They Paid Me, Went Bankrupt and Then Sued to Get That Money Back: How to Avoid Being an Unsecured Creditor

May 11, 2020

The unfortunate reality of the COVID-19 pandemic is that several businesses will not be able to survive this crisis. Legal experts agree that there will be an uptick in bankruptcy filings and Congress took note. The recently enacted CARES Act expanded access to the streamlined, small business Chapter 11 bankruptcy process to more businesses by increasing the debt limits from $2.7 million to $7.5 million for one year. With more bankruptcies on the horizon, businesses already concerned about receiving timely payments from customers must now consider whether they will retain payments received from a company that is on the verge of bankruptcy.

For those not familiar with preference claims, it is true – a creditor that is paid in the 90 days before bankruptcy may be sued for the return of those payments. The policy behind permitting a trustee or debtor-in-possession to “claw back” these “preferential” payments is premised upon the bankruptcy goal of treating similarly situated creditors equally. With this in mind, a creditor who must return the preferential payment is entitled to an unsecured claim in the bankruptcy case for the returned amount. In cases where there may be little or no cash available for unsecured creditors, this outcome can be frustrating and confusing.

A common question for businesses concerned about a preference claim is, “I suspect a customer who owes me money is going to file for bankruptcy. Should I accept payment?” The immediate answer to that question is “Yes.” Cash is king, and taking the money is almost always good advice. The more important and difficult question to answer is, “What can I do to avoid returning the payment if I received payment in the 90 days before my customer filed for bankruptcy?” The answer lies in understanding the elements of a preference claim and the defenses available to creditors. Reviewing these elements and implementing certain best practices to support a defense can put a business in a better position to address the claim if that time comes.

To establish a preference claim, the trustee or debtor-in-possession must prove that the payment was a transfer of the debtor’s property (cash), made on account of an antecedent debt (not a prepayment), made while the debtor was insolvent, made within 90 days of the bankruptcy and results in the creditor receiving more than it would receive in a liquidation. Most of these elements can be established through evidence of the payment and when the creditor received the payment. The element of insolvency, if challenged by the creditor, requires expert analysis. In cases where the preference exposure is relatively small, retaining an expert to challenge insolvency is not cost-effective.  The better approach for businesses is to focus on what they can prove — the preference defenses.

There are two statutory preference defenses: (1) the ordinary course of business defense and (2) the new value defense. The burden is on the creditor to establish the defense. Because preference claims are generally pursued near the second anniversary of the bankruptcy filing (the statutory deadline for filing a preference claim), it is abundantly critical that businesses maintain and preserve accurate records that establish:

  • dates of invoices and shipments
  • dates that payments were received
  • bank records evidencing payments
  • communications with the customer showing the attempts (or lack thereof) to collect past due amounts.

All this information is necessary to establish the defenses.

Ordinary Course Defense: The ordinary course defense has two prongs: (1) ordinary course between the parties (courts review the prior course of dealings between the parties) and (2) ordinary course in the industry (courts review the course of dealings in the creditor’s industry). These defenses are exclusive, and the creditor only needs to establish one of the prongs. 

The best practice approach for the first ordinary course defense prong is consistency in all dealings with the customer. Unusual collection practices on the eve of bankruptcy could be detrimental to an ordinary course defense. It’s not that collection activities are not allowed. It’s that collection activities remain ordinary and consistent to fall within the defense.

For instance, if there are 30-day payment terms and collection calls are normally made when the account is 60 days past due, maintain this practice. If payments are routinely made by check, don’t demand a wire payment.  If payments are routinely late without past due notices being sent, don’t start sending notices. If several invoices remain unpaid, be cautious of accepting partial payments or settled payment amounts, if this was not the historical dealings between the parties.

Regarding the second prong (ordinary in the industry), the inquiry is basically a comparison of the payment practices between the creditor and other similar businesses in the creditor’s industry. In some cases, experts are employed to do a detailed “days sales outstanding” analysis based upon an industry-wide survey. In cases where this may not be feasible, courts have allowed testimony by an employee that has experience in the industry.

In a recent case, a court determined that late payments that deviated from past practices were ordinary in the industry during a downturn in the economy or the particular industry. Applying that to the current economic downturn caused by the coronavirus may be a very useful defense for creditors.

New Value Defense: “New value” is an extension of further credit (e.g., money, goods, or services) to the debtor before bankruptcy. The defense typically applies where the debtor makes a preferential payment, and the creditor continues to provide additional credit for goods and services after the payment.  The credit extended after the preferential payment is a defense to the amount of the preference claim.

For instance, the creditor receives a $10,000 payment and subsequently extends credit for new goods and services after receipt of the payment in the amount of $4,000. If the new value is unpaid and the bankruptcy is filed, the creditor is entitled to apply the new value amount ($4,000) to the preference payment ($10,000), resulting in a $6,000 preference claim. Thus, continuing to provide goods and services on credit to a distressed business is incentivized.

To advise a creditor of a potential preference claim, a trustee or debtor-in-possession often sends a letter to the creditor who received the payment demanding return of the funds.  If that does not work, however, she may file a “preference” lawsuit against the creditor in the bankruptcy court. In chapter 11 reorganization cases, the debtor-in-possession must also include a preference analysis in its disclosure statement, which discusses the amount of preference claims and their potential collectability. In some instances, the debtor or trustee may file suit without advising the creditor and potentially without an in-depth analysis of the viability of the claim.

What should you do if you receive a preference demand letter, are served with a complaint or suspect that you may have some preference exposure in a recently filed bankruptcy case? Get in touch with your bankruptcy lawyer right away. A bankruptcy lawyer can help you examine the facts of your case, evaluate the plaintiff’s chances of proving the preference elements, and discuss the elements of your defenses. By quickly evaluating the transaction or transactions at issue and responding to a demand letter with clear, thoughtful analysis, many preference lawsuits are avoided entirely or settled before significant time and money is spent on defense.

Phelps’ bankruptcy team has litigated and defended numerous preference actions. They are available to advise clients facing potential preference exposure or seeking guidance on staying paid when your customer files for bankruptcy. For more information related to COVID-19, please also see Phelps’ COVID-19: Client Resource Portal.