Re Evaluating Your Exposure When Your Customer Files for Bankruptcy

When your customer or client files for bankruptcy, the normal first response is to lament over the likely write-off or write-down of any accounts receivable that remain unpaid. However, as any trade creditor who has been a target of a debtor’s or bankruptcy trustee’s preference claim will attest to, that may be just the start of the financial implications.

Preference Claims

Preference claims arise when the debtor has paid a trade creditor outside the normal trade terms relating to their business relationship or that of the industry. For example, if the normal terms for your customer are net 30, which in fact follows what historically has occurred, but for the months² leading up to the bankruptcy filing the customer was paying in 60 days, a presumption of a preferential payment will arise. Accordingly, in this example, the creditor will likely face a claim from the debtor or trustee in bankruptcy for all payments received during the preference period that fall outside the normal 30-day term.

The shields against the debtor’s or trustee’s sword are known as affirmative defenses. The most common are (1) “ordinary course”; and (2) “new value” defenses.³ Under both, the creditor is claiming that either (a) the historical financial relationship (prior conduct) of the parties is consistent with the payments received by the creditor during the 90-day period preceding the bankruptcy filing, or (b), the creditor provided “new value” to the debtor subsequent to the claimed preferential payment that offsets the preference, in whole or in part.

Defining the Ordinary Course

At first glance, this would appear to be a straightforward and perhaps mechanical exercise; however, what are often overlooked by debtors, trustees and creditors alike are the subjective factors which define “ordinary course” between the debtor and the creditor.⁴ What defines the ordinary⁵ course of dealing between the parties is a fact-specific determination that may prove difficult to determine with confidence when businesses are operating in a troubled environment or are flirting in the zone of insolvency. Creditors are especially susceptible to an ordinary course challenge when their customers/clients are experiencing financial stresses, as they are more likely to become aggressive in their collection efforts, or to otherwise interact with their customer in a manner inconsistent with prior conduct and/or their normal historical relationship.

A significant factor to consider is whether a creditor’s collection efforts during the preference period (the 90-day period preceding the bankruptcy filing)⁶ were in fact “ordinary”. If the activities of the creditor fall outside the historic business relationship with the debtor, it is likely that a debtor in possession or the trustee will assert that the payment(s) received by the creditor do not qualify as “ordinary course” and seek return of those payments received during the preference period. Interestingly, even if the payment(s) received otherwise qualify as ordinary course (e.g. within normal payment terms), extra-ordinary collection efforts by the creditor can neutralize that defense. Circumstantial factors that intuitively would be evaluated by both the debtor and creditor will generally also be looked at by the court, such as: volume of transactions; composition of payment streams; established practice and custom (or whether no such patterns existed); method of payment; and actions the creditor may have taken to gain an advantage in the face of the debtor’s financial condition.

Recent Rulings

Judicial decisions have highlighted the importance of evaluating behavior by creditors during the preference period.⁷ In one recent case,⁸ the trustee raised the argument that the creditor threatened to withhold future shipments if outstanding payments weren’t made. Although the court found that both the payment activity and the “threats” were consistent with past dealings, the court’s attention to both factors illustrates that a reviewing court will carefully evaluate the entire course of conduct by the parties.Other cases reach the opposite result when the historical dealings between the parties diverge from the preference period activity, such as a pattern of harassing phone calls, e-mail threats, or communications between personnel that are not normally involved in the collection process.Furthermore, an alteration of payment terms prior to the preference period that diverges from historical norms, even if agreed to by both parties before the transaction is even initiated can be viewed as a departure from ordinary course.

The Message

The message that is being delivered by the recent spate of adversary complaints being filed by debtors and trustees is that ordinary course defenses raised by creditors will likely be attacked on both financial and behavioral grounds. Creditors should be forewarned that collection techniques as well as trading arrangements will be closely scrutinized for evidence of departures from ordinary course business dealings in the pursuit of preferential payment repayments to the estate. Before you congratulate your credit and collection team for extracting payments from your financially troubled customer, it is prudent to closely examine the processes they employed to achieve their results.

1 See 11 USC Section 547(b)
2 For non-insiders, the preference period is 90 days.
3 See 11 USC Section 547(c)
4 See 11 USC Section 547(c)(2)
5 “Ordinary” is not specifically defined by the Code.
6 Under 11 USC 547 (a)(4), there exists a rebuttable presumption that the debtor was insolvent.
7 While the timing of a bankruptcy by a customer cannot be predicted with precision, one must be alert once it come to the creditors’ attention that the debtor may be in financial distress.
8 Miller v. Westfield Steel, Inc. 426 B.R. 111 (Bankr. D. Del 2010).