Defending Against a Preference Claim

If you think that, in collecting your accounts receivable, there is nothing worse than not being paid, consider this: You could collect the money, spend it, and then be ordered to give it back.

That is what can happen if your customer files for bankruptcy within 90 days after he gives you a full or partial payment on his outstanding balance. Someone will almost surely make a preference claim against you – so called because you would appear to have received “preferential” treatment over other creditors with whom you are otherwise in the same boat.

Fortunately for you, there are defenses that you can raise against a preference claim, namely:

• contemporaneous exchange,

• subsequent new value, and

• ordinary course of business.
  

These defenses exist not just to help creditors avoid preference claims, but also to encourage creditors to continue doing business with, and extending credit to, financially strapped customers.

The third defense – ordinary course of business – may be the most common but, in some cases, the most difficult to prove. Fortunately, in the federal courts there has evolved a fairly objective test for deciding whether an alleged preference payment was made according to ordinary business terms. That test takes into account not just the credit practices that are appropriate to your industry but also the payment history between you and your customer.

BACKGROUND

The Bankruptcy Code allows a trustee or debtor-in-possession to recover – as preferences – any payments or other transfers of assets by a debtor to a creditor within 90 days of the debtor’s bankruptcy filing.

The preference provision has two main purposes: to prevent a debtor from favoring any of its general unsecured creditors over the others; and to discourage creditors, upon hearing that the debtor is about to file bankruptcy, from storming the courthouse to file eleventh-hour lawsuits to collect the debts owed them.

Proving a preference. To back up his preference claim, a trustee or debtor-in-possession must show that five conditions applied to the payment:

• The debtor made a payment or transferred property to, or for the benefit of, the creditor.

• The payment or transfer occurred within 90 days of the debtor’s bankruptcy filing (that period grows to a full year for payments to insiders).

• The debtor made the payment to reduce an existing debt owed to the creditor.

• The debtor was insolvent when the payment occurred.

• As a result of the payment or transfer, the creditor received more from the debtor than he would have received in a Chapter 7 liquidation of the debtor.
  

ORDINARY COURSE OF BUSINESS

To successfully raise the “ordinary course of business” defense, you (the creditor) must prove both of the following: The debt on which you received the payment was incurred in the ordinary course of business between you and the debtor; and the payment was made in the ordinary course of business between you and the debtor, according to ordinary business terms.

Whether the debt was incurred or the payment was made in the ordinary course of business is relatively objective and easy to prove or disprove.
The second consideration in each element is more subjective, as it takes into account the specific, historical billing and payment relationship that existed between you and the debtor prior to the 90-day preference period. If the alleged preference payment was consistent with the manner in which previous payments were made, that strengthens your defense against the preference claim.

• Example 1: XYZ Company was a long-time customer that habitually paid its bill, with charges ranging from $1,000 to $7,500, between 45 and 60 days after the due date. A week before filing its bankruptcy petition, XYZ made a $5,000 payment on its account, 55 days past the due date. When a preference claim is made against that payment, you should be able to successfully defend against the claim by showing that the payment was consistent with XYZ’s payment history with your company.

• Example 2: For its first three months as a customer, JKL Company paid its bill on or before the due date. However, charges for the fourth month, considerably higher than any of the previous months, went unpaid for 75 days before a check finally arrived. A week after you received that payment, JKL filed for bankruptcy protection. The inevitable preference claim will be much more difficult to defend than in the case of XYZ, because of (a) your relatively short credit experience with JKL and (b) the contrast between the collection periods for the first three payments and the final payment.
  

COURT DECISIONS

In the last decade, decisions in federal appellate courts have lent some clarity to the ordinary course of business defense, to the benefit of creditors.

In a 1993 ruling in the Tolona Pizza Products case, the court held that “ordinary business terms” encompass practices in which companies similar to the creditor engage. Only dealings that are so “idiosyncratic” as to fall outside the broad range of terms offered by similar companies would be disallowed. The court also noted that it is unnecessary to show strict conformity with industry standards, since no two credit relationships between debtors and creditors are identical. That view was reaffirmed in the 1994 Molded Acoustical Products decision.

In another case, the court held that the greater the length of the parties’ relationship prior to the preference period, the more the creditor could vary its credit terms with the debtor from the industry norm and still satisfy the ordinary course of business test.

CONCLUSION

A preference claim against a payment you received from a now-bankrupt customer is a serious matter, but it is not a slam dunk for the party making the claim. Legitimate and widely accepted defenses are available to you, provided you took a business-as-usual approach to the transaction and the resulting debt and payment.

An experienced bankruptcy attorney can help you analyze the validity of the preference claim and your defenses against it.