Compass Newsletter - Articles

Preferences in Bankruptcy - the Second "Whammy"

by Eric Yandell
Fall 2002

Recently, a client of ours expecting a large check for goods sold on account to a "good customer" opened the envelope to find instead a notice of bankruptcy, the first of a possible "double-whammy." The client became an unsecured creditor in a large business reorganization, a most disconcerting position. The chances of receiving more than 10% of its unpaid charges are slim and may take years. The second whammy may come in a year or two when the client receives a letter advising that it must refund payments it did receive, because such payments are "preferences." In other words, not only may the client forfeit most of what it didn't get paid, it may have to pay back some of what it did get paid.

"Preferences" are transfers (normally payments) against pre-existing debts that enable a creditor to receive more than its share of the debtor's assets if the assets were liquidated on the date of filing. The law presumes that creditors paid within 90 days before filing are those the debtor "prefers" to pay, and brings those funds or assets back into the estate to redistribute among all creditors. If the creditor was an "insider" (such as a director or relative), the 90 day window increases to one year. If a creditor doesn't repay, the debtor may sue where it filed bankruptcy, which may be the east coast.

A creditor may defend a preference claim on several grounds, and, with a little planning, can improve its chances of success. Four defenses are noteworthy. The first three defenses recognize that some payments do not actually diminish assets available to general creditors. The fourth seeks to encourage vendors or providers to continue to deal with troubled businesses in hopes that a bankruptcy will be averted. Here's how those defenses play out.

First, if the debtor sells a piece of equipment at fair market value and is promptly paid, a "substantially contemporaneous exchange" occurs, which is likely not "preferential" because what the debtor lost in equipment value, it made up for in cash.

Second, if the debtor forwards that cash to a creditor whose debt is secured by that piece of equipment, it is not preferential, because secured creditors take priority over general creditors in bankruptcy anyway. Similarly, if the debtor pays a creditor that could perfect a lien (say, a supplier of construction materials), that payment is not preferential, because the payment replaces a lien that would have priority. (Note with these first two defenses that a payment is still a preference to the extent it exceeds the collateral's value.)

Third, a vendor that provides more goods or services on credit after it receives the preferential payment has a full or partial defense, because those goods or services arguably add to the assets available to general creditors without an offsetting payment and are therefore deemed "new value."

Finally, if the debtor pays when and in the manner it normally does - even if that time exceeds the credit terms - it may be a payment "in the ordinary course of business" and thus not a preference.

While no amount of planning can completely avoid exposure to preference claims, a little may help:

  • If you regularly sell or consign goods to one or more large accounts, consider setting up a purchase money security interest arrangement. A good account agreement signed at the outset of the relationship is advisable. Make sure you have good information on your customers - state of origin; form of business; names of owners; business locations; etc. Keep an ear open for industry scuttlebutt.
  • Know your lien rights if you have them and make sure you provide necessary notices and take action within applicable time frames.
  • Monitor your repeat customers to make sure they adhere to your credit terms. If they start to slide, formal steps should be taken. Put them on COD and create a formal repayment arrangement. Payments made pursuant to such an arrangement may be "ordinary course" payments if such workouts are standard in your industry.
  • For "friendly" loans - e.g. to your child's business or even to your own - keep the arrangement business-like. Get a note and a security interest. If your business is otherwise adequately capitalized, your loan, if secured, should be entitled to the same priority as the bank's loan. Insist on timely payments. In most instances, it is better to be repaid and loan back than to forbear; if you need to forbear, document your forbearance.
  • Know who else may compete for the collateral securing your loan. Understand priority rules and what is necessary to keep your interest perfected. Information regarding lien creditors and security interest holders is currently available at no cost in many states over the internet. Periodically check information on your larger customers.

While these steps will not keep your customers out of bankruptcy, they may help minimize both the insult and the injury to your business.