Huddleston Bolen | Main & Court

Doing Business in a Down Economy

Every business needs its customers to pay. But that can become especially difficult in tough economic times. Bankruptcy law adds additional complications that you should be aware of when attempting to collect from customers.

This is the second in a series of four issues on bankruptcy law, describing how specific rules impact you as a provider of credit to your customers. In this series, we provide information on how you can take full advantage of your rights and tips on how you can avoid the many pitfalls that could prolong the bankruptcy process or constrain your ability to collect on the debt.

In the last issue of Main and Court, we discussed the implications of the automatic stay when attempting to collect from your customers who have declared bankruptcy. In this issue we address preferential transfers and the ability of a trustee to recover such transfers from creditors.

In the next issue we will discuss reclamation. The law allows certain creditors that have delivered goods to the debtor before bankruptcy to take back, or reclaim, the goods from the debtor. The seller's exact reclamation rights depend on how soon prior to the petition date the goods were delivered.

The fourth and final issue of this series will address proof of claims. The law requires, with a few limited exceptions, creditors to submit a proof of claim by a specified date. The court will typically not allow the claim to be paid by the bankruptcy estate if the proof of claim is not submitted by the required date.

I hope you find this information useful and informative. Please feel free to contact me if it raises any questions or if there is anything we at Huddleston Bolen can do to assist you.

Preferences

One of the goals of bankruptcy law is to treat similarly-situated creditors in a similar manner. To do that, bankruptcy law puts in place a number of measures that are designed to prevent a rush by creditors from grabbing the debtor's assets. This is the reason that bankruptcy law imposes the automatic stay, which prevents creditors from collecting debts once the debtor files for bankruptcy.

However, it is often the case that the debtor's financial fall into insolvency occurs over a period of time. Because of a fear that certain creditors will be preferred and have the opportunity to collect debts or take collateral to secure their debts before a bankruptcy case is filed, Congress has established a bright line standard (90 days for most creditors, 1 year for insiders) for looking back after a bankruptcy case is filed. The preference statute allows the bankruptcy trustee to reach back for a certain period of time and re-acquire certain assets that the debtor transferred or pledged to creditors. These actions are called "preference avoidance actions" because the debtor has arguably "preferred" to pay back that particular creditor, and the trustee is "avoiding" the "unfair" preference by reacquiring the assets. In theory the preference recovery statutes make sense; however, in reality, the preference statutes often make unsuspecting trade creditors return payments when the creditor did nothing wrong.

There are five elements to every preferential transfer:

The transfer is of an interest of debtor in property to or for the benefit of a creditor, which means that a creditor either must take possession of the property, or be the beneficiary of the transfer;
The transfer is for or on account of an antecedent debt owed by the debtor before such transfer was made, which means that the underlying debt must arise before the transfer occurs;
The transfer is made while the debtor is insolvent, which can be either cash flow insolvency—the debtor is unable to pay his or her bills when they come due—or balance sheet insolvency—the debtor has more liabilities than assets. (Note that there is a presumption that the debtor is insolvent for the 90 days immediately preceding the beginning of the bankruptcy case);
The transfer is made on or within the applicable time period prior to the start of the bankruptcy case, normally 90 days, but can be as much as 1 year for certain insiders, and
The transfer allows the creditor to receive more than the creditor would have received in an ordinary Chapter 7 liquidation. (Note that the case itself does not have to be a Chapter 7 liquidation. Instead, the court runs a hypothetical mathematical calculation: If the case was a Chapter 7 liquidation, would the creditor have received less than the amount of the transfer?).

Safe-Harbors for Creditors

While certain transactions are unfair preferences that bankruptcy law wants to avoid, many transactions meet all of the preference elements but qualify for exemption. Congress does not want to discourage these legitimate transactions. As a result, bankruptcy law provides some exceptions, or "safe-harbors", to protect innocent and routine transactions from preference avoidance actions. The exceptions or safe-harbors are defenses which must be asserted by the creditor being targeted with a preference avoidance action.

One useful safe-harbor is the "ordinary course of business" exception. A transfer is not an avoidable preference if it satisfies 2 critical tests:

The transfer was in payment of a debt incurred in the ordinary course of business of the debtor and creditor (i.e. a normal arms-length transaction) AND
The transfer either must be normal in light of the parties' previous dealings with each other, or it must be normal in light of industry practice.

