Limiting Exposure for Preference Payment Liability When Customers are in Financial Distress
Although the full-extent of the business disruption due to the COVID-19 pandemic is not yet known, the unprecedented recent events are certain to have a far-reaching impact upon commerce, including a near-certain uptick in business bankruptcy filings. Often times, companies that sell goods or provide services on credit are surprised to learn that customer/client payments may be subject to claw back in the customer's/client's bankruptcy case as a "Preference Payment".
What is a Preference Payment?
Section 547 of the Bankruptcy Code authorizes a debtor in bankruptcy (or its bankruptcy trustee, as the case may be) to commence a lawsuit against a creditor that received payments from the debtor in the 90 days prior to the bankruptcy filing. In order to recover a preference payment, the debtor/trustee need only show that:
- A transfer was made by the debtor to or for the benefit of a creditor;
- The transfer was made on account of an antecedent debt owed by the debtor before the transfer was made;
- The debtor was insolvent at the time of the transfer;
- The transfer was made on or within 90 days before the filing of the bankruptcy case (or one year prior to the bankruptcy case if the creditor is an insider of the debtor); and
- The transfer enabled the creditor to receive more than it would have received in a Chapter 7 liquidation.
These elements are crafted to ensure that a creditor has not improved its position (or been "preferred") vis-à-vis other creditors in the 90 days prior to the filing of the bankruptcy case.
The Bankruptcy Code was recently amended so that the debtor/trustee must at least serve as the gatekeeper in limiting preference actions only to those which "based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses" give rise to a preference action. Once the debtor/trustee proves the foregoing elements, the burden then shifts to the creditor to establish an affirmative defense to the preference litigation (see below for a discussion of preference defenses).
Understanding that not all creditors who provide goods and/or services on credit should be subject to claw back, the Bankruptcy Code lists affirmative defenses to preference liability, which include that the preferential transfer:
- Was made in the "ordinary course of business" between the debtor and creditor (e. the transfer was not the result of collection efforts and was made in similar time and on similar terms to historic payments by the debtor to the creditor);
- Was made prior to the creditor's advance of "new value" (e. additional goods and or services) to the debtor for which the creditor was not paid. Any unpaid "new value" will serve as a dollar-for-dollar credit against any preference liability; and/or
- Was a "contemporaneous exchange", meaning that the debtor paid for the goods/services at the same time that the goods/services were provided by the creditor.
Although these defenses often serve as a basis to eliminate preference liability or as leverage in a settlement discussion with the trustee/debtor, the defenses are affirmative in nature, meaning that the creditor carries the burden of proof and must prove the facts giving rise to the defenses in litigation. These defenses will not serve as the basis for a motion to dismiss the preference litigation in its early stages.
Limiting Preference Exposure on the Front-End
While there is no certainty that a trustee/debtor will not file suit to recover payments made in the 90 days prior to its bankruptcy filing, there are steps one can take to limit potential exposure:
- Monitor payment activity from customers/clients. Understand the ordinary course of dealing with particular clients, monitor the manner and timing of payments, determine if there has been a change in established business practice, and keep open lines of communication with customers/clients;
- Review invoice terms and assess whether there is any need for goods/services to be provided on credit. Since only payments "on account of an antecedent debt" may only be recovered as preferences, cash-on-delivery or prepayment terms may allow a creditor to argue that the trustee/debtor can never establish an essential element of a preference claim;
- If invoices must be issued following the provision of goods/services, maintain consistency in the issuance of invoices and the terms upon which invoices are issued.
As a final point, even if there is a suspicion that a bankruptcy is imminent, never reject payment solely over concern that such payment may later be construed as a preference. Money paid for goods/services provided that may be subject to avoidance in later litigation is better than no money at all.