Business, Bankruptcy, Bad Debt – and You

Everyone knows that doing business with payment terms providing for payment in the future poses a risk. Our clients often contact us asking us to write letters and file suits against customers who have either refused to pay or are unable to make payments on past due invoices. Unfortunately, on many occasions, you are not the only vendor that is hounding them for payment on a past due account. 
On the bright side, the retention of a lawyer and the aggressive pursuit of the debt will often improve your chances of receiving payment. Once the legal pressure causes the customer to pay, there is usually a sense of relief knowing that you received payment when many other vendors did not. 
However, if the customer is truly in a financial crisis and intends to seek bankruptcy protection from its creditors, this aggressively pursued payment may not stand. Specifically, if the customer files for bankruptcy protection and a payment was made within ninety days of the filing, the bankruptcy trustee may contact you and request reimbursement for that payment. 
This request for reimbursement for the payment is called a “preferential payment.” The United States Code, Title 11, Section 547, defines a preferential payment as:
 

• The transfer of an interest of the debtor’s property;
• To or for the benefit of a creditor;
• For or on account of an antecedent debt owed by the debtor before such transfer was made;
• The payment was made while the debtor was insolvent;
• The payment was made within ninety days of the filing of a bankruptcy petition; and
• The payment enables the creditor to receive more than what the creditor would have received in the liquidation proceeding.

Essentially, this preferential payment scheme applies to your payment if it was made within ninety days of your customer filing a bankruptcy petition.  If the bankruptcy trustee believes that the payment made to you falls within this category, the trustee will send you a notice demanding the return of the payment. 

Not So Fast
Just because you receive a letter from the trustee does not mean that you necessarily have to return the money.  There are several defenses that can be asserted to the request for repayment. The most common defense is that the payment was made in the ordinary course of business. The ‘ordinary course of business’ defense applies in scenarios where the debt was incurred in the ordinary course of business between the parties and was paid according to the usual pattern or pursuant to customary terms for that industry.  For example, if you have a history of dealing with this particular customer where you invoice the customer immediately after the work was completed, and the customer always paid the invoice within thirty days of the issuance of the invoice, you can argue that the payment was made in the ordinary course of business and ask that the request for reimbursement be rescinded.
This defense protects creditors who are paid in a customary fashion. The overriding role of the preferential payment refund system is to keep creditors from moving up several rungs on the payment ladder by receiving payments before other creditors that may receive their payments in the normal course of the bankruptcy proceeding.
The second defense to the request for repayment applies if the payment was made as a contemporaneous exchange for new value. The Bankruptcy Code states that preferential payments must relate to an antecedent debt. Thus, if the payment is for something new and the payment is made contemporaneously with the delivery of new goods or services, the payment would not fall within the scope of the preferential payment system. An example of this would be if you had an ongoing business relationship with a customer and you became concerned about their ability to pay, because several invoices remain unpaid. You could change your business relationship and agree to only provide goods or services if payment is made at the time of the transfer. Thus, the payment is made contemporaneously with the provision of the goods or services and would be protected. However, any payments made on the previously issued invoices would not be exempt and the ninety day payment rule applies.
An ‘additional defense’ is referred to as the enabling loan exception. This defense can be utilized when a creditor obtains a purchase money security interest in property acquired by the debtor. The payment made in return for the goods cannot be rescinded to the extent that the security interest secures new value that was provided by the signing of the security agreement.
A creditor can also assert a subsequent new value defense. This defense provides that the trustee may not rescind a payment if the creditor gave new value to the debtor such as a subsequent shipment of new goods after the payment was made. This defense only applies if these new goods are not protected by a security interest for the benefit of the creditor. Essentially, this exception allows for the payment of previously supplied goods when you have entered into a subsequent transaction for which you have not been paid or protected with a security interest.

Decisions, Decisions …
Now that you have an awareness of the system, and how it applies to your payment, the question remains, what should you do once you receive the notice from the bankruptcy trustee? Due to the uncertainties involved with bankruptcy litigation, we recommend that you hold on to the payment until forced to return it. Often, the first response is to do nothing. When an entity files for Chapter 7 bankruptcy protection, the trustee sends out notices to all of the entities that received payments during the ninety day window. These notices are usually sent out in the normal course of business and the trustee has usually not performed a cost benefit analysis or examined the payment closely. Thus, as the bankruptcy progresses, the trustee may find that reimbursement for your payment is not worth the time and attention that would be required to get it back. As such, ignoring the notice may be all that is needed to get the trustee to move on to other creditors.
If the trustee continues to pursue the claim for reimbursement, it is a good time to ask the trustee to prove that the payment is actually a preferential payment covered under the Bankruptcy Code. Under the Code, the trustee has the burden of proving that the payment was preferential and should be returned. This request will make the trustee look at the matter closely and, if the trustee finds that a valid argument does not exist, the trustee may abandon the claim. If the first two responses are not effective, you can then assert your defenses. 
If all of this fails, and the bankruptcy trustee continues looking to recover your payment, don’t give the money back quite yet. It is important to remember that you are not the only creditor from whom the trustee is seeking reimbursement and that you are in a good position to try to negotiate a compromise.  As long as you are still holding on to the funds, you can try to negotiate a compromise that is acceptable to the trustee. A settlement will allow you to keep a portion of the funds. If you return the funds, you will not be in a position to negotiate as you are simply put back into the pool of creditors that will be paid based upon your priority in the bankruptcy system.
Now that you have an overview as to how a preferential payment will be handled, you are in a better position to make a decision as to how to avoid getting onto such a predicament in the first place and respond once you receive such a notice from a trustee. Furthermore, knowing how this system is administered, you can structure your future payment terms and collection efforts to try to avoid being caught in bankruptcy limbo.

(As published in the September 2014 edition of Marine News - http://magazines.marinelink.com/Magazines/MaritimeNews)