Maximizing Defenses Against Preference Claims in your Customer’s Bankruptcy

The story is familiar. Your company has a customer that has been purchasing goods or services from your company for a long time. The customer is exhibiting signs that it is experiencing financial difficulties. The customer’s payments of the company’s invoices become slower and eventually past due.  The business relationship is valuable to both the customer and your company: the customer needs your company’s goods or services and the customer provides important revenue to your company. Neither party wishes to terminate the relationship. The financial condition of the customer continues to deteriorate and the customer resorts to the filing of a petition under the U.S. Bankruptcy Code.  Your company may or may not cease providing goods or services to the customer.

Your company receives a letter from the attorneys for the customer or from a trustee appointed in the customer’s bankruptcy case demanding that your company repay all of the money paid to your company by the customer in the ninety days before the bankruptcy petition was filed. You are outraged at this demand; your company provided the goods or services and the customer got the benefit of those goods and services.  Does the U.S. Bankruptcy Code allow this to happen?  As more fully described below, the answer is, “it depends.” This article is intended to help you know how to best to turn that answer into “No”.

Section 547 of the U.S. Bankruptcy Code (the “Code”) deals with payments made by a debtor to its creditors before the bankruptcy case was filed.  Specifically, it provides that a trustee or in some circumstances, the debtor, may recover a payment made by the debtor (1) to or for the benefit of a creditor, (2) for or on account of a debt owed by the debtor before the payment was made, (3) made while the debtor was insolvent[1], (4) made on or within 90 days before the filing of the bankruptcy petition (the “Preference Period)[2], and (5) that enabled the creditor receiving the payment to receive more than it would have received if the debtor’s case was a liquidation case, the transfer was not made and the creditor received payment as provided by the Code (this latter element is commonly referred to as the “liquidation test”).

Appropriately, section 547 of the Code also provides a creditor with certain defenses against the demands to repay money received by that creditor. The most important of these defenses are the contemporaneous and subsequent new value defenses and the ordinary course of business defense. In sum, these defenses can protect funds paid to the company to the extent the company provided new value (1) in an intentional, substantially contemporaneously exchange or (2) after the new value (new goods or services) was given and that new value itself remained unpaid.  An example of these “new value” defenses is when either contemporaneously or after a company’s receipt of a payment from the customer, the company provides new goods or services to the customer.  In such circumstances, the company gets what is, in effect, a credit for the new goods and services against the payment it receives.

The other primary defense is generally called the “ordinary course of business” defense.  It can also be a valuable tool for dealing with a financially troubled customer.  This defense has two elements:  (1) the debt must have been incurred in the ordinary course of business between the customer and the company, and (2) the payment by the customer must have been paid either (a) in the ordinary course of business between the customer and the company or (b) made according to ordinary business terms of the company’s industry. These two categories of “ordinary course defenses” are often referred to by courts as the “Objective Standard” and the “Subjective Standard”, respectively.  Understanding the contours of these two defenses and taking the appropriate actions with a struggling customer can greatly increase the likelihood of successfully defending a demand to disgorge payments made by the debtor-customer to your company in the 90 days before it commences a bankruptcy case.

The Objective Standard

The Objective Standard measures whether the disputed payments were made in the ordinary course of business in the creditor’s industry.  This test is broad.  To utilize this standard, the creditor must present specific evidence about its industry’s ordinary business terms.  For example, if your company sells widgets and the timing and form of the payments you received from the financially troubled customer during the Preference Period are within the industry’s normal range of the period between when widget sellers ship the widgets and receive payments from their customers (i.e., the industry standard), the payments made to your company will be protected by the ordinary course of business defense.

The Subjective Standard

The Subjective Standard considers the normal payment practices between the customer and the company and by that standard measures the “ordinariness” of the payments made in the 90 days before the bankruptcy petition is filed.  The courts can consider a multitude of factors, with no one factor being determinative in the analysis.  These factors include (1) the length of time the parties engaged in the type of transactions at issue (the longer the relationship, the more defined the payment history can be determined, (2) whether the subject transfers were in an amount greater than is usually paid, (3) whether the payments at issue were made in a manner different from previous payments (such as a change from regular check to wire transfer), (4) whether there was an unusual action by the debtor or the creditor to collect on or pay the debt, and (5) whether the creditor took any action to gain an advantage in light of the debtor’s deteriorating financial condition.  However, the most consistently important factor is the difference, if any, between the timing of payments made by the customer before the Preference Period and the timing of payments made by the customer during the Preference  Period.  This standard is most effectively utilized if the analysis is based on transactions between the company and the customer during a time in which the customer was financially healthy and experiencing financial difficulties.

The two most common tests to determine the “ordinariness” of the timing of a payment are the “average lateness method” and the “total range method.”  The average lateness method compares the average time of payment after the issuance of the invoice prior to the Preference Period against the average time of payment during the Preference Period.  If the differences are not significant, the company is able to assert a strong defense against the recovery of payments it received during the Preference Period. If the differences in the two averages are material or skewed by outliers, the use of the “total range method” should provide a more complete picture of the financial relationship between the company and its customer. This method is more tolerant of outlier payments and as a result, payments made outside of the total range during the Preference Period typically must be well outside that range to be considered not made in the ordinary course of business.

Strategies to Protect Against Preferential Transfer Litigation

  1. Be proactive.
  2. Educate your accounts receivable personnel about preferential transfers and the defenses available.
  3. Establish and maintain standards and thresholds for identifying financially troubled customers and taking actions to prevent or reduce exposure to future exposure to preference liability.   Determine the applicable range of payments for your industry using the total range method (the Objective Standard) and review and update that range annually.
  4. Monitor customer accounts for changes in the timing of payments.  Determine the applicable historical range of payments by the customer using the “average lateness method.”
  5. Require customers whose payment history is changing to provide financial information as a condition to continue to sell on credit.
  6. Change payment terms in response to indicia of customer financial difficulties. (Caution:  A change in payment terms, such as COD, may provide a new value defense, but may also make an otherwise “ordinary course” payment no longer “ordinary”.  However, acting quickly may offer the opportunity to create a new “ordinary course of business” with the customer.)
  7. When in doubt, seek competent legal advice.

[1] In a bankruptcy case, the debtor is presumed to have been insolvent on or during the 90 days immediately preceding the date of the filing of the bankruptcy petition.

[2] This period is extended to 1 year for payments made to an “insider” of the debtor.

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These articles are provided for general informational purposes only and are marketing publications of Gentry Locke. They do not constitute legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult your own lawyer concerning your situation and specific legal questions you may have.