Companies often find themselves in the frustrating position of becoming a defendant in litigation. But as frustrating as being forced into litigation can be in the typical commercial dispute, companies that find themselves defendants in bankruptcy preference proceedings acquire a unique ire. Once a bankruptcy case is filed, companies that provided goods or services to a customer and had been paid by the customer can be sued for recovery of the payment if received within 90 days of the bankruptcy filing. This often occurs even where the company may have a sizable claim for unpaid invoices that may go unsatisfied in the bankruptcy case.

We often hear from clients after the lawsuit is filed. At that stage, options are limited by what occurred pre-bankruptcy, and many defenses that could have been available are no longer possible. So what can you do to limit preference lawsuits?

First, What Is a Preference?
Section 547 of the Bankruptcy Code permits a debtor (or, if appointed, a trustee) to “avoid” and then recover payments made to creditors within 90 days of the bankruptcy filing. The policy underlying the preference statute is that payments to unsecured creditors that might have been “favored” shortly before the bankruptcy must be returned to the debtor’s estate so that all unsecured creditors can share pro-rata in the debtor’s assets.

The following elements that must be established to recover a preference payment are straightforward: (i) a transfer of property of the debtor (typically, a payment but can be a lien on its property); (ii) made to or for the benefit of a creditor; (iii) for or on account of a debt owing prior to the payment being made; (iv) made while the debtor was insolvent; (v) made within 90 days before the bankruptcy petition was filed (or one year if the creditor is an “insider”), which is the check clearing date for check payments; and (vi) the transfer enabled the creditor to receive a higher payment than the creditor would have received in a Chapter 7 liquidation if the payment had not been made. The last element means payments made to fully secured creditors cannot be preferences.

So, Are Any Defenses Available?
Fortunately for creditors, the Bankruptcy Code provides defenses to a preference claim. The most common defenses are (i) the ordinary course of business defense; (ii) the subsequent new value defense; and (iii) the contemporaneous exchange for new value defense.

The Ordinary Course of Business Defense
The ordinary course of business defense applies where a payment was received either (i) within the ordinary course of the business of the debtor and the creditor; or (ii) on the ordinary terms for the applicable industry. For the first alternative, courts typically analyze the method and timing of the payment, which requires a creditor to usually demonstrate that the payment was received consistent with the parties’ past payment history, e.g., for the past year, the debtor paid roughly 30 days from invoice and the challenged payments were all received roughly 30 days later as well. For the second alternative, expert testimony is generally needed to explain the collection practices in the industry in question.

Subsequent New Value
If a creditor, after receiving the disputed payment, subsequently provides new value (such as goods or services) to the debtor, the value can be credited against the payment.

Contemporaneous Exchange for New Value
If the alleged preference payment was intended by both the debtor and creditor to be a “contemporaneous exchange for new value,” then that payment generally cannot be avoided. This can be a true C.O.D. payment (such as a cashier’s check) that the creditor receives contemporaneous with the release of the goods that the C.O.D. payment covers.
How Can I Limit Preference Exposure?

C.O.D. or Cash Payments
If you are concerned that a customer is nearing bankruptcy, insist on C.O.D. payments before releasing any goods. Clients sometime believe that “C.O.D.” means receipt of a personal check prior to or contemporaneously with release of goods. This is insufficient, however, because the check does not clear until some point in the future. We recommend a cashier’s check or other form of cash payment. Also, if there are outstanding invoices due, do not apply the new payment to old invoices but to the goods provided at the time of payment. And be sure all records are maintained to document the terms of the C.O.D. delivery.

Rather than a C.O.D. payment, we often recommend that clients just be paid in advance of providing services or delivering goods. Then, the debtor or trustee could not prove in bankruptcy that the payment was made on an antecedent debt – no debt had been incurred yet.

Have a Third Party Pay
A preference requires a transfer of a debtor’s interest in its property. Therefore, payments made on behalf of a debtor by third parties would not be a preference because the third party, not the debtor, is the one who transferred funds to the creditor

Earmarking Doctrine
Even where a debtor makes a payment on its debts to a creditor, courts recognize the “earmarking doctrine.” This doctrine protects payments that are funded by a third party and specifically “earmarked” for the creditor. The third party funding the payment should document its intention that the payment be used to pay the creditor. If done properly, this results in a payment not being treated as a preference because the funds are not considered the debtor’s property.

Maintain Records and Credit Terms Where Possible
Proving an “ordinary course of business” defense requires that a creditor maintain organized and detailed records tracking the dates invoices are due against payments received. Clients who have successfully negotiated a settlement based on the ordinary course of business defense can present records to the trustee or debtor supporting their defense. We encourage clients to follow best record keeping practices for this reason (among others). If the records are unclear or unavailable, a creditor is hampered.

Often, there is a natural temptation to insist on more restrictive credit terms with a financially distressed company or engage in more aggressive collection practices. If, however, a payment is made within the preference period on account of these new terms or practices, the creditor is less likely to prove an ordinary course of business defense, which depends on consistency with the parties’ ordinary course of business. Prepayment or C.O.D. payment is a better approach in such circumstances.

These strategies should reduce your risk of being exposed to preference liability or at least place you in a better position to assert any defenses if you receive a preference demand. Often, a trustee or a debtor will negotiate a settlement prior to filing suit based on our presentation of a viable ordinary course of business or new value defense. For this reason, we encourage you to contact your attorney immediately after receiving a preference demand letter (which is often sent prior to filing suit). Some clients ignore the letter entirely (leading to a lawsuit that could have been avoided) and others return the payment without consideration of any defenses. Both approaches must be avoided. Finally, if you receive a check from a customer that has not yet filed bankruptcy, but you believe one is imminent, do not return the check for that reason! Deposit the payment, even if there is a chance that it might be a preference payment. A bankruptcy may not, in fact, be filed and, even if there is a filing, a settlement at less than full value can often be negotiated.

Boodell & Domanskis, LLC’s creditors’ rights and litigation attorneys can provide counsel on how best to avoid preference litigation and, if necessary, defend your company in any bankruptcy preference proceedings.