Count to 90 Before You Count Your Money
By Len Spagnolo*
When you sell goods or services on open account, there’s always a risk of non-payment. That’s understood. But when you finally receive payment, you expect the risk of non-payment to vanish. In other words, you expect to keep the money. Bankruptcy law can upset that expectation. It can require you to return payments that you received during the 90 days prior to your customer’s bankruptcy filing date. In effect, this law against “preferential transfers” perpetuates the risk of non-payment for up to 90 days after you receive payment. That reality should influence whether, and how, you do business with someone whom, you suspect, is close to filing bankruptcy. This newsletter explains what every business person ought to know about the law against preferential transfers.
I. The Preference Problem
Assume you sell $100,000 of goods or services on credit. Your buyer pays you $60,000, leaving a balance of $40,000. Within ninety days after you receive the $60,000 payment, your buyer files bankruptcy. You grudgingly file a proof of claim for the $40,000 balance. Several months into the bankruptcy case, your buyer/debtor sends you a letter demanding return of the $60,000 payment as a “preferential transfer.” You ignore the letter. After all, why should you return the $60,000 when the debtor still owes you $40,000?
A couple of months later, the debtor sues you in bankruptcy court. The complaint seeks to recover the $60,000 you received as a “preferential transfer.” The complaint also requests that your $40,000 claim be “disallowed” (i.e., not paid to any extent) unless and until you return the $60,000. If the bankruptcy court finds that the $60,000 was a preferential transfer, you will have to return it to the debtor. In that event, you’ll be out the $40,000 you were never paid plus the $60,000 you were paid, leaving you with a $100,000 claim against the debtor (which, of course, you will likely never collect).
II. The Preference Policy
The policy underlying bankruptcy preference law is rather straightforward. It’s to ensure, or at least better ensure, that as the debtor slides toward bankruptcy, it uses its limited financial resources to pay its creditors equitably. Note: the key word here is “equitably” (read “fairly”), not “equally.” In other words, when the debtor has insufficient funds to pay all of its creditors in full, it should not pay some of its creditors to the exclusion of others. Instead, the debtor should pay its creditors on a pro rata basis or according to some other fair formula.
III. The Preference Law
In practice, preference law is complicated and somewhat arbitrary. For example, preference law presumes (whether factually true or not) that the debtor was insolvent during the ninety days prior to the bankruptcy filing date. It then enables the debtor to recover payments it made during this 90-day “preference period” (the 90-day preference period is extended to one year where the creditor who received the payment was an “insider” of the debtor).
During the 90-day preference period, the insolvent debtor, by definition, is unable to pay all of its creditors in full. In fairness, the debtor should use its limited cash to pay some amount to all of its creditors. In practice, however, the debtor typically pays (i.e. “prefers”) creditors with whom it must remain on good terms (that is, critical suppliers) and pays nothing to its other creditors (non-critical suppliers). After the debtor files bankruptcy, preference law enables the debtor (or bankruptcy trustee) to file suit and recover payments made during the preference period (so called “preferential transfers”). Once recovered, these payments can be re-distributed more equitably among all of the debtor’s creditors.
Most creditors have strong opinions about the fairness (or not) of preference law. A creditor who’s forced to return a preferential transfer will find preference law illogical and grossly unfair (“The debtor did nothing more than pay me what I was legally owed. Why should I give the money back, especially when the debtor still owes me money?”). A creditor who received nothing during the preference period will find preference law eminently logical and fair (“I’m no different from the debtor’s “preferred creditors.” We’re all owed money. It was unfair of the debtor to pay them but not me.”). Both positions evoke some sympathy, but when it comes to taking a position on the fairness of preference law, where you stand is where you sit.
IV. The Preference Defenses
Congress was not totally unsympathetic to preference defendants. Several defenses are available. Space limitations allow brief discussion of only the two most common ones: the “ordinary course of business” defense and the “subsequent new value” defense.
A. The Ordinary Course of Business Defense
The ordinary course of business defense protects creditors who maintain their historical business relationship with the debtor as the parties slide into the preference period. For example, assume that prior to the preference period, the debtor and its creditor had 30-day payment terms and the debtor timely paid by check. If, during the preference period, the debtor pays the creditor by check, within 30 days, the creditor will likely be able to keep the payment.
