Defending Against a Preference Claim
One way to avoid having to return a payment from a bankrupt customer is to show that the payment was made in the "ordinary course of business"
If you think that, in
collecting your accounts receivable, there is nothing worse than not being paid,
consider this: You could collect the money, spend it, and then be ordered to
give it back.
That is what can happen
if your customer files for bankruptcy within 90 days after he gives you a full
or partial payment on his outstanding balance. Someone will almost surely make a
preference claim against you – so called because you would appear to have
received “preferential” treatment over other creditors with whom you are
otherwise in the same boat.
Fortunately for you,
there are defenses that you can raise against a preference claim, namely:
subsequent new value,
ordinary course of
These defenses exist not
just to help creditors avoid preference claims, but also to encourage creditors
to continue doing business with, and extending credit to, financially strapped
The third defense –
ordinary course of business – may be the most common but, in some cases, the
most difficult to prove. Fortunately, in the federal courts there has evolved a
fairly objective test for deciding whether an alleged preference payment was
made according to ordinary business terms. That test takes into account not just
the credit practices that are appropriate to your industry but also the payment
history between you and your customer.
The Bankruptcy Code
allows a trustee or debtor-in-possession to recover – as preferences – any
payments or other transfers of assets by a debtor to a creditor within 90 days
of the debtor’s bankruptcy filing.
The preference provision
has two main purposes: to prevent a debtor from favoring any of its general
unsecured creditors over the others; and to discourage creditors, upon hearing
that the debtor is about to file bankruptcy, from storming the courthouse to
file eleventh-hour lawsuits to collect the debts owed them.
Proving a preference.
To back up his preference claim, a trustee or debtor-in-possession must show
that five conditions applied to the payment:
The debtor made a
payment or transferred property to, or for the benefit of, the creditor.
The payment or
transfer occurred within 90 days of the debtor’s bankruptcy filing (that
period grows to a full year for payments to insiders).
The debtor made the
payment to reduce an existing debt owed to the creditor.
The debtor was
insolvent when the payment occurred.
As a result of the
payment or transfer, the creditor received more from the debtor than he
would have received in a Chapter 7 liquidation of the debtor.
Ordinary Course of Business
successfully raise the “ordinary course of business” defense, you (the creditor)
must prove both of the following: The debt on which you received the
payment was incurred in the ordinary course of business between you and the
debtor; and the payment was made in the ordinary course of business
between you and the debtor, according to ordinary business terms.
Whether the debt was
incurred or the payment was made in the ordinary course of business is
relatively objective and easy to prove or disprove.
The second consideration
in each element is more subjective, as it takes into account the specific,
historical billing and payment relationship that existed between you and the
debtor prior to the 90-day preference period. If the alleged preference payment
was consistent with the manner in which previous payments were made, that
strengthens your defense against the preference claim.
Example 1: XYZ Company was a
long-time customer that habitually paid its bill, with charges ranging from
$1,000 to $7,500, between 45 and 60 days after the due date. A week before
filing its bankruptcy petition, XYZ made a $5,000 payment on its account, 55
days past the due date. When a preference claim is made against that
payment, you should be able to successfully defend against the claim by
showing that the payment was consistent with XYZ’s payment history with your
Example 2: For its first
three months as a customer, JKL Company paid its bill on or before the due
date. However, charges for the fourth month, considerably higher than any of
the previous months, went unpaid for 75 days before a check finally arrived.
A week after you received that payment, JKL filed for bankruptcy protection.
The inevitable preference claim will be much more difficult to defend than
in the case of XYZ, because of (a) your relatively short credit experience
with JKL and (b) the contrast between the collection periods for the first
three payments and the final payment.
In the last decade, decisions in federal appellate courts have lent some
clarity to the ordinary course of business defense, to the benefit of creditors.
In a 1993 ruling in the
Tolona Pizza Products case, the court held that “ordinary business terms”
encompass practices in which companies similar to the creditor engage. Only
dealings that are so “idiosyncratic” as to fall outside the broad range of terms
offered by similar companies would be disallowed. The court also noted that it
is unnecessary to show strict conformity with industry standards, since no two
credit relationships between debtors and creditors are identical. That view was
reaffirmed in the 1994 Molded Acoustical Products decision.
In another case, the
court held that the greater the length of the parties’ relationship prior to the
preference period, the more the creditor could vary its credit terms with the
debtor from the industry norm and still satisfy the ordinary course of business
A preference claim
against a payment you received from a now-bankrupt customer is a serious matter,
but it is not a slam dunk for the party making the claim. Legitimate and widely
accepted defenses are available to you, provided you took a business-as-usual
approach to the transaction and the resulting debt and payment.
An experienced bankruptcy
attorney can help you analyze the validity of the preference claim and your
defenses against it.