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Understanding “Preferences” - Can Your Bankrupt Customer Recover Payments Made to You?

  • February 18, 2002

The last year has seen an increase in the number of bankruptcy filings, in the Carolinas and nationwide. Parker Poe has seen a corresponding increase in the advice sought by our clients concerning bankruptcy filings by or against their customers. One of the most common issues faced by vendors and other creditors of bankrupt companies is the threat of “preference” claims, or demands for the return of payments made by the bankrupt company (or “debtor”) during the ninety days immediately preceding its bankruptcy filing. These claims usually begin with a letter from an attorney demanding the immediate return of specific payments made by the debtor during the ninety-day preference period, and lawsuits often result when the demand is not honored or compromised within a short time frame. This summary is intended to provide a basic overview of preferences in bankruptcy.

A Common Scenario

Your company sold a substantial amount of goods to a customer on the usual 30-day payment terms. When you were not paid on time, you investigated and determined that the customer was having financial difficulties. Fearing a huge bad debt write-off, you immediately contacted the customer and worked out a payment plan. Over the course of several weeks, just before the customer sought bankruptcy protection, you were paid in full. You breathed a sigh of relief, realizing that your diligence had saved the company from having to accept pennies on the dollar as an unsecured creditor in the customer’s bankruptcy case.

Then a letter arrives, and you are certain that there is some sort of mistake. Explaining that your company was “preferred” over other creditors, the debtor’s attorney demands that you pay back the money you worked so hard to recover and threatens to file a lawsuit if the payments are not returned before a specified date. How can this be possible, when the payments you received were unquestionably legitimate and you acted within your rights at all times in collecting the debt?

Overview of Preference Law

With our open economy and free market system, companies regularly compete with each other and, in most cases, to the diligent go the rewards. Under ordinary circumstances, if a company were to pay one creditor and fail to pay another, no one would have recourse against the paid creditor. Not so in bankruptcy.

Federal bankruptcy law enables a trustee in bankruptcy (or the debtor itself in a Chapter 11 case) to recover “preferences,” which may generally be defined as any payment: (1) on pre-existing debt (i.e., advance payments are not included), (2) made during the 90 days immediately preceding the bankruptcy filing, and (3) which enabled the recipient to recover more than it would have recovered if the payment had not been made, and the debtor’s assets had been liquidated and distributed to all creditors on a pro rata basis. By deterring diligent creditors from taking the debtor’s remaining assets (to the detriment of less diligent creditors), this law seeks to ensure that similarly situated creditors share equally in the assets of the debtor. Subject to certain exceptions, any creditor that has received a preference is required to return it to the “pot” from which distributions are made — the bankruptcy estate — and all similarly situated creditors (including creditors that were forced to disgorge preferences) are entitled to claim their pro rata share of the estate.

The policy underlying preference law is that a debtor on the verge of bankruptcy should not be permitted to selectively pay “preferred” creditors, while leaving other creditors unpaid and without any effective recourse against the debtor’s depleted assets. Preference law does not take into account the debtor’s or the creditor’s motives, however, and it casts a broad net. This can lead to harsh and unfair results, because the recipients of preferences are often those creditors that acted diligently and in good faith, rather than insiders or those that exercised undue influence over the debtor’s financial affairs. The bankruptcy code mitigates against such results by exempting from recovery any payments made in the ordinary course of business and according to ordinary business terms (i.e., payments made in a manner consistent with established practice and according to contract or invoice terms). The bankruptcy code also allows a creditor to keep otherwise preferential payments to the extent that the creditor gave “new value” to the debtor after the payments were made (e.g., by delivering goods for which the creditor was never paid), thus enhancing the debtor’s value by an amount equal to the payments that depleted it.

Minimizing Your Preference Exposure

There are several steps that a business can take to minimize its potential preference exposure in dealing with an insolvent customer. One simple way to minimize preference exposure is to reduce the amount of credit that you extend, especially to companies with questionable financial stability. If possible, require payment before, or simultaneously with, delivery. Cash on delivery (COD) transactions normally cannot be avoided as preferences, because something of value is given to the debtor in return for its payment and thus there is no “net” loss to the debtor. If COD transactions are not feasible for your business, insist that customers adhere to your payment terms and established payment practices. These practices will not immunize you from preference risk, but they should reduce your exposure.

The bankruptcy attorneys in Parker Poe’s Commercial Contracts Practice Group specialize in helping businesses and individuals minimize these risks within the constraints imposed by commercial and bankruptcy laws. We stand ready to advise you on preference issues and other bankruptcy and insolvency matters. For more information, contact:

Bill Porter (704) 335-9019

Chip Ford (704) 335-9840

Brian Darer (919) 890-4170

Will Esser (704) 335-9507

Chris Fernandez (704) 335-9531