IN PART ONE of this article, I discussed the basics of preference litigation and the options available in defending such claims. For obvious reasons, it was geared towards the litigators among us. This installment touches upon ways to minimize, ahead of time, the risks of dealing with financially troubled companies – something most of our clients are doing with increasing frequency. This article is designed to help the corporate lawyer in advising his or her clients.

What is a Preference?

Federal bankruptcy law vests debtors in bankruptcy with the extraordinary power to set aside and recover certain pre-bankruptcy transfers known as "preferences." Generally speaking, §547 of the Bankruptcy Code empowers debtors to recover payments made: (a) on account of goods and services previously furnished to the debtor on credit; (b) within 90 days of the commencement of the debtor’s bankruptcy case; (c) while the debtor was insolvent; and (d) which enabled the trade creditor to receive more than it would otherwise receive in a liquidation of the debtor under Chapter 7 of the Bankruptcy Code.

The purpose of the Bankruptcy Code’s preference provisions is to promote equality of distribution among similarly situated creditors in bankruptcy by requiring that creditors who received payments during the preference period return those payments if they cannot prove the payments were non-preferential. This is true even if the payments were proper in a non-bankruptcy context.

Facially, at least, almost any payment made in connection with unsecured credit extended to a financially troubled business is vulnerable to a preference attack if the business seeks bankruptcy relief within 90 days of the payment. The broad sweep of the preference provisions is further enhanced by the Bankruptcy Code’s presumption that debtors are insolvent during the 90-day preference period and by the practical fact that in the vast majority of bankruptcy cases, there are insufficient assets to pay creditors in full.

What are the Defenses?

Although the scope of the Bankruptcy Code’s preference provisions is intentionally broad, there are statutory defenses to preference liability, designed to encourage creditors to continue doing business with financially troubled companies. Familiarity with these defenses is indispensable to developing credit policies that will minimize the risk of preference litigation with customers who seek bankruptcy protection. The three principal defenses implicated by the extension of unsecured credit are outlined briefly below.

First, an otherwise preferential transfer may not be voided if the debtor and the creditor intended the transaction to be a "contemporaneous exchange for new value" given to the debtor, and the exchange was, in fact, substantially contemporaneous. A common example of this defense is a cash-on-delivery sale.

Second, the Bankruptcy Code accepts payments made in the "ordinary course of business" from avoidance as a preference. There are three elements to this defense: (a) the payment must have been on ac count of debt incurred in the ordinary course of the business or financial affairs of the debtor and the creditor; (b) the payment must have been made in the ordinary course of dealings between the debtor and the creditor; and (c) the payment must have been made according to ordinary business terms. In order to establish this fact-intensive defense, creditors typically must present evidence that, among other things, details the debtor’s payment history with the creditor, including the amount, manner and timing of payments, and whether such payments fell within the parties’ contract terms. Creditors are also required to proffer evidence demonstrating that the parties’ payment history is consistent with industry norms and that they did not employ any unusual collection efforts in connection with the payments the trustee seeks to avoid.

Third, creditors who provide the debtor with goods and services on an unsecured basis following a preferential transfer are entitled to a dollar-for-dollar credit against any liability for the payment if the debtor fails to pay for such goods and services. This is known as the "subsequent new value" defense or "subsequent advance" rule.

How to Minimize the Risk of Preference Claims.

The above defenses to preference claims suggest the following credit policies to reduce preference risk when doing business with financially distressed businesses:

• Sell on a COD or COO Basis. By definition, a preference is a payment for goods and services sold on credit. Cash-on-delivery and cash-on-order sales in which payments are made by cash rather than check do not involve the extension of credit and, therefore, are not avoidable as preferences. Such transactions typically fall within the shelter of the Bankruptcy Code’s "contemporaneous exchange defense."
• Retain a Security Interest in Goods Sold on Credit. Unlike unsecured creditors, secured creditors whose claims are fully collateralized get paid in full in bankruptcy cases. This means that payments made to fully secured or oversecured creditors cannot be preferential because they do not enable the creditor to receive more than it would otherwise receive in a Chapter 7 liquidation. If this policy is adopted, care should be taken that the security interest is properly documented and perfected in accordance with non-bankruptcy law before goods are delivered.
• Obtain Guaranties from Third Parties. The Bankruptcy Code’s preference provisions do not purport to reach payments from non-debtors. By obtaining the guarantee, or at least our underwriting, from a solvent third party, a trade creditor can shift to that party the risk that its customer will seek bankruptcy relief. Such a third party might be willing to do so if it is a principal of the customer and can make sure that the customer does not seek bankruptcy relief until the payment is outside the preference period.
• Manage the Timing of Credit Extensions. As noted above, the Bankruptcy Code provides for a dollar-for-dollar offset against any liability for a preferential payment to the extent that after the payment a trade creditor furnishes its customer with goods and services on an unsecured basis and the customer fails to pay for such goods and services. An offset is not available, however, for unpaid goods and services furnished to the customer before a preferential payment is made. Preference liability can be minimized, therefore, if attention is paid to the timing of the extensions of credit. Specifically, the protections of the "subsequent new value" defense can be optimized if a trade creditor requires that it be brought current by its customer before shipping additional goods or providing new services on credit. Although the payment bringing the creditor current may be preferential, the payment is protected from avoidance to the extent that new credit is extended after the payment.
• Deposit Checks Promptly and Consider Requesting Payments by Cash, Wire Transfer or Bank Checks. Generally speaking, only payments made within 90 days of the commencement of a bankruptcy case are avoidable as preferences. In addition, the time of payment is measured when the customer’s check is paid by its bank, not when the trade creditor receives the check. The earlier the check is cashed, therefore, the more likely the payment will be outside the 90-day preference period. By the same logic, accelerating payments by requiring them to be made in cash, by wire transfer or bank check may, under appropriate circumstances, reduce preference exposure. Altering the required method of payment, however, may eliminate the availability of the ordinary course defense, so this technique should be used cautiously.
• Apply Payments to Most Recent Invoices. Payments that fall within the parties’ contract terms and the range established by the parties’ customary payment practices are more likely to be protected by the ordinary course of business defense than late payments outside of contract terms. Broadly speaking, it will be easier to establish the ordinary course of business defense if payments are applied to customers’ most recent invoices rather than their oldest account balances.
• Establish Consistent Trade Terms and Maintain Accurate Payment Records. The protection of the ordinary course of business defense is most likely available when the timing, method and amount of the customer’s payments are consistent with industry practice, follow a regular pattern and when there is no significant slippage or acceleration in payment terms. Adopting uniform trade terms that reflect the parties’ actual practices, accordingly, will assist in establishing an evidentiary record that supports the ordinary course of business defense. Similarly, maintaining accurate payment records and retaining contemporaneous documents that memorialize shipments of inventory, the provision of services and customer payments will also assist in the presentation of this defense.

Ultimately, preference litigation is an unavoidable risk of extending credit on an unsecured basis. That risk can be managed, however, by adopting appropriate credit policies that take advantage of the defenses to preference liability established by the Bankruptcy Code. Having such policies in place can make the difference between getting paid in full or in part on a receivable or having to write off the account.

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