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The Bankruptcy Preference: Do Nothing Wrong. Get Sued Anyway.

The Bankruptcy Preference: Do Nothing Wrong. Get Sued Anyway.

What if I told you that a magical world exists where giant blue creatures live in harmony with their planet but are forced to fight off an invading human force seeking out the planet’s ‘unobtanium’ (seriously, someone in Hollywood was paid to come up with that)? You’d say Avatar must have been running on cable last week (it was) and that absent a few thousand crazies devoted fans who really need to find a hobby, nobody believes the magical world of Pandora really exists. Fair enough.

What if I told you that a magical world exists where Company A sells goods to or performs services for Company B, there is nothing defective or inherently wrong with the goods/services, Company B gladly pays for the goods/services, and two years later Company A is being sued by a bankruptcy trustee in a preference action to return all the money it received in payment from Company B? By the time we’re done here today, I’m fairly sure you’ll be longing for the magical world of Pandora (which, last I checked, did not have any bankruptcy courts).what if i told you

What is a preference you ask? In simple terms, a preference is a transfer of an interest of the debtor in property, to or for the benefit of a creditor, for or on account of an antecedent debt, generally made within 90 days of the bankruptcy filing, made while the debtor was insolvent, and which allows the creditor to receive more than it would have received if the payment had not been made and the claim was paid through the bankruptcy process. Simple enough? Good. My work here is done.

Much like the Internal Revenue Code, the Bankruptcy Code is not exactly written for normal people non-lawyers. While this may be too simplistic, a preference is when you receive payment from a company/individual who, within 90 days of your receipt of payment, files for bankruptcy. A preference claim does not assert that you did something wrong or offended someone’s mother – it simply wants to ‘claw back’ the payment you received so that it can be added to the pool of assets that may ultimately be distributed to the creditors.

Preference actions are unique in that they can affect any business – so long as you are being paid for goods or services, your company is at risk. But fret not – there are defenses to preference actions that you can raise in an effort to protect what is rightfully yours. Yes, upon receipt of a demand letter (or worse yet, a lawsuit), you can assert that the payment(s) you received were in the “ordinary course of business” or that you provided “new value” to the debtor after the payments and therefore the payments you received should be protected. Of course, trying to apply one of these defenses several months or years after-the-fact is somewhat like trying to fit a square peg in a round hole (add in the fact that a bankruptcy trustee can sue you in a far-away court and that you generally cannot recover attorneys’ fees in a preference action, and you can see why the deck is usually stacked against you).

Hand trying to put Square peg into a round holeWait a minute – didn’t you say “fret not”? Ok I lied – sue me (no wait, please don’t!). We know that nobody (other than bankruptcy trustees) like preference actions, that certain defenses exist, and that those defenses are of limited utility if we only address them upon receipt of a lawsuit. This leads to only one logical conclusion – never accept mail from a bankruptcy trustee. Can’t sue me if you can’t find me, sucker (note: please don’t follow that advice). Like most litigation avoidance advice, you should be planning ahead now to avoid potential problems in the future. A preference defense is strongest when it is obvious to everyone involved, and a bankruptcy trustee is less likely to pursue a preference claim against you when it appears to be a stinker (the technical legal term) or perhaps put the trustee at risk of sanctions for an non-meritorious claim.

Let’s focus on the most commonly asserted preference defense – “ordinary course of business.” In a nutshell, a trustee may not ‘avoid’ an otherwise preferential transfer if it was made either (i) in the parties’ ordinary course of business, or (ii) according to ordinary business terms. What that means in layman’s terms is that the power to establish a solid preference defense rests with you – not after you receive a demand letter from the trustee but months/years before the debtor ever files for bankruptcy. It is up to you to establish a ‘baseline of dealing’ with your customers and then diligently following that baseline.

What I mean by this is establish upfront with your customers how and when payment is due – do you invoice customers? Do your invoices provide that payment is due within X days? Do your invoices specify what forms of payment you accept? Do you call customers that are delinquent on their payment? Do you send cousin Frankie to break a few knee caps when payment is really late? (Please don’t answer that last one).  How you interact with your customers will dictate whether a strong preference defense is available to you. The key is a consistent course of dealing – yes, my invoices require payment within 30 days but this customer has always paid approximately 45 days later. The more consistent you are with your customers, the better the likelihood is that you can resist a trustee’s claim to your hard-earned money.

Of course, sometimes consistency is simply not an option – some customers cannot be wrangled no matter how hard you try and some customers may file bankruptcy before you ever have the opportunity to establish a baseline. That’s not to say that you’re up the proverbial creek when it comes to eventual preference claims, but it does mean your strategies in resisting such claims should evolve. Dealing with a customer that is struggling to make payments and appears on the verge of ruin? Perhaps consider demanding cash-in-advance (it’s only a preference if payment is made “on account of an antecedent debt”) from that customer. At the point where you’re dealing with a demand letter or actual lawsuit? Don’t just pay and assume you’re in the wrong – the trustee wants to settle and probably has dozens (if not hundreds) of other defendants to deal with – chances are you can work out something far more favorable than originally demanded.

Remember, only you can prevent forest fires preference lawsuits. It may require some diligence in implementing/following policies, but it certainly beats the alternative of being raked over hot coals by a monster being forced to disgorge your hard-earned money to a bankruptcy trustee.