Limiting Exposure for Preference Payment Liability When Customers are in Financial Distress

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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:

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).

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:

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:

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.

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