If you’re a vendor, supplier, or a service provider and get paid for your goods or services, you could find yourself on the wrong end of a preference claim. What’s worse, the company that just paid your company on an overdue invoice, files for bankruptcy within 90 days of that payment. A year and a half later, you get a letter from a bankruptcy trustee demanding that you pay back all or some of the money you were entitled to for the value of the goods and services you provided. Nothing worse than to have a slow-pay or no-pay customer only to have that customer now want to force you to disgorge the payment or payments you had been waiting for. Now what? It’s time to look for legal counsel to defend your preference claim.
What is a Preference Claim?
Generally speaking, payments made by a debtor to a creditor for an existing debt within the 90 days before a bankruptcy case was filed are open to being clawed back by the debtor (or its trustee) as a preference. This is an oversimplification, but to get into the nitty gritty, you should hire a good bankruptcy lawyer who knows the technical bits. Also, if you’re an insider of the debtor (partner, relative, person in control, etc.) — bad news. You’re potentially on the hook for payments made to you within the year before the bankruptcy was filed.
Well, that doesn’t seem fair, does it?
Under the Bankruptcy Code, the goal is to provide a pro rata distribution to all of the debtor’s creditors. One mechanism that can be used by a debtor or trustee is to take back payments made to a creditor that had the effect of “preferring” payment to that creditor over other creditors. That’s why it is called a “preferential transfer.” Make sense?
Preference Defense
The good news is that there are two common defenses to preference claims contained within the Bankruptcy Code itself. The first is a defense based on a contemporaneous exchange for new value under section 547(c)(1). The basic idea here is that even if the debtor has racked up a big outstanding balance and left it unpaid, you can still provide new goods or services and get paid for those new goods or services — as long as the exchange of goods for payment is meant to be and in fact, is, substantially contemporaneous. This defense will be blown out of the water if you apply a new payment to old, outstanding invoices.
The other common defense is the ordinary course defense under section 547(c)(2). The ideal facts here would be that you and the debtor have done business for years, the provision of goods and services occurs on a regular time frame, the invoices contain payment terms, and the invoices are regularly paid within those terms. If you keep providing goods or services, then receive and apply payment in a consistent, regular manner, you are likely to have a solid ordinary course defense.
Setting Up Your Defenses
A good defense to a potential preference claim starts well before a bankruptcy is ever filed; and that requires you to engage in certain business practices to set up a transactional history that fits squarely within the new value and ordinary course defenses mentioned above. You can also take steps to modify what was the ordinary course of business, but ensure it meets the contemporaneous exchange for new value requirements. Applying late payments to outstanding balances on old invoices will erode your defenses. Instead, set up your defense by, for example, providing smaller amounts of product, with payment terms changed to cash on delivery. By doing this, you can maintain the business relationship, continue to earn revenue, and set yourself up for a good preference defense, should the need arise.
Overall, the best chance to limit your exposure in the case of a preference claim is to contact experienced bankruptcy counsel to evaluate your defenses and show the debtor or trustee how they apply to your unique situation.
For more information or to seek counsel from our debtor & creditor law group, please reach out to request a consultation or call us at 216-696-1422.
