Do I have to repay a customer’s payment if the bankruptcy trustee demands it?

The customer has been overdue for months, and every time you try to collect the balance, they say they’ll get back to you soon. Finally, they pay you in full. Then you never hear from them again. Until you hear they filed for bankruptcy. Glad you got the money when you did?

But once you have the money in your hands and have used it to settle the past-due balance on your books, then your once and former customer comes back - or at least, their estate attorney does. You get a letter that says they’d like to get that money back. That they’ll sue you in a court on the other side of the country to get it if they have to. Are you really, at this late point in this event, obligated to give it back?

What Kinds of Payments Count as Preferences

Whatever your customer tells you, you’re not the only creditor to whom the customer owes money. You were just the first one to whom they paid it. Under section 547 of the Bankruptcy Code, if it’s a preferential payment - i.e., if the customer paid you within 90 days before filing bankruptcy - the Trustee can get it back and divvy it up, pro rata, to all the creditors.

But wait - why is the rule like this? It’s unfair for a failing company to pay some of its creditors in full while everyone else gets nothing. The rule stops creditors from racing to the courthouse to sue first. Instead, the remaining assets will be divided under the supervision of the court, pro rata, between the creditors.

Section 547 spells out exactly what kinds of payments count as preferences.

• First, that “preferential payment” has to be on an antecedent debt, meaning a debt owed before the payment, rather than a debt incurred after payment is made.
• Second, the customer must have been insolvent at the time of the payment. And don’t assume insolvency can only happen in bankruptcy.
• Third, the payment must have been made within 90 days before the filing or within a year if you are an insider (which generally means an owner, family member, officer or director of the company).
• Fourth, the payment must have made you better off (i.e., enabled you to retain a larger share of what was owed to you) than if you had merely received a pro rata share through the bankruptcy.

The trustee or debtor-in-possession must prove every element. Then the payment is avoided and you must refund it (unless a defense applies) even if the goods were never disputed and nobody meant to prefer you.

The trustee has two years after the filing, generally, to sue. The suit has to be brought in the bankruptcy court where the customer filed, which can be hundreds of miles away.

Several Defenses

Ready to write a check? You may not have to. Section 547 also gives you several defenses. Here are the three that matter most for day-to-day dealings.

“Contemporaneous exchange,” says the Code. If the payment was a contemporaneous exchange, then you may not have to give it back. What does that mean? It means the customer is paying you for a new thing, not for an old thing. So, for example, the customer ordered 1000 widgets and paid you at the time of the order for the widgets.

The second defense is that the customer paid you for the goods within the ordinary course of business and within the time they usually pay. So if the customer bought 1000 widgets every month and always paid you within 30 days, the payments are probably defensible.

Third, you have a “subsequent new value” defense. So, for instance, the customer gave you $10,000 on a very old debt, a clear preference. Then you shipped $5,000 of widgets that had never been paid for. If that happened, you can offset the $5,000 in goods never paid for against the demand.

Protect Yourself from a Preference Attack

So what can you do now to protect yourself from a preference attack? There are three things that come to mind.

• One, you should have a collection policy and schedule. A collection policy helps you keep the payments you receive within the ordinary-course defense.
• Two, collect per the terms of the contract as well as the customer’s past payment history.
• Three, do not ask the customer to “catch up” or pay their entire balance unless your contract gives you the right to do so.

Nothing feels more unfair than a preference claim. You collected the money, put it on your ledger and used it to pay some of your creditors. Then, boom - years later you get a demand letter. Even though you were the first, you might still be last, so plan accordingly.