Especially in our current economic climate, the financial woes of a customer can have painful repercussions for your business. The following scenario is one you may have experienced. One of your largest customers files for bankruptcy, leaving you with $75,000 in unpaid invoices. Your lawyer advises that, other than filing a proof of claim and hoping your eventual recovery in the bankruptcy case amounts to more than mere pennies on the dollar, there is nothing you can do (unless the debtor has received your goods within 20 days of its bankruptcy filing, in which case you may have a priority claim known as a "503(b)(9)" claim, so named for the section of the Bankruptcy Code covering such claims). So you absorb the hit to your bottom line and move on as best as you can.
The real kicker, however, comes a year or two down the road. You receive a letter from lawyers for the debtor or a bankruptcy trustee, or even more daunting, a summons and complaint that has been filed in the Bankruptcy Court, demanding the return of the payments you received from the debtor within 90 days prior to its bankruptcy. You are warned that these payments were "preferences" under section 547 of the Bankruptcy Code, and that they must be returned. What does that mean, and what can be done in response?
WHAT ARE PREFERENCES?
The United States Bankruptcy Code permits a bankruptcy trustee or debtor-in-possession to avoid and compel repayment of certain transfers made by a debtor to a creditor in the 90 days prior to the filing of a bankruptcy petition (the "preference period"). These transfers are referred to as "preferences."
Section 547 sets forth the elements that a debtor-in-possession or trustee must satisfy to avoid a preference. Specifically, the trustee must prove that the payment was a transfer of an interest of the debtor in property (i) to or for the benefit of a creditor; (ii) for or on account of an antecedent debt owed by the debtor before such transfer was made; (iii) made while the debtor was insolvent; (iv) made on or within 90 days before the date of the filing of the bankruptcy petition (or within one year of filing if the creditor is an insider); and (v) that enabled the creditor to receive more than such creditor would otherwise receive in a Chapter 7 liquidation. The trustee bears the burden of proving each of these elements.
The notion of preference liability – in particular, the fact that a trustee may recover payments received on a completely legitimate debt – strikes most creditors as being grossly unfair or unreasonable, especially when the debtor may still owe money to the creditor. While there is no sugarcoating the fact that, on the individual creditor level, it is unfair, from a broader policy perspective the rationale for the preference law is to level the playing field among creditors – some of whom may have received nothing from the debtor during the preference period while other creditors received some or all of what they were owed. The ability of a debtorin- possession or trustee to recover preferential transfers ensures that like-situated creditors receive an equitable share of the debtor's assets in proportion to their respective claims. Moreover, as discussed more fully below, a creditor is not defenseless in a preference action as the creditor may assert defenses set forth in the Bankruptcy Code.
WHAT ARE THE STATUTORY DEFENSES TO PREFERENCE ACTIONS?
The Bankruptcy Code affords creditors a number of defenses to preference liability. These statutory defenses are aimed at encouraging creditors to continue doing business with a financially distressed entity. The three most common statutory defenses are: (i) contemporaneous exchange for new value; (ii) subsequent new value; and (iii) ordinary course of business.
Contemporaneous Exchange for New Value Defense
The contemporaneous exchange for new value defense protects transfers that are both: (1) intended by the debtor and the creditor to be a contemporaneous exchange for new value given to the debtor; and (2) in fact, a substantially contemporaneous exchange. See 11 U.S.C. § 547(c)(1). The rationale behind the contemporaneous exchange for new value defense is simple: if the creditor provides the debtor with "new value" (i.e., goods or services) in exchange for payment, the debtor's bankruptcy estate has not been diminished as a result of the payment.
Example: During the preference period, creditor ships $10,000 in goods or merchandise to a customer. At the time of shipment or very shortly thereafter, the customer pays $10,000. Provided that both the creditor and the customer in bankruptcy intend that the exchange of goods for payment be a contemporaneous exchange, the $10,000 payment would be protected and not subject to avoidance by the trustee as a preference in the event of customer's bankruptcy.
Subsequent New Value Defense
The subsequent new value defense prevents a trustee from avoiding a transfer where the creditor subsequently provides new value to the debtor, which new value was not secured by an otherwise unavoidable security interest and on account of which the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor. See 11 U.S.C. § 547(c)(4). Subsequent new value provided to the debtor may be offset against the potential preference liability that the creditor faces.
