Without question, the world has changed quite dramatically over the last several months. As COVID-19 continues to proliferate around the globe, many are left in its wake of economic disruption and turmoil. While it is difficult to know what we can expect once the pandemic subsides, one thing is readily foreseeable and widely predicted: a dramatic increase in the number of bankruptcy filings. As such, it is imperative to protect yourself and your business from being dragged into, and down by, another party’s bankruptcy.
An unfortunate consequence of this pandemic is that many businesses are likely to fail, and many people are likely to be out of work for an extended time. As a result, Rightfully, many businesses and individuals will, rightfully, seek protection and become debtors under the federal bankruptcy laws. Of course, the most immediate and obvious consequence for creditors is the restructuring or outright discharge of the debtors’ outstanding obligations. While that itself can be exceptionally frustrating—if not devastating—for creditors, it might not be the only ramification. A creditor that received payments from the debtor in the 90-day period leading up to the bankruptcy petition may face a “preferential transfer” claim to claw back those payments.
What Is a “Preferential Transfer” Claim?
Generally speaking, to protect against some creditors receiving preferential treatment over others, the Bankruptcy Code empowers the appointed bankruptcy trustee to sue for the recovery of payments and asset transfers made within 90 days before the debtor’s bankruptcy petition, and apply it towards the debtor’s outstanding, unsecured obligations. The purpose of recovering these “preferential transfers” is well-intentioned, to ensure that all unsecured creditors are treated fairly and receive a proportional share of the debtor’s assets. This protects against some creditors receiving payment during the preference period, while other creditors receive nothing. But in application, the demand to return these payments is often salt in the wound of honest creditors that have already been forced to write-off other debts that have not and never will be paid.
How Can You Reduce Your Preferential Transfer Liability?
Fortunately, the law provides frustrated creditors with various defenses to preferential transfer claims, most of which are based on the circumstances of the particular transactions at issue or the history of transactions between the creditor and the debtor. Therefore, by implementing certain practices and procedures, a business can effectively reduce its risk of facing a preferential transfer claim and, if a claim is brought, minimize the amount at risk.
As the creditor, you will have the burden of proof to establish a defense to a preferential transfer claim so, first and foremost, it is absolutely essential to maintain clear, complete records of the transactional history with the debtor. This includes complete records of orders, invoices, payments terms, products and services provided, delivery information, date payment was received from the debtor, method of payments (and copies of checks, if applicable), any late fees or penalties that were applied, and any communications with the debtor in connection with collection efforts. A well-documented account history will likely give you a distinct advantage over the bankruptcy trustee who is forced to rely on the often shoddy records obtained from a failed business. The best practice would be to establish and implement a standardized protocol for maintaining such records.
One of the best ways for a creditor to keep track of customers and which may be struggling financially is to establish uniform terms and conditions for all transactions. These terms and conditions should be clearly stated, understandable, and enforced. Implementing and enforcing uniform terms and conditions will allow you to identify customers that are falling behind on payment obligations, while also enabling you to take appropriate action to protect against preferential transfer liability for payments that are subsequently received. More importantly, it will also ensure that you are aware of, and can put a stop to, growing receivables that might be discharged through bankruptcy.
Along those lines, if you extend credit to customers, be certain to set a limit on the amount of credit available and hold to it. Exceeding credit limits is an indication that the customer may be struggling financially. By allowing a customer to exceed their credit limit, you are increasing the amount at risk of discharge if the customer does file for bankruptcy. Additionally, actions taken to collect on the excess outstanding balances may impair your ability to assert significant defenses to a preferential transfer claim, as explained below.
The most common defense to a preferential transfer claim is known as the “ordinary course of business”, which is established in one of two ways. The first is to demonstrate that the payments in question were made in accordance with the normal standards for the creditor’s industry. The easiest way to preserve this as a possible defense is to ensure that your payment terms are within a range that is common or reasonable in your industry.
