As the saying goes, what goes up, must come down. After years of robust growth, the U.S. economy appears to be hitting a rough patch. In the coming months, it is likely that some businesses will not survive the challenges that lie ahead, and will be forced to file bankruptcy.

As bankruptcy attorneys, we find that one of the most difficult issues to explain to a client is receipt of a demand letter from a bankruptcy trustee seeking return of payments from a customer received months or years before. To add insult to injury, the customer, now a debtor in bankruptcy, often still owes the client. In addition, the letter typically includes a threat that if the payment is not returned, the trustee will file a lawsuit.

This claim by the trustee is referred to as a “preference” action. The intent of the law is to prohibit insolvent companies from playing favorites or preferring a particular vendor over another. Preference claims force the so-called “preferred” vendor to return the payment so that all general creditors can enjoy equality of treatment.

A preference claim is, unfortunately, very simple to bring and very easy to prove. To successfully assert the claim, a trustee must establish that a payment was made to or for the benefit of the creditor:

  • Within 90 days of the bankruptcy filing
  • For an “antecedent” debt
  • When the bankruptcy debtor was insolvent
  • As a result, the creditor received more than it otherwise would in a Chapter 7 liquidation

The debtor is presumed to be insolvent within 90 days of the bankruptcy filing, and to rebut that presumption is expensive because it generally requires engaging appraisers or other experts. Therefore, to defeat the claim, the creditor usually looks to one of several enumerated defenses.

Know your rights

First, assess whether the trustee has brought the claim in the proper venue. Frequently, the case is brought in a court that is across the country, making it inconvenient and expensive for the creditor to defend. If the preference claim is less than $27,750, the suit must be filed in the creditor’s “home” district. If the venue is improper, the case is subject to dismissal. Notifying the trustee of this deficiency may well get the claim withdrawn.

If venue is proper, there are two common defenses that may help to reduce or eliminate the claim.

First, if payment was made in the “ordinary course of business,” it is not recoverable. To prove a payment was made in the “ordinary course,” the creditor must demonstrate it was made consistent with industry practice or consistent with your past dealings with that customer. Even if the customer always paid slowly, but did so with regularity, the defense may still be available.

Second, there is the so-called “new value” defense. In certain circumstances, if the creditor shipped or provided services after receipt of payment, then the value of goods shipped or services provided 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.

Strategies for limiting exposure

Train your employees to identify changes in a customer’s pattern regarding payment of invoices. If payments are not made timely, demand for payment should be promptly made in writing. These practices can help minimize exposure.

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

If an account is out-of-terms, the creditor should request the customer arrange for payment to be made from a third party, such as an affiliate or a parent. A third-party payment is unavoidable because the 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 the trustee recovers a preferential payment, the creditor 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.

For small commercial accounts, consider taking less than $7,575 in settlement of an overdue account. A creditor has an absolute defense if the aggregate payment received in the preference period is less than $7,575. If the debt is near $7,575, accept $7,574 and waive the balance to induce payment. Other techniques exist including taking security.

In the end, if all else fails, still take the payment! As a wise bankruptcy judge once said: “A preference is not illegal; it’s just avoidable.” While thoughtful planning can reduce the risk of loss in a preference action, accepting payment is better than not receiving any payment at all.