The proliferation of bankruptcy preference claims has left many creditors frustrated. After a debtor has filed for bankruptcy and you are faced with preference litigation, existing facts may not be helpful to your defense. But there are certain steps that you can take prior to a debtor filing for bankruptcy that could stack the facts in your favor.
When Creditors Can Expect Preference Litigation
Timing.
Suits to avoid and recover preferences must be filed within two (2) years after the filing of a bankruptcy petition (or within one (1) year after the appointment of a bankruptcy trustee if the trustee was appointed during the initial two year period), so creditors often will not know that they will face preference litigation until two to three years after their payments were received.Common Legal Defenses
Ordinary Course of Business.
The ordinary course of business defense is intended to leave the normal financial transactions between a debtor and its creditors undisturbed by protecting those credit transactions that are made in the ordinary course of business of the parties and in some jurisdictions in the ordinary course of the industry as well.Substantially Contemporaneous Exchange for New Value.
This defense applies where the transfer was intended by the debtor and the creditor to be a substantially contemporaneous exchange for new value given to the debtor by the creditor, and there was in fact a contemporaneous exchange. Courts do not employ hard and fast rules as to what constitutes "contemporaneous." The most common example of a contemporaneous exchange is a COD (cash on delivery) transaction.Subsequent Exchange for New Value.
A debtor or a trustee may not avoid or recover a transfer to or for the benefit of a creditor to the extent that such creditor subsequently provided new value (i.e., goods, services, etc.) to the debtor. The rationale behind this defense is that because the creditor transferred new value to the debtor, there was no depletion of the debtor’s estate. Remember that the key issue to this defense is timing—the creditor must have provided new value to the debtor after receipt of the allegedly preferential transfer.What You Can Do - Preparation and Liability Prevention
There are several strategies that creditors should consider implementing both at the outset of and during the business relationship. These measures are not fool-proof, but they do aid in building stronger defenses to a future preference action. Some of these strategies may result in you having to weigh future preference exposure with the cessation of business, a tradeoff that only hindsight will correctly see in every instance.
Industry Standards.
The ordinary course of business defense requires a defendant to prove that the transfers were made in accordance with ordinary business terms. Courts require that one or both of the following tests be met.The transfers were made in accordance with industry standards. Creditors should consider contacting other companies to collect a sampling of the payment terms followed in that industry, and keep records of this survey as an evidence of the industry standard at the time the payments were received. Utilizing payment terms generally comparable to those in the industry will be beneficial to your defense.
The transfers were made in accordance with the ordinary course between the creditor and the debtor. Be careful about modifying long standing credit practices when the debtor is having financial trouble. The ordinary course may be destroyed or you will be left arguing that you had two ordinary course periods, which may be rejected by the courts. The downside if the credit terms are not altered is that the customer may refuse to purchase additional goods, resulting in lost sales.
Record-Keeping.
The ordinary course of business defense requires some mechanism for identifying and illustrating the historical course of dealing between the parties – generally one to one and one-half years. Changes in technology result in frequent replacement of computers and record-keeping systems. Without that data, establishing an ordinary course of business defense becomes difficult. Accurate records often lead to a quick and cost-effective settlement. It is often worth the effort to analyze potential exposure when a debtor files for bankruptcy, and plan accordingly based upon that potential exposure.C.O.D.
By requiring payment at the time of delivery of the goods, those transactions will be shielded from preference exposure. The downside is that the customer may refuse to accept C.O.D. terms and opt to terminate the relationship, resulting in lost sales.Letter of Credit
. Requiring a letter of credit can eliminate preference exposure. Because the payment is made by the issuer of the letter of credit, the payment is not a transfer of the debtor’s property and is not a preferential transfer.Payments from Third Parties.
Receiving payment from a third party can eliminate preference exposure. Because the payment is not a transfer of the debtor’s property, it is not a preferential transfer. In some instances, a related entity might be willing to satisfy the debtor’s obligations so that the network of entities continues to operate without interruption. It is similarly conceivable that, on a short term basis, a secured creditor may opt to make payments on behalf of the debtor in hopes of protecting its collateral.Prepay.
Because payment is received prior to the delivery of goods, prepaid transactions are not payments on account of antecedent debt and are not preferences.Terminate Relationship.
If payment is collected more than 90 days prior to the bankruptcy filing, the creditor is exposure-free, unless the creditor is an insider, which extends the preference period to one (1) year. Depending on the creditor’s current financial status and the creditor’s business, it sometimes makes business sense to continue the relationship and receive funds today, and worry about future lawsuits when and if they do arise tomorrow.The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
