This article contains a brief overview of managing preferential payments in commercial bankruptcies. The information is not, nor is it intended to be legal advice. It is imperative that any action you take to be done on the advice of competent legal counsel, and not based solely upon this article.
While you may be focused on your company’s bottom-line, cash flow and liquidity (i.e., your ability to stay afloat) during these uncertain economic times, it is also important to consider how your largest customers may be weathering the storm. Most finance departments have ample experience working with slow-paying customers, but unless you happen to be a bankruptcy professional, you’re likely unaware of many of the potential risks for your company if your customer files for bankruptcy. One such example – that many people don’t hear about until being on the receiving end of a legal demand letter or lawsuit – is the alleged “preferential payment”.
“Wait a minute, you’re telling me that when I lost one of my best customers who went bankrupt, and I was only paid on a small fraction of the invoices for all the goods that I delivered to them, that the little I was paid before they went bankrupt – now you want me to pay that back…two years after it all happened?”
“Yes, you need to pay it back…
…unless you can assert a legitimate defense allowed under the law, but keep in mind that the burden of proof is on you to do so, and you will likely have to hire professionals to help.”
Preferential Payments – Awareness is Key
According to the Bankruptcy Code, payments received from a company in the 90 days before the company files for bankruptcy (or one year if the payments are to a company insider) are deemed to be “preferential” if the payments satisfy a few basic requirements. For example, a payment must have been made by a debtor to a creditor on account of an existing debt – which is another way of saying that credit had been extended prior to the payment being made. In most circumstances, payments made by a customer (i.e., debtor) to its supplier (i.e., creditor) in the 90 days before the customer files for bankruptcy, will qualify as being preferential.
What is often most frustrating is that creditors in this situation can be found liable for preference exposure even after following regular business protocol (i.e., receiving payment on outstanding invoices owed after having provided the customer with goods or services). While every situation may have its own complexities, there are general steps that may be taken to help minimize preference exposure associated with customers that may be or become distressed:
- Request Cash in Advance (CIA): If a customer no longer maintains its regular payment patterns or displays other signs of significant distress, consider requiring that the customer pay CIA for all future orders.
- If doing so, make sure that payments are actually received in advance or contemporaneously with the delivery of goods/services. (Establishing terms and executing on terms do not always go hand in hand.)
- Although this can help reduce the potential for preference exposure, it may also hasten the end of your relationship with the customer. (No one said this was easy.)
- Do not make sudden changes: Unless switching to CIA payment terms, once there is an indication that a customer may be in distress, it is very important to maintain business dealings with the customer in accordance with your historical relationship with them. For example:
- If the customer typically pays invoices in approximately 45 days, do not start requesting payment within 20 to 30 days.
- If you have never previously called or emailed the customer requesting payment of an overdue invoice, now is not the time to start.
- Ending the relationship: Making the strategic decision to stop doing business with the customer can be a safe option, but threatening to do so could jeopardize any future payments from them.
Reducing Potential Preference Exposure
To encourage suppliers to continue providing goods to a highly distressed customer, the Bankruptcy Code allows the claim for certain unpaid goods to receive Administrative Priority status if the customer ultimately files for bankruptcy. This special status is granted for (unsecured) claims associated with unpaid goods that were received by a debtor within the 20-day period prior to a bankruptcy filing (by the debtor).
Why does this matter? In many cases, these claims will be paid in full or at a significantly higher rate of recovery than unsecured claims without this status. Thus, there is an advantage to creditors of having payment terms at or near 20 days. In addition to simply receiving payments faster, in the event of a bankruptcy filing by a customer, such terms can increase the probability of there being a greater amount of unpaid goods that fall within the 20-day period at the time of the bankruptcy filing. These goods would receive Administrative Priority status and qualify to potentially be paid in full.
It may therefore be worthwhile to offer a concession to customers in exchange for their agreeing to such terms. However, this is a long-term solution that should be considered before a customer becomes distressed. As noted earlier, changing terms or simply requesting shorter terms in the period immediately prior to a bankruptcy filing often just makes the preference problem worse.
Defending Against Preference Claims
Another frustrating aspect of being on the receiving end of a preference claim is that under the Bankruptcy Code, such claims may be initiated up to two (and sometimes three) years after the original bankruptcy filing (i.e., when you might least expect it). However, the Bankruptcy Code does establish certain “defenses” that can help reduce or eliminate potential preference exposure, including:
- Contemporaneous Exchange of Value
- When goods or services are provided at roughly the same time that payment is made (and the intent was to do so).
- Subsequent New Value
- The value of goods or services provided after a potential preferential payment, but before the bankruptcy filing, may be applied as an offset to reduce any exposure associated with that payment on a dollar-for-dollar basis, pending certain qualifying factors.
- Ordinary Course of Business
- Subjective Test: Potential preferential payments that are deemed to have been made within the “ordinary course of business” between the debtor and creditor in the context of their historical relationship (prior to the 90-day period) are protected and do not have to be repaid.
- Objective Test: Potential preferential payments that are deemed to have been made within “ordinary business terms” in the context of the relevant industry are protected and do not have to be repaid.
Written by Michael Edelschick. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com
Restructuring and turnaround services as well as operational value creation services within the United States are offered through BDO Consulting Group, LLC, a separate legal entity and affiliated company of BDO USA, LLP, a Delaware limited liability partnership and national professional services firm. Certain restructuring and turnaround services may not be available to attest clients of BDO USA under the rules and regulations of public accounting.
Learn more about Commercial Bankruptcy:
- Introduction to Chapter 7
- Introduction to Chapter 11
- When Your Customer Files Chapter 11
- Executory Contracts in Chapter 7 and 11 Bankruptcies
- Selling Bankruptcy Claims: Opportunities and Risks
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