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'What the Heck Do You Mean I Have to Give the Money Back!'

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A preference claim from a customer's bankruptcy filing can be a nasty surprise.

Most business creditors are familiar with the usual pitfalls of a customer’s bankruptcy—the loss of a receivable, the delays in collection and the wind down of orders. Less familiar is the unexpected loss than can result from a preference claim. Imagine receiving payment for delivering a credit customer’s order—then learning you have to give the money back.

In simple terms, a “preference” is a transfer of value, usually a payment made by a debtor to a creditor, to cover a pre-existing debt just prior to the debtor filing for bankruptcy. As you might expect, preference actions fly in the face of modern business practices and give rise to a great deal of ire. They make little sense until you consider the policy behind the U.S. Bankruptcy Code and avoidance actions in general. The drafters of the code believed that, during the period in which a debtor is running short of cash, no single creditor should be “preferred” over the others. During the cash-strapped period before filing for bankruptcy, a customer may make payments to a creditor that he values and ignore other creditors he owes money. The preference statute permits a debtor to recover these payments so that they can be redistributed on a pro rata basis to all creditors, preventing any favoritism.

Section 547(b) of the Bankruptcy Code states that a prima facie claim for the recovery of a preferential transfer exists where a debtor makes a transfer of an interest in property:
a) To or for the benefit of a creditor;
b) For or on account of antecedent debt owed before such transfer was made;
c) Made while the debtor was insolvent;
d) Made within 90 days before the date of the debtor’s bankruptcy petition; and
e) That enable the creditor to receive more than he would receive if a) the transfer had not been made, b) the bankruptcy was a Chapter 7 liquidation, and c) the creditor received payment via the liquidation.

Bankruptcy case law generally has regarded an “antecedent debt” as simply a debt or obligation of the debtor that was due and owing prior to the preferential transfer of payment. Section 547(f) further provides that the debtor is presumed to have been insolvent during the 90-day period prior to filing for bankruptcy protection. Finally, a preference claim will not arise if the customer pays all of his trade creditors in full during the bankruptcy.

But, if the debtor can demonstrate that the transaction meets these conditions, then he is entitled to recover the value of that payment from the creditor despite the creditor having performed no wrongful acts. To cite one example, in Ames Merchandising Corp. v. Cellmark Paper, Inc., 450 B.R. 24 (Bankr. S.D. N.Y. March 28, 2011), the debtor filed a claim to recover $1.9 million it paid to Cellmark within the 90 days prior to its bankruptcy. There was absolutely no dispute that the debtor accepted and used Cellmark’s products, that the payments to Cellmark were due or that the payments were properly made to Cellmark. Nonetheless, after reviewing the statutory elements of section 547, the bankruptcy court ordered Cellmark to repay the $1.9 million it received from the debtor during the 90-day “preference period,” plus prejudgment interest.

As a metals distributor, if you are providing goods or services to a customer on credit terms and you are concerned he may file for bankruptcy protection, prepare yourself to face potential claims for the recovery of preferential transfers.

Defenses to a preference claim
What can a creditor do to protect himself against unanticipated preference claims?
* Get cash in advance or cash on delivery. Cash paid in advance or at the same time the goods change hands is not subject to preference claims. Under the bankruptcy law, a claim for a preferential transfer only exists if the liability was antecedent or owed by the debtor prior to the preferential payment being made. Likewise, if the cash is intended by the customer and the creditor to be a contemporaneous exchange of payment for value, and is in fact substantially contemporaneous, then the creditor has a defense under section 547(c)(1).

* Credit insurance and letters of credit. If the nature of your business does not permit you to use cash in advance or cash on delivery terms, then you might consider obtaining credit insurance for any customers at risk of insolvency. Be sure that such insurance expressly provides coverage for preference and other avoidance claims.

Another alternative is to have the customer obtain an irrevocable letter of credit to guarantee payment of trade debts. If you are able to secure such a letter of credit, take care not to allow the outstanding amount of accounts receivable to exceed the amount of the letter.

* The ordinary course defense. Section 547(c)(2) provides a “safe haven” for payments that are incurred between the customer and creditor if those payments are either a) made in the ordinary course of business of the customer and creditor or b) made according to ordinary business terms. To strengthen this defense, it is important for a creditor to avoid unusual collection activity and to require the customer to conform to the parties’ agreed credit terms.

Pay close attention if a customer’s payments begin to arrive earlier or later than usual. Should a customer contact you and request more time to pay outstanding invoices, don’t be too quick to comply. Simply by permitting this change in the credit terms, you could dramatically reduce the strength of your ordinary course defense.

* Maintain your records. Finally, it is important to carefully preserve the account records of any customer that files for bankruptcy. If you receive notice that a customer has filed for bankruptcy, or you receive a complaint or demand letter to recover preferential payments, you should immediately assemble and preserve all documents and records relating to your transactions with that customer. Often debtors do not have access to complete business records at the time they assert a preference claim. If you have complete documentation, you have more ammunition to assert your defense to a preference claim and stand a better chance of hanging on to the money.

[Nathan A. Wheatley is a senior counsel with the Ohio law firm of Calfee, Halter & Griswold LLP, with special expertise in the areas of creditor's rights, bankruptcy and insolvency litigation. He can be reached at or by phone at 216-622-8573.]

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