If you run a business which sells goods or services on credit you may eventually receive a notice that one of your customers has filed for bankruptcy protection, owing you money for the goods or services previously supplied. (That is the insult.)
The real problem is when you later get sued in bankruptcy court to recover payments that you received from your customer during the 90-day period immediately preceding the bankruptcy filing. These are known as “preference payments”. A preference payment is generally defined as a payment by the debtor (your customer) received by a creditor (you) on account of a prior debt made while the debtor was insolvent and within the 90-day period before the filing of the bankruptcy petition. In short, the Bankruptcy Code allows the debtor or its bankruptcy trustee to come after you for payments that you have already received for goods or services you already delivered. Sounds pretty unfair, doesn’t it?
The theory underlying the recovery of preference payments made within 90 days prior to the bankruptcy is that a failing business may choose to pay some of its creditors and not others as the business is failing, resulting in those paid creditors being favored over the unpaid creditors. The bankruptcy preference rules pull those payments back into the bankruptcy estate so that they can be evenly divided among all unsecured creditors.
If your business is sued to recover payments received from a bankrupt customer there may be potential defenses available to allow you to keep the payments. The most common defense is known as the “ordinary course of business defense”. This defense would be available where the customer’s payment was received either (i) in the ordinary course of business or financial affairs of the parties, or (ii) according to ordinary business terms. In other words, if the payments were made routinely in exchange for goods or services under ordinary circumstances, with nothing unusual or out of the ordinary going on, you should be able to keep the payments. However, it is not quite that simple, and the courts have developed some fairly intricate rules to determine whether payments are indeed “ordinary course” payments.
- Example: Suppose your normal payment terms are that the customer is required to pay within 10 days of invoice. Your records show that the customer generally paid between 8 and 12 days after invoice during the 2-year period prior to bankruptcy. However, in the 90-day period immediately preceding the bankruptcy, the customer’s payment pattern changed, increasing to 20 days or more after invoice. Those recent payments probably would not qualify for the ordinary course defense because they did not fit within the historical pattern of payment. Oddly enough, if your customer always paid a little late, say within 20 days of invoice, and the recent payments were also made within 20 days of invoice, those payments probably would qualify as ordinary course because they are consistent with the long-term payment history. In other words, no major change occurred in the last 90 days.
Bankruptcy preference litigation can be frustrating because it is often counterintuitive. The example above shows that allowing your customer some “slack” as their financial condition deteriorates can actually hurt you in bankruptcy court. The opposite is also true. If you impose more restrictive credit terms when you sense your customer is becoming financially distressed, this can also undermine a successful ordinary course payment defense. Any significant change in credit terms immediately prior to bankruptcy, whether positive or negative, can spell trouble for the ordinary course payment defense.
Finally, it is worth noting that preference litigation is often resolved by a negotiated settlement between the creditor and the bankruptcy trustee, where only a portion of the preference payments are paid back by the creditor. The actual percentage paid back will be directly related to the strength of the ordinary course payment defense demonstrated by the creditor. This involves good recordkeeping, being able to demonstrate a consistent payment pattern, and no favoritism to the debtor.
— Kevin Palmer