November 8, 2013

Payback time: Know how a bankruptcy customer can cost you

Written By

Emily L. Pagorski
Member, Stoll Keenon Ogden PLLC

Business First | November 8, 2013

By Emily Pagorski

Businesses that are fortunate enough not to have much bankruptcy experience may believe that the worst thing that can happen if a customer files bankruptcy under Chapter 7 (liquidation) or Chapter 11 (reorganization) is not getting paid.

But if you talk to a business having experienced much customer bankruptcy, you will learn that there is something much worse: being sued by the customer for the return of payments received by the business during the 90 days before the bankruptcy filings.

This is known as a “preference” action and there are some things every business should know.

Why should a creditor have to give back the money?
One of the primary goals of the preference statute is to ensure that a debtor’s assets are distributed equally among all of its creditors who have the same priority, i.e. to avoid the situation in which one creditor has been paid in full while another creditor is out $100,000.

The preference statute therefore enables the debtor’s estate to recover payments made during a “lookback period” so the funds may be redistributed to creditors pro rata if anything is left after the cost of the bankruptcy case.

Preference actions also discourage creditors from pushing a troubled business into bankruptcy.

What are the elements of a preference action?
The Bankruptcy Code authorizes a bankruptcy trustee or a debtor in possession to recover a payment if it was to or for the benefit of the creditor; for or on account of an prior debt owed by the debtor; made while the debtor was insolvent; made on or within 90 days before the bankruptcy filing if the creditor is a general creditor or made one within year if the creditor is an insider of the debtor; and that enables the creditor to receive more than it would have if the case was a Chapter 7 liquidation, the payment had not been made, and the creditor received payment of the debt to the extent provided by the Bankruptcy Code.

Does the Bankruptcy Code require preference actions?
No, preference actions are generally discretionary.

For example, if a reorganizing debtor needs pre-petition vendors to continue supplying it going forward, that debtor is less likely to file preference actions.

Indeed, a debtor might waive its right to file preference actions in exchange for creditors voting to accept a plan of reorganization.

If a Chapter 11 unsecured creditors committee is appointed, debtors often assign preference actions to the committee which may pursue them for its constituents.

Bankruptcy trustees (mandatory in Chapter 7 and occasionally appointed by the court in Chapter 11) also can file preference actions.

When and where can a preference action be filed?
Generally speaking, a preference action must be filed within two years of the debtor’s bankruptcy filing.

If a Chapter 11 trustee is appointed during this time, the deadline is the longer of two years or one year from the date that the trustee is appointed.

If the debtor’s debts are not primarily consumer debts, the aggregate value of the transfers sought to be recovered must be at least $6,225 before a preference action may be filed. Also, some courts have held that preference actions against non-insiders seeking to recover less than $12,475 might only be filed in the district in which the creditor defendant resides.

Are there defenses?
Yes. If the debtor paid in advance or on COD terms, there likely isn’t a preference as there isn’t any prior debt.

Also, if a creditor supplied the debtor with additional goods or services after receiving a payment, it may have a subsequent new value defense because the later-supplied items “replenish” the debtor’s estate, negating the preferential treatment. Another common defense is the ordinary course of business defense.

Here, a creditor argues that because its invoices were always paid within the same number of days both prior to and during the lookback period, the payments were “ordinary” and not preferential.

There are other defenses, and all can be complex.

A business should immediately consult with an experienced bankruptcy attorney when a customer files bankruptcy to talk about whether to file a claim in the case, defenses to possible preferences and about how to preserve information relating to those defenses.


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