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The concept of "preferences" is one of the more complicated areas of bankruptcy law, and also one of the most frustrating for creditors. When a bankruptcy trustee, or the debtor in a Chapter 11 case seeks to force a creditor to return funds received from the debtor in the days leading up to the bankruptcy filing, it is called a preference action. In these situations, the creditor is often still owed additional money by the debtor.
That is, not only is the creditor owed money at the time that the bankruptcy case was filed, but it is being asked to return payments that it received before the case was filed. This article explores some of the ways for a creditor to minimize its exposure to preference actions by bankrupt customers.
What Is a Preference?
One of the fundamental tenets of bankruptcy law is the notion that equally situated creditors should receive an equal distribution of the debtor's property. This balance is upset when, in the months leading to bankruptcy, a company picks and chooses which creditors to pay. Often, there is no intent to prefer one creditor over another the preferential payment may simply be the result of the squeaky wheel getting the grease.
However, in order to prevent the unequal treatment of creditors -- whether intentional or otherwise - the Bankruptcy Code grants the Chapter 11 debtor the power to undo (or, in bankruptcy parlance, to "avoid"), under appropriate circumstances, transfers of money or property that occurred prior to the bankruptcy filing. Moreover, the law also imposes upon a debtor the fiduciary obligation to exercise the power to avoid preferential payments.
Specifically, according to §547(b) of the Bankruptcy Code, a debtor may attack: (1) any transfer of money or property; (2) made on account of an antecedent debt; (3) while the debtor was insolvent; (4) during the 90 days before the bankruptcy filing; (5) where the transfer enabled the creditor to receive more than it would have in a hypothetical Chapter 7 liquidation. There are many nuances within these parameters, however, any payment to a creditor that satisfies these five elements is likely to be identified by a debtor as a potentially avoidable preference.
The Bankruptcy Code also identifies seven affirmative defenses that a creditor can employ to defend a preference action. The following is a brief description of some of the steps a creditor can take to maximize its ability to implement one or more of the affirmative defenses.
Limiting the Risk of a Preference Action
When a creditor first begins to suspect that a customer is in financial trouble, the creditor should immediately review its payment terms with the troubled customer. For example, most businesses are in the habit of crediting a customer's oldest invoices first. While this keeps receivables from aging, this also invites a preference action. Instead, when a creditor surmises that there is trouble, it should move to cash in advance or cash on delivery ("C.O.D.") terms. Since there can only be a preference when there is a payment "on account of an antecedent debt," any cash in advance or C.O.D. payments received in the days leading to bankruptcy should be safe from a preference action.
The lesson here is that, when a customer is in financial trouble, a creditor should move to ensure full payment on any new business before worrying about getting old invoices paid.
If a creditor does not feel comfortable demanding cash in advance or C.O.D., it is still a good idea to invoice immediately and advise the troubled customer that it must pay quickly or be cut off from further goods and services. Most times, if it is clearly documented that payments made by the failing company were being made shortly after invoicing for recently provided goods or services, the creditor may have a viable defense to a preference action. Conversely, the more time that passes between when new goods or services are provided and when payment is received, the more susceptible the payment is to being attacked as a preference.
Inevitably, creditors who are given this sort of advice want to know what they are supposed to do with the past due bills. After all, ensuring payment on new business is only half the battle. For smaller companies, one strategy is to arrange a payment schedule for the past due balance and have it personally guaranteed by a principal of the troubled customer. By doing this, the creditor creates the ability to pursue an individual in addition to the customer which may be headed to bankruptcy. This frequently results in the debt owed being addressed more quickly than it would be absent the personal guaranty.
In particular circumstances, there are other ways to keep payments from a customer in financial trouble from being characterized as preferences. In some situations, a creditor may arrange to take a purchase money security interest in goods provided to a customer. This is because, during the 90 day preference period, the Bankruptcy Code protects any lien which is created in goods solely to secure payment for the goods. Similarly, liens that arise by operation of a statute, such as mechanics liens or tax liens, cannot be avoided as preferences (although they sometimes are subject to attack under other sections of the Bankruptcy Code).
Finally, your clients should bear in mind that all doubts regarding how to proceed in any given situation should be resolved in favor of collecting as much cash as possible from the financially-distressed company. The main reason for this is that a creditor is almost always going to achieve a better result defending a preference action than having never received the money in the first place.
Conclusion
In summary, most businesses will sooner or later be faced with a customer who files for bankruptcy protection. A prudent business should develop policies that allow it to continue to conduct new business with troubled companies while also minimizing the risk of being asked to return payments made by these customers in the days leading up to a bankruptcy filing.
For more information about this topic, please contact Robin White (rbw@mglaw.net) or one of our other Insolvency attorneys. |
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