How can my business avoid returning payments from a customer who files bankruptcy?

Imagine you have a customer who buys from you on credit, and has been for years. Imagine that one month, a payment is a few days late. When you call to ask about it, you are promised it is in the mail. A week later, another call, another promise. A month later you get a notice of bankruptcy. You can call a bankruptcy attorney and they may tell you that under Section 547 of the Bankruptcy Code, you may have to return any money you received within 90 days of the bankruptcy filing. That can happen with Chapter 7 liquidations, and also under Chapter 11 restructuring. Your business legitimately did the work, or sold the goods, and now you may have to disgorge the money you were rightfully paid. It seems unfair, but you can certainly be in that position.

The Preference Rule

Section 547 is arguably one of the worst provisions of the Bankruptcy Code. It is filled with good intentions, but has major flaws. Ostensibly it was meant to keep a creditor who knew a debtor was in bad financial condition from getting payment first. The point is to make sure that no creditor has an undue advantage over other creditors of the debtor. But the creditor’s knowledge (or not) is irrelevant. Where the recovered money goes is the second flaw. It goes into the bankruptcy estate, supposedly to be divided equally among creditors. However, a very large portion goes for professional fees of the lawyers and accountants and others who work on the case.

So, is there anything you can do to reduce your exposure to preference claims? Yes. There are several techniques you can use, and I will list them from most practical and important to least, though some may not work for your business, or may be impractical.

The Payments Were Made in the Ordinary Course of Business

Your first defense is that the payments were made in the ordinary course of business. If the payment is per the usual invoice terms, you have almost a safe harbor. Most companies have 30 day terms. Few companies which are in dire financial straits pay that quickly, but if a contract with a troubled debtor defines payment terms as 30 days and you call day 20 to remind them to pay, and they pay in 30 days, you are fine. A friendly reminder call on day 20 is not pressure. It is just good customer service.

Say a customer pays in 60 days on 30-day terms for three years. That is the pattern, and the law accepts that. One thing: the pattern has to be steady. But what if, as delays grow, the payment is applied to an invoice 120 days old? It may not sound like a difference, but it is. At some point, the delays are too long, and the norm has broken. That is not ordinary and may not be OK. Pay particular attention to how far back invoices get paid. So what do you do when you see the line of payments is bending the wrong way? Fixing that is possible but hard: apply the newest payment to the newest invoice. That is just an argument, and hardly a sure bet.

Contemporaneous Exchange of Value

Your next potential defense is the contemporaneous exchange of value, which applies where the sale is COD. You deliver the goