When a customer becomes a debtor in bankruptcy, your first act should be to take all necessary steps to avoid violating the automatic stay imposed by the United States Bankruptcy Code. The automatic stay is interpreted broadly, but, in short, you and anyone acting on your behalf must suspend all collection activity, including lawsuits, collection calls, billing, etc., unless and until the Bankruptcy Court orders otherwise.
You will then want to go back and examine historical transactions to determine the extent of your exposure to risk of having to return payments to the customer’s bankruptcy estate. If you have taken steps like those set forth below, then (1) the possibility that you may be required to return payments will not be a complete surprise and (2) you will already have a good sense of your exposure.
Is this letter for real?
As those in the unenviable position of having received a demand letter from a bankruptcy trustee have found, such letters are very real. In fact, the United States Bankruptcy Code empowers a bankruptcy trustee or estate to compel recipients of certain payments made by the debtor during the 90-day period immediately preceding the commencement of the case to disgorge those payments. This power can be enforced even when a recipient is owed money from the debtor.
Do I really have to pay it all back?
Not necessarily. The Code provides certain defenses, summarized below.
Insolvency. Insolvency is generally not a contested issue (because most bankruptcy debtors were struggling long before the 90-day “preference period”). However, it is important to note that a prerequisite for recovery of a “preferential payment” is that the debtor was insolvent at the time a payment was made or was rendered insolvent by the transfer. Insolvency is presumed under the Bankruptcy Code, but it is a rebuttable presumption. If there is any question whether a debtor was insolvent at any point during the 90-day period, then you and counsel should consider retaining an insolvency expert to provide an analysis.
Ordinary Course Defense. Payments made within the ordinary course of business established between a debtor and the recipient are not recoverable. The meaning of “ordinary course” in this context is not as obvious or intuitive as it may appear. The meaning of “ordinary course” and application of this defense have been widely litigated. This defense is somewhat subjective and inherently fact intensive, taking into account factors such as timing of payment, manner of payment (e.g., grouping of invoices and method of payment), changes in quantities, changes in terms and conditions, and communications between the parties to the transaction. Analysis supporting an ordinary course defense requires the comparison of the transactions within the 90-day period with the transactions prior to the preference period (typically going back 18-24 months prior to the case).
Subsequent New Value Defense. A typical “subsequent new value” defense involves a retainer, deposit, or cash payment made in advance of shipment. A vendor is entitled to credit against preference exposure the value of goods (for which the vendor was not paid) delivered following receipt of the otherwise avoidable transfer. You will need to establish timing of delivery (e.g., bills of lading), because the credit is for goods actually delivered after a payment was received and before the commencement of the case. The value of the goods subsequently delivered is sometimes also subject to dispute.
Contemporaneous Exchange Defense. A typical contemporaneous exchange transaction is cash on delivery (COD). The transaction must be substantially contemporaneous and must be intended by the parties to be a contemporaneous exchange. Since intent is one element that must be proven, it is preferable that it be memorialized in an agreement, email, or other written record. Payment by wire transfer helps support a contemporaneous exchange defense if tendered promptly.
In summary, letters demanding recovery of payments made during the 90-day period immediately preceding a bankruptcy case require immediate attention. Facts must be determined, appropriate supporting documentation assembled, applicability and strength of potential defenses analyzed, and defenses timely asserted. It may be necessary to assert a combination of defenses. You should consult counsel promptly upon receipt of such a demand letter.