical results. It is important for credit managers to have a basic understanding of preference laws and their effect on non-bankrupt companies.

What is a preference? In a bankruptcy proceeding, all creditors are intended to be treated equally. Generally, if, in the 90 days before a bankruptcy filing, the soon-to-be-bankrupt debtor pays one creditor and not another, the bankruptcy code provides that the debtor or trustee can recover those monies and divvy it out equally among creditors. The policy of the preference law is to prevent creditors from pushing a business that is in financial straits over the edge into bankruptcy. It prevents over-aggressive collection practices and promotes equality among similarly situated creditors, without respect to their actions.

From a business perspective, there is nothing more illogical than a preference recovery action. Take, for example, the small Vermont supplier of a large superstore, say, Ames. At the time Ames filed for bankruptcy protection, Ames owed the supplier a considerable sum. It then proceeded to close down all its stores. The supplier therefore suffers the double blow of losing a steady customer and having to write off a large balance. The triple blow comes nearly two years later when the Ames estate now seeks the return of any monies it paid to the supplier during the 3 months prior to the bankruptcy filing. And to make matters worse, the Ames case was administratively insolvent, meaning that the second phase of divvying out to unsecured creditors never occurred.

Because the bankruptcy estate's complaint must merely show that the payments were made by the debtor within the 90 days before the filing to a creditor who at that time was holding a claim (called antecedent debt), large scale suits are frequently filed against every creditor who received a check from the debtor within that 3 month period. It is the defendant's job to then prove a variety of defenses that may be available to the defendant. For this reason, it is unwise to ignore a preference demand, because the estate will have no trouble obtaining a default judgment for the full amount, despite any available defenses.

Fortunately, Congress has also devised defenses to preference actions—the three most common of which are labeled contemporaneous exchange, subsequent new value and ordinary course of business. The contemporaneous exchange defense is ordinarily used for payments made c.o.d., because the payments are not being made on account of an antecedent debt. Therefore, that payment would not be deemed a preference. For the subsequent new value defense, goods or services supplied after each preferential payment or payments can be subtracted from the preference demand.

The most litigated defense is the claim that the payments were made in the ordinary course of business. This phrase is not specifically defined in the bankruptcy code, but it was developed in support of those would-be defendants who did not engage in any different or aggressive collection practices before the filing. Because what constitutes ordinary course has been developed on a case by case basis, litigation can be quite expensive. The proof often comes down to counting the number of days past invoice that payments were received in the pre-preference period, as compared to the preference period. The case law varies as to the number of days beyond average that would constitute a preference.

It is important for small businesses to know their customers and watch for signs of bankruptcy. Requiring payments c.o.d. or on a secured line of credit is the best protection. Of course, this is not always practical. And, because a bird in the hand is always preferable, a small business should never refuse payment merely because a bankruptcy appears imminent. Preference suits aren't always brought and are usually settled for a percentage, so it is always better to take the money when available. The simplest way to protect against preference recovery and to align defenses, is to retain documentation. Unaware of preference litigation, many businesses fail to save all invoices and payment records for the necessary three years. Equally important is to hire experienced bankruptcy counsel to negotiate and handle the defense.

Upon the October effective date of the Bankruptcy Reform legislation, there will be several changes, such as venue changes, which will assist the preference defendant. Stay tuned for an upcoming article on the changes.

The information provided in this article is offered for informational purposes only; it is not offered as and does not constitute legal advice. Every situation is unique— you are encouraged to seek legal consultation to address your individual circumstances.