Minimizing Preference Clawback Risk When Dealing With Distressed Customers
You can’t take that away from me! There are few things more frustrating for your business than having a financially-distressed customer pay you for the goods or services that you had provided, only to have that customer clawback those payments as “preferences” after it files bankruptcy. The U.S. Bankruptcy Code allows debtors and other bankruptcy estate representatives to avoid and recover “preference” payments if all of the following elements exist: (a) the payment was made to a creditor; (b) the payment was made for or on account of an antecedent debt that the client owed to the creditor at the time of payment; (c) the payment was made while the debtor was insolvent; (d) the payment was made during the 90-day preference period (that period is extended to one year if the creditor is an “insider” of the client); and (e) because it received the payment, the creditor was able to receive more than it would have received in a Chapter 7 liquidation.
Because of the economic turmoil caused by the COVID-19 pandemic, businesses that transact with financially-distressed customers are now at much higher risk of having legitimate payments clawed back by their customers’ bankruptcy estates. Nevertheless, there are several practical steps that your business can take right now, to reduce your risk of preference liability.
Advance Payments / C.O.D. / Retainers
Your business can request that financially-troubled customers pay you in advance for future goods or services, or that those customers pay you on “C.O.D.” (a.k.a., cash on deposit) terms. Alternatively, your business can obtain a retainer from customers. Retainers are more common for service providers, such as attorneys and accountants, and are used to fund payments for future services.
The customer’s bankruptcy estate must be able to prove to the court that the payments it seeks to clawback were actually made to satisfy of an existing debt. Therefore, getting paid in advance or on C.O.D. is one of the best strategies for minimizing liability, because the estate would not be able to prove that important element of its preference action.
Obtain Collateral to Secure Future Payments
In some circumstances, it may be possible for the customer to pledge collateral to secu4446re future payments that are owed to your business. To the extent the customer pledges collateral and your business properly perfects its security interest in that collateral, the customer’s bankruptcy estate would not be able to demonstrate that the future payments allowed you to receive more than what you have obtained in a Chapter 7 liquidation. However, the pledge of collateral, in and of itself, can be considered a preference if the customer files bankruptcy within 90 days after that pledge is secured.
Shorten Payment Terms
If a client is unwilling to pay for services in advance or on C.O.D., your business can nevertheless shorten the timeframe for payment of its invoices. To the extent your customer pays your business in arrears for goods or services that you had already performed, those payments are on account of an existing debt (and therefore can be clawed back as a preference). Nevertheless, if your customer pays you more quickly, there is a better chance that the customer will not file bankruptcy within 90 days of making that payment. Transfers made outside that 90-day window will not be recoverable as preferences, unless your business is an “insider” of the customer (in which case the window is one year).
It also is important to ensure that your customers make payments via wire transfer so that your business receives the funds immediately. Obtaining payments by wire also eliminates the risk of the customer filing bankruptcy before a check clears. If a customer’s check bounces as a result of its filing bankruptcy, you cannot force the customer to re-issue that check.
Take Advantage of Potential Defenses
Even if a customer made payments in arrears and within the 90 days before its bankruptcy filing, your business may still be able to take advantage of certain defenses if you are sued in a preference clawback action. The defenses that apply most often are summarized below.
- Ordinary Course of Business Defense: Your business may be able to avoid preference liability by establishing an “ordinary course of business” defense. This defense will apply if the payments that your customer made during the 90 days before its bankruptcy filing (the “Preference Period”) were similar in timing, amount and method of payment to the payments that the customer made before the Preference Period (the “Pre-Preference Period”).
Courts look to a variety of factors in determining whether a transfer was made in the ordinary course of business. These factors include whether: (a) the interval between the date your business invoiced the customer and the date the customer paid that invoice was similar during both the Preference Period and the Pre-Preference Period; (b) the method of payment (e.g., check vs. wire) was similar during both the Preference Period and the Pre-Preference Period; (c) invoices were sent and payments were made in accordance with the terms of any agreement between your business and the client; and (d) your business engaged in any unusual collections practices vis-à-vis the customer during the Preference Period. The ordinary course of business defense is a highly factual defense, and when preference actions are negotiated, much of the settlement discussions typically center around the strength (or weakness) of the creditor’s ordinary course of business defense.
- Subsequent New Value Defense: In addition, your business can assert a “subsequent new value” defense to the extent that it provided new value to the customer after it received a preference payment. For example, if your business receives a preference payment of $100,000, but subsequently provides $80,000 of goods or services for which it does not receive an otherwise voidable transfer, then you would be able to retain that $80,000.
- Contemporaneous Exchange for New Value Defense: Your business could also defend against a preference action by demonstrating that the payment was made as part of a contemporaneous exchange for new value provided by the transferor. To take advantage of this defense, you must demonstrate that the payments were intended by you and your customer to be a contemporaneous exchange for new value given to the debtor, and that the payments were in fact a substantially contemporaneous exchange.
If your business is either served with a preference complaint or receives a letter demanding repayment of alleged preference payments, your business should not simply repay the amount that is demanded. Typically, preference complaints and demand letters do not take into account your business’s potential defenses. If your business receives a complaint or a demand letter, you should gather information to assess your defenses. If your customer sues your business in a preference clawback action, you can typically negotiate with the customer’s bankruptcy estate regarding how much, if any, of those payments you will need to return.
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