A ‘preference’ you’d prefer to avoid: Steps to prevent being caught up in a bankruptcy court ‘preference’ action

Joe Foster Headshot
Joseph A. Foster
Director, Corporate Department
Published: New Hampshire Business Review
December 5, 2008

It’s a fact of business: Some customers will pay slowly and sporadically, promise to catch up, convince you to ship more and then, sadly, file for bankruptcy.

Having written off the debt and mentally moved on, two years later you may receive a letter from the bankruptcy trustee demanding you return those all-too-small sporadic payments, along with a threat that if you fail to do so he will sue you in a courthouse that is often hundreds, if not thousands, of miles away. He will not care that you are still owed amounts by the bankrupt customer. The suit can be filed even if you are still owed more than the amount you were paid and he seeks to recover.

This type of claim by the trustee is called a “preference” action. The intent of the law is to prohibit insolvent companies from playing favorites or preferring a particular vendor. Preference claims force the preferred vendor to return the payment so that all creditors can enjoy equality of treatment. By recovering funds from the preferred vendors, the discriminated vendors can ultimately receive more, or so the theory goes.

But except in the rarest of circumstances the preference law seems only to bring one thing: insult to injury.

A preference claim is unfortunately very simple to bring and very easy to prove. All the trustee needs to prove is that a payment was made:

  • Within 90 days of the bankruptcy filing
  • For an “antecedent” debt
  • When the customer was insolvent
  • As a result, you received more than you otherwise would in the bankruptcy.

These elements are easy to establish. The company is presumed to be insolvent within 90 days, and to disprove that is obviously costly. It would require appraisals and experts to disprove insolvency, and except in the largest of cases simply does not make economic sense to challenge the presumption.

Therefore, the burden is on you to prove one of several enumerated defenses available. That means hiring legal counsel to defend you in a bankruptcy court that may be anywhere in the United States.

Know your rights

Defenses exist under the code, two of which commonly are asserted and often work. First, if payment was made in the “ordinary course” of business, it is not recoverable. To show a payment was made in the “ordinary course,” you must demonstrate it was made consistent with industry practice or consistent with your past dealings with that customer. If the customer always paid slow but with regularity, the defense may work.

There also is the so-called “new value” defense. If you shipped or provided services after payment and the new invoice remains outstanding, the new invoice can be offset against the payment the trustee is seeking to recover. This “new value” defense encourages businesses to continue to trade with a troubled customer.

While it’s helpful to know your rights in a preference action, it is always better to avoid the action altogether.

First, when payment is slow, try to convert the customer to payment in advance or C.O.D., which is not recoverable because they are not made on account of an antecedent debt.

Less obvious options also are available. If an account is out-of-terms (i.e. payment now definitely would be outside the “ordinary course”), you may demand they arrange payment from a third party, such as an affiliate, parent, subsidiary or even a lender if properly documented.

A third-party payment is unavoidable because the bankrupt customer’s assets are not used to make the payment.

A similar approach is to seek a third-party guarantee by a solvent entity. If a preferential payment is recovered by the trustee, you will be able to pursue the guarantor for payment. If an outright guaranty is rejected, ask for one more limited – a guaranty against preference recoveries only. The guarantor may feel the extent of potential liability is acceptable when it is limited to the preference period.

For small commercial accounts, consider taking less than $5,000 in settlement. Amendments adopted in 2005 provide an absolute defense if the aggregate payment received in the preference period is less than $5,000. If the debt is near $5,000, accept $4,999 and waive the balance to induce payment.

Other techniques exist, such as taking security, transferring the payment or assigning payments to third parties. If all else fails, still take the payment! Thoughtful planning can reduce the risk of loss in a preference action. But accepting payment is better than not receiving any payment at all.