Protecting Your Company Against Preference Lawsuits

From the Fort Worth Business Press:

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Protecting your company against preference lawsuits
Robert Simon and Spencer Soloman – Guest Columnists

What is a “preference” lawsuit?

Your company sells to a long-time customer and delivers an invoice for $10,000. The customer pays the $10,000 thirty days after the invoice is due. Sixty days later, the customer files for bankruptcy. A year goes by, and you receive a letter from a trustee appointed to liquidate the customer’s assets in the bankruptcy case. The trustee demands that you turn over the $10,000 “preference” you received prior to the bankruptcy and threatens to sue you if you refuse. You toss the letter in the recycling bin; after all, you have done nothing wrong. Unfortunately, that doesn’t matter. When a debtor files for bankruptcy, it (or its bankruptcy trustee) may recover payments made to creditors during the 90-day period before the bankruptcy was filed. The debtor’s intent to “prefer” one creditor over another is not required. Preference lawsuits can result in liability for companies that have done nothing wrong other than accept money for a debt justly owed.

Defenses

The bankruptcy law creates some defenses to preference liability. First, the debtor must be insolvent at the time it made the preference payment. If the debtor was not insolvent when the payment was made (and did not become insolvent by making the payment) there is no preference liability. Second, a preference must be money paid to satisfy a past debt. No liability arises where money and goods or services are exchanged simultaneously. Third, the bankruptcy law creates a defense for payments made in the “ordinary course of business.” If your company has been extending credit to the debtor for a period of time and the money you received in the 90-day period followed the historical pattern of payments, that money may not be recoverable. However, payments that do not fit the historical pattern (i.e. late payments, early payments, or partial payments) may result in liability. Finally, if your company provided new goods or services to the debtor after receiving a preference payment, you may be able to offset the value of those items from your preference liability.

Prevention
The easiest way to avoid preference exposure is by not extending credit to troubled companies. If you believe a customer may be insolvent, sell by COD only. Accepting payment in this way makes the transaction contemporaneous, and not on account of a past debt. Thus, no preference.

Companies should also educate their credit managers about preference law. A credit manager’s first instinct when dealing with delinquent accounts is to demand that the oldest invoices be paid first, thereby delaying payment of current invoices. Accepting late payments for past-due invoices will likely destroy the ability to assert an ordinary course of business defense. The credit manager should be educated to insist that current invoices be paid immediately, especially if he or she suspects that a customer is in financial trouble. A company that has accepted payments for 90- or 60-day-old invoices is a highly attractive target to a bankruptcy trustee.

Improving your negotiating position by requesting a jury trial
If your company has been sued for a preference, requesting a jury trial may provide an advantage. Jury trials can increase the expense, delay, and aggravation of the litigation, making you a less attractive target, particularly if your exposure is relatively small. Additionally, a jury is more likely than a bankruptcy judge to sympathize with a creditor who has done nothing wrong except receive payment for a legitimate debt. A creditor may lose the right to obtain a jury trial by filing a proof of claim (a document filed with the bankruptcy court stating the amount owed to a particular creditor). Although creditors that do not file a proof of claim may forego sharing in the distribution from the bankruptcy case, sometimes it makes good business sense not to do so. For example, filing a proof of claim for $10,000 where your potential preference exposure is $100,000 is probably not a good idea if you wish to preserve your right to a jury trial. And if the value of the debtor’s assets reflects that there will be no meaningful distribution to creditors, improving your negotiating posture by requesting a jury trial may be far more valuable than a proof of claim.

Conclusion
Many options are available to companies at risk for preference exposure or which have already been sued. Adopting policies and educating credit managers about accepting payments from financially troubled companies might mean the difference between success and failure in a preference lawsuit.

Robert Simon and Spencer Solomon are attorneys with the law firm of Barlow Garsek & Simon LLP, 3815 Lisbon Street, Fort Worth or www.bgsfirm.com.

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