The ordinary course exception is fact specific and involves looking at each transfer (payment), the debtor's payment history with the creditor, the creditor's terms for payment, the debtor and creditor's relations with each other, etc. This defense can be costly to litigate but is useful in settling a preference action.

If a creditor continued to sell products and services to the debtor during the preference period, the creditor may be able to invoke the subsequent new value defense. This defense is generally available for a transfer to the extent that the creditor gave new value to the debtor after the transfer. For example if A Company received a $10,000 payment in the preference period from debtor but later sold debtor $7,500 in products (which was unpaid when the bankruptcy was filed), A Company's preference exposure is reduced from $10,000 to $2,500. In order for a creditor to avail itself of the subsequent new value safe harbor, the creditor cannot have taken a security interest to secure the sale or the debtor cannot have made an otherwise unavoidable transfer to or for the benefit of the creditor.

Another useful safe-harbor is when debtor's transfer is a contemporaneous exchange for new value given by a creditor. (Note that the exchange (1) must be intended by the parties to be contemporaneous for new value given, and (2) actually must be contemporaneous.) This exception is available for purchases promptly paid for by the debtor (for example, a COD purchase). While the specific facts of each case determine whether a transfer (payment) qualifies as a contemporaneous exchange, a good rule of thumb is 30 days or less between receipt of the product or services and payment.

In regards to new value, the law holds that value can include money or money's worth of goods, services, new credit, or a release of property previously transferred. The value given by the creditor must approximate the value of the debtor's transfer. Thus, the value must be tangible and actually enhance the value of the debtor's estate.

Time for Filing Preference Avoidance Actions

The time period for bringing a preference action is the earlier of (i) the later of 2 years after entry of the order for relief (typically entered the first day the bankruptcy case is filed) or 1 year after the appointment or election of the first trustee if the trustee is appointed or elected before the expiration of the 2 year term; or (ii) the case is closed or dismissed. The time period for a trustee to bring a preference avoidance action is typically 2 years from the date of the bankruptcy filing.

In addition to bankruptcy preference avoidance statutes, some states have their own preference recovery statutes which may be used in tandem with the bankruptcy statutes. For example, Kentucky has a preference recovery statute which can be used to recover certain transfers made within 6 months.

The Impact of Preference Avoidance Actions

Preference avoidance can have a devastating impact on creditors. In times of economic trouble, it is likely that creditors are facing financial challenges as well. If the trustee uses a preference avoidance action to re-acquire some of the creditor's assets, this may cause a cash crunch for the creditor. The debtor keeps the goods and services received from the creditor but the creditor may have to return payments received. As stated previously, the preference statutes can be unfair in application.

Practice pointer:When a customer files bankruptcy, in addition to checking amounts that are unpaid and filing a proof of claim for such amounts, look to see if you received any payments from or on behalf of the debtor with 90 days of the bankruptcy filing (or 1 year if you are an insider of the debtor). Pull the invoices, shipping and delivery confirmation for each payment and note who in your business dealt with the debtor and note the names of the debtor representatives with whom you dealt. If payment terms changed during the last year of doing business with the debtor, note any such changes. This process should not take too long, and will help provide you with a defense if you later receive notice from the trustee of a preference avoidance action against your company.

Conclusion

A preference action is a tool authorized by the Bankruptcy Code to level the playing field among creditors for debts repaid even before a debtor declares bankruptcy. It allows the trustee to recover amounts paid by the debtor to preferred creditors during the applicable preference period if certain elements are met.

Creditors must be cautious when a debtor's payment falls outside of their normal practice or industry standards. Because preference avoidance actions can quickly reduce a creditor's cash flow, a creditor who believes a debtor is becoming insolvent or a creditor who is being targeted with preference avoidance actions should contact a qualified bankruptcy attorney immediately. It may be possible to reduce your potential preference exposure by changing the structure of your transactions. Also, when a debtor files bankruptcy, it is a good idea to talk to your bankruptcy counsel about possible preference exposure at the beginning of the case. If you later receive a letter or lawsuit demanding return of payments, you will be prepared with your defenses and, most likely, will lessen the amount of your potential preference exposure.