The ordinary course defense may be available even if the parties’ course of dealing during the preference period varied from their written contract terms. Consider a creditor whose invoices identify the payment term as “net 30 days.” If, during the preference period, the creditor received a payment within 45 days of the invoice date, he will be permitted to offer evidence that, prior to the preference period, the debtor regularly paid within 45 days. As the number of pre-preference period billing and payment cycles increases, so too does the strength of the creditor’s argument.
“Out of the ordinary” facts can make the defense unavailable. In the first example, above, payment by wire transfer would be viewed as “out of the ordinary.” So too would the existence of dunning letters or e-mail, even if the creditor has a history of sending them to the debtor.
Here’s something that might surprise you. Assume the parties’ contract states a 30-day payment term. To accommodate its cash-strapped debtor, the creditor extends the payment term to 45 days. During the preference period, the creditor receives payments within 45 days of each invoice. On those facts, the court might well find that the creditor’s receipt of payments within 45 days was not “ordinary course.” (This result would fall under the category of “No good deed goes unpunished.”). The creditor can persuade the court to accept 45 days as “ordinary course” by demonstrating, to the court’s satisfaction, that the debtor made 45-day payments for a sufficient number of months prior to the preference period.
To have an ordinary course defense, the creditor must prove one additional fact. The creditor must prove that the parties’ “ordinary business terms” were substantially similar to the “ordinary business terms” of similarly situated parties in the same industry. If the parties’ business terms differed from those in the industry generally, the creditor will not have an ordinary course of business defense. As you might expect, one difficult issue is determining how to define the relevant “industry” for purposes of comparison.
B. The Subsequent New Value Defense
The subsequent new value defense protects creditors who extend “new value” to the debtor after receiving a preferential payment. “New value” includes money or money’s worth in goods, services or new credit.
The defense works like this: Assume that during the 90-day preference period, the creditor received a $10,000 preferential payment. Thereafter, the creditor shipped $6,000 in additional goods, for which the creditor was never paid. On those facts, the creditor’s net preference exposure would be $4,000. If, during the preference period, the creditor had shipped $6,000 of new goods first and then received the $10,000 preferential payment, the creditor’s net preference exposure would be $10,000, not $4,000. That’s because the creditor must give the new value after receiving the preferential payment.
Unused new value can be carried over. For example, assume that during the preference period, the creditor received a $10,000 payment, then gave $4,000 in new value, then received another $2,000 preferential payment, and then gave $5,000 in new value. On those facts, the $5,000 of new value would reduce the $2,000 preference payment to $0 and the $3,000 in “unused” new value would be added to the $4,000 of other new value (for a total of $7,000 of new value), and applied to reduce the $10,000 preferential payment, leaving the creditor with a net preference exposure of $3,000. If the creditor could establish an “ordinary course of business” defense (or some other available defense) with respect to that $3,000, he may be able to avoid returning any money at all to the debtor.
The preference laws and their defenses are extremely fact-sensitive and legally complicated. Therefore, the strengths and weaknesses of any particular preference action and defenses can be evaluated only after thorough analysis by someone with considerable experience and knowledge in the area of bankruptcy law.
Actually, the ideal time to address potential preference exposure and possible defenses, is prior to the debtor’s bankruptcy filing, when the creditor suspects that the debtor may be sliding toward a bankruptcy filing and, therefore, into a potential preference period. During that time, the creditor should consider working with an experienced bankruptcy attorney to coddle payments from the debtor in such a way as to at least minimize, if not totally eliminate, the creditor’ risk of having to return payments in the event of a bankruptcy filing by the debtor. Once the debtor files bankruptcy, the debtor’s case for recovering any preferential payments, and the creditor’s defenses, will be fixed.
The moral of bankruptcy preference law is this: “Count to 90 (days) before you count (on keeping) your money.” If you receive a payment from the debtor and more than ninety days have passed, you can count on keeping the money (where payment is made by check, start counting from the date the bank honors the check, not the date on the check). Prior to that time, however, you should factor into your decision to extend further credit to the debtor the possibility that you may not be permitted to keep the payment you just received.
*Partner, Bentz Law Firm, P.C. Len has practiced bankruptcy and creditors rights exclusively for 20 years, including a two-year clerkship with a United States Bankruptcy Judge. He has handled over 3,500 such cases in virtually every bankruptcy court in the country.