Protecting Against Preference Demands in a Bankruptcy Case

A. Thomas DeWoskin

By A. Thomas DeWoskin

I just came across an article on guarding against preferential transfers. If you own a business and one of your customers files bankruptcy, not only are you likely to lose the money the customer currently owes to you, but you might also have to give back some money you’ve recently collected! The bankruptcy laws may deem those payments to be “preferential payments” or “preferences,” which have to be returned to the bankrupt company or to its Trustee. The bankruptcy laws on preference recovery are some of the most unfair laws around because there is no “preferring” requirement to a preference. It’s all just a matter of timing.

If you receive a demand to return a preferential transfer, see a qualified business bankruptcy lawyer immediately. This is not a matter for a consumer bankruptcy lawyers who file cheap bankruptcies for people that have too many credit cards.

There are several defenses to a preference demand. The most common involve “new value” and the “ordinary course of business.”

The “new value” defense is pretty simple – if the debtor paid you an old $10,000 account receivable before it filed bankruptcy, the payment might be recoverable from you as a preference. If, after you receive the money, you extend $10,000 in additional credit, the “new value,” to the debtor, they cancel each other out. Obviously, that defense is a matter of luck, since you don’t know when or if the customer is going to file bankruptcy.

The “ordinary course” defense, however, is something you might be able to prepare for. The bankruptcy laws provide that payments in the ordinary course of business are not recoverable preferences. If you regularly bill your customers on thirty-day terms and it regularly pays according to terms, those payments are being made in the ordinary course of business, the payments you received before the bankruptcy filing generally are safe.

But suppose your customer starts to pay more slowly, or only makes partial payments. You, being a good business person, react to protect yourself. You put the customer on fifteen-day terms, or demand that it provide collateral for future shipments, or take some other action to insure collection. You’ve done the right thing, but future payments are no longer being made in the ordinary course of business! By taking responsible action, you’ve made yourself liable to a preference demand if your customer files bankruptcy.

So – what to do? You try to turn the “out of the ordinary” into the “ordinary”:

  • First, make your best efforts to keep the customer as close to ordinary terms as possible for as long as possible.
  • If these efforts are not successful, at least try to keep the customer within industry standards.
  • If neither attempt works, institute the new terms at the first sign of trouble. If enough time passes before the bankruptcy filing, the new terms will have become the ordinary terms.

As an additional option, you could enter into a new contract with the customer. The new contract could set out the new terms, and provide that you are not obligated to sell to the customer at all. If you choose to sell, however, these are the new ordinary terms of the arrangement.

Being forced to return substantial preferential payments can send your business into bankruptcy itself. Be sure that your accounts receivable staff is sensitive to customer behavior, to the industry’s rumor mill, and anything else that may suggest coming trouble. Review the situation with a bankruptcy attorney to discuss what strategies your company could take, and stay off the receiving end of preference demand letters.

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