Preferences – Avoiding the Addition of Insult to Injury

Joe Foster Headshot
Joseph A. Foster
Director, Corporate Department
Published: Concord Chamber of Commerce and Nashua Chamber of Commerce
October 1, 2008

It’s just a fact of business – some customers will always pay slowly and sporadically, more so in difficult economic times. The Bankruptcy Code offers little help to business owners, and can often add insult to injury. If a slow or sporadically-paying customer files bankruptcy, no matter how much you are owed, recent payments often can be recovered from you by the bankruptcy trustee in what is commonly referred to as a “preference action.” All the trustee needs to prove is that a payment was made: (1) within 90 days of the bankruptcy filing; (2) for an “antecedent” debt; (3) when the customer was insolvent; and (4) as a result, you received more than you otherwise would in the bankruptcy. Generally, these elements are easy to establish, and the burden is on you to prove your defense. That means hiring legal counsel to defend you in a bankruptcy court that may be anywhere in the United States.

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. As they say, the best defense is a good offense, so let’s look at the steps to take to protect your interests from the start. First, when payment is slow, try to convert the customer to payment in advance or C.O.D. If your goods or services are critical to the customer, and it has liquidity, it may agree to the switch. Payments in advance or C.O.D. are not recoverable because they are not made on account of an antecedent debt. If you document payments were in advance or C.O.D, you may get really lucky and dissuade a trustee from filing suit altogether.

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. So long as the third party does not file its own bankruptcy, the payment should be safe from the trustee.

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 on 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 like taking security, transferring the payment or assigning payments to third parties. When large amounts are involved, these and other techniques should be considered with counsel when it becomes apparent you are dealing with a financially distressed customer.

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. A preference is not illegal, just potentially avoidable.