Example: During the preference period, customer pays creditor $20,000 on an outstanding invoice. Following creditor's receipt of this $20,000 payment, creditor ships the customer $15,000 in additional goods. The customer subsequently files for bankruptcy without paying creditor for the $15,000 in additional goods. Applying the new value defense, creditor may apply this $15,000 in subsequent new value to reduce its preference exposure to $5,000.
Ordinary Course of Business Defense
The third common defense is the ordinary course of business defense, which protects transfers made in the ordinary course of business between the debtor and creditor. See 11 U.S.C. § 547(c)(2). To avail itself of this defense, a creditor must prove that the transfer was made either in the ordinary course of business or financial affairs of the parties (the "subjective test") or according to ordinary business terms in the industry in which the parties are engaged (the "objective test").
An analysis of the ordinary course of business focuses primarily upon the amount of time that passes between invoicing and payment, industry standard invoice terms, typical efforts taken by vendors in the industry to collect accounts receivable, whether accounts receivable in the industry are typically factored, and similar considerations regarding the timing and manner of payment between the parties. A deviation from the standard course of conduct will tend to support a finding that payments are out of the ordinary course of business and thus should be avoided as preferences.
The defense is predicated on consistency. Thus, with respect to the subjective test, to prove that the parties' business relationship remained consistent both before and during the preference period, it is essential that the creditor maintain meticulous and detailed records for transactions made both during the preference period as well as prior, recording the date invoices were issued, payment terms, and the dates on which payments were received. While it may be tempting, a creditor should avoid changes in payment terms in the weeks and months leading up to the filing of the bankruptcy petition, as a bankruptcy court may construe payments made according to those new terms as outside the parties' ordinary business relationship. An exception to this rule is if the change in payment terms is to payment in advance or COD, because such terms will remove the payment from the reach of the preference provision entirely – payment in advance or COD is not "on account of an antecedent debt" and therefore, by definition, not a preference.
With respect to the objective test, a creditor must prove that the parties' relationship was consistent with that found among similarly-situated entities in the applicable industry. This is usually accomplished through the use of expert witnesses who can opine as to the industry standard for course of dealing between parties in the vendor's industry. The typical expert is a credit professional having experience in the pertinent industry.
Example: Creditor's contractual arrangement with customer is that customer pays on 45-day net terms. Over the course of the prior year, however, customer frequently paid within 55 to 65 days. In the 90 days prior to its bankruptcy, customer makes payments to vendor which are within 60 to 65 days net. Although the agreed upon terms were 45-days net, because customer and creditor established a course of payment which was often 55 to 65 days net, if this occurred frequently enough, most courts would likely find that none of the payments received during the preference period within 55 to 65 days net were a preference.
CAN STEPS BE TAKEN IN ADVANCE OF BANKRUPTCY TO REDUCE PREFERENCE EXPOSURE?
In addition to asserting these statutory defenses once a demand for return of a preference has been made, creditors may also proactively adopt credit strategies to implement in their dealings with a financially distressed entity prior to the filing of a bankruptcy petition. Such strategies may include requiring payment in advance or payment COD and improving recordkeeping practices, among other things. For example, if a trade creditor doing business with a financially troubled debtor wishes to preserve the contemporaneous exchange defense, it is prudent to create a new account ledger for the debtor and apply payments received to this account contemporaneously with any shipment being made to the debtor. Trade creditors will lose this defense by applying payments received to aging invoices.
CONCLUSION
Preference actions pose a real threat to any creditor doing business with financially distressed entities. An informed and proactive creditor can reduce its potential preference exposure by implementing credit strategies that, in the event of a future preference demand, permit it to avail itself of the statutory defenses to preference actions.
Cozen O'Connor's bankruptcy attorneys have significant experience in defending against preference actions and counseling clients in formulating credit strategies aimed at reducing potential preference exposure. For more information, please contact Eric L. Scherling (Philadelphia, 215.665.2042, escherling@cozen.com) or Lauren J. Grous (Philadelphia, 215.665.4658, lgrous@cozen.com).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
