Client Q&A: A Customer That Went Bankrupt Is Suing to Recover Payments It Made to Me; What Can I Do?

A customer that went bankrupt is suing to recover payments it made to me. What can I do?

When a business goes bankrupt, it very often happens that everyone to which the company paid money in the 90 days before the bankruptcy petition was filed gets sued to recover those payments in what is called a "preference" action. It does not matter whether the payments were for goods actually received or services actually rendered. It does not matter that you did nothing wrong. If you got the payments just before the bankruptcy, the bankruptcy estate can sue to get them back.

What is a Preference Action?

This sounds crazy, until it happens to you (and maybe even after it happens to you).

Before I discuss what can be done, here's what is happening. The logic of a preference action is that it is unfair that some creditors get paid for goods or services they provide just before a bankruptcy and others do not. So, the answer is to claw back the money every creditor got from the debtor for the 90 days before the bankruptcy filing, so the money can be shared on an equal basis among all affected creditors. For example, if the bankruptcy estate succeeds in recovering $500,000 from you in a preference action, you now have a $500,000 claim against the estate and the $500,000 you paid gets thrown into the pot of money used to pay all creditors. Of course, if the bankruptcy estate ends up paying only 10 percent on claims, the $500,000 that was taken from you gets paid back as only $50,000. Maybe it is fair in general, but it can represent a serious loss to you.

Even worse, if you are a corporate insider, the preference period is one year, not 90 days.

What Can You Do?

Generally speaking, all the bankruptcy estate has to show is that you received the payments in the 90-day preference period. However, there may be defenses that, if you can prove them, will stop the bankruptcy estate from clawing-back the money.

The bankruptcy code contains a number of defenses. Here are the ones we encounter the most:

You can avoid having to return the payments during the preference period if you can show that the payment was for a debt incurred in the ordinary course of business and that the payment was made in the ordinary course of business or according to ordinary terms.

A typical situation where this defense applies is where the debtor was a regular customer of yours, you were providing it goods or services before the bankruptcy and in the 90 days before the bankruptcy, it paid you on the same terms it always did.

What does this mean? Imagine that you bill your clients with payment due 30 days after invoicing and the debtor routinely paid its bills on day 30. If, during the preference period, it kept paying on day 30, you may have a ordinary course of business defense. Of course, life is often messy and it would be unusual for a customer always to pay exactly on time. So, litigating an ordinary course of business defense usually involves statistical analysis of the billing and payment history to determine whether the payments during the preference period were similar to the ones before the preference period.

One issue that comes up in proving whether the payments were in the ordinary course is whether you pressured the debtor to pay during the preference period in a way you would not otherwise have done.

Another common defense is the subsequent new value defense. There, you have to show that you gave "new value"--typically, goods or services--to the debtor after the date of the challenged payment, and that you were not paid for that value or if you were, the payment was not avoidable. An example of this would be that you provided goods or services during the preference period for which you were not paid. If those payments came after the preference payments, they qualify as new value and will offset the preference payments.

There is a related defense called the contemporaneous new value defense. This defense applies when the payment is received at the same time you provide the good or services. For example, if a transaction was COD.

Conclusion

There are other defenses, and the application of the three common defenses I discuss above is more complicated than the short examples I have given show. So, if you are sued in a preference action, you should get experienced counsel to advise you.

There is one piece of good news, though. It would cost a bankruptcy trustee a lot of money to litigate a preference action against every vendor. And, the amounts involved can often be small. So, it is generally--although by no means always--the case that the trustee is willing to negotiate. The bad news is that since people usually settle, a trustee will not just go away unless you can present a strong defense. On the other hand, this means that a typical preference action does not involve the same costs as a full-blown litigation. Rather, there is initial fact gathering and then, hopefully, negotiation and settlement.

If you are a defendant in a preference action, we likely can help you. Give us a call.