The second way is to demonstrate that the payments made during the preference period were consistent with the history of prior payments. If payments received during the preference period are generally consistent in amount, frequency, manner of payment, and the time between invoicing and payment with those received over the prior course of dealings between the parties, the defense will apply. Therefore, you should ensure that you are consistent in enforcing your terms and conditions for payments. Fortunately, because you have been maintaining complete records of your transactions with the debtor, you will have all pertinent information to establish a baseline for the comparison! However, to the extent you have a customer that has a history of late payments, you should determine what would constitute “ordinary” with regard to that customer’s payments and endeavor to ensure consistency going forward.
For most businesses, the natural inclination when a customer becomes delinquent is to restrict the customer’s credit and impose more stringent credit terms to force the customer to come current on past obligations. However, such actions are inherently inconsistent with the ordinary course of business between the parties and if payments received during the preference period are due to these new, more restrictive terms, the defense will not apply. Furthermore, keep in mind that more aggressive credit terms and policies may increase the likelihood that your customer files for bankruptcy protection.
Implement clear policies for collecting on customers’ accounts to ensure that collections are pursued in a standard, routine, and reasonable manner. Creditors should maintain open dialogue with delinquent customers regarding outstanding debts and should refrain from sending threatening or harassing correspondence. Actions that deviate from standard collection practices are more prone to be deemed unusual or “non-ordinary”, which will undermine the ordinary course of business defense. These standard credit policies should include procedures for establishing, reviewing and adjusting credit limits and credit terms; protocols for seeking recovery of past due invoices; and rules for determining when to stop shipments and/or switching to cash-on-delivery or cash-in-advance terms.
Another common tendency in dealing with a delinquent customer is to apply incoming payments to the oldest outstanding invoices. This is a mistake. Applying current payments to the oldest balances will only maximize the number of days between invoicing and payment, which can take those payments outside of a reasonable range necessary to establish the ordinary course of business defense. It will also eliminate another critical defense, the “contemporaneous exchange for new value” defense, explained below.
Another common defense to a preferential transfer claim is that the transaction represented a “contemporaneous exchange of new value” between the parties. This defense is clearly established where the debtor’s payment was made at or near the same time as the goods or services were provided. Accordingly, if you find that a customer is struggling or unable to stay current, you should not hesitate to discuss implementing a C.O.D. policy for all future transactions until the customer’s account is brought current.
The critical date for establishing various defenses is the date payment was received by the creditor. The best way to establish this date is to deposit any payments immediately upon receipt. To the extent that the payment might qualify as a contemporaneous exchange, promptly depositing the check is critical. Furthermore, because the preference period looks back 90 days from the bankruptcy petition, each day you hold onto a check, you effectively increase the chances that the payment might fall within that 90-day range. Even worse, you increase the possibility that you might be left holding a largely worthless piece of paper if your customer files a bankruptcy petition before you deposit the payment.
To constitute a preferential transfer, the payment in question must be made “on account of antecedent debt”; that is, a pre-existing obligation to the creditor. Therefore, if you require a customer to prepay for the goods or services that will be provided, that payment by definition can never be a preference.
Only payments on unsecured debt can constitute a preference. Accordingly, if you are able to establish a security interest in goods sold to a customer, then the payments for those goods cannot constitute a preference. Similarly, some transactions allow creditors to lien assets as a means of ensuring payment on an obligation. Payments made to satisfy the lien are also exempt from preference liability.
Of course, these strategies may not be viable for your business or your industry, and even then, they will not eliminate all possible preferential transfer liability. They will, however, put your business in the best position to retain all payments received from a bankrupt customer.
If you learn that a customer has filed bankruptcy, you must immediately stop any and all collection efforts. You should also take action to identify and protect all information that might be relevant to a potential preferential transfer action and ensure that all such records—whether electronic or physical—are excluded from document destruction policies. Additionally, all personnel with knowledge or information regarding the customer should be advised to preserve their records. And if you do receive notice of a preferential transfer claim, you should immediately consult a business litigation attorney to evaluate your case and protect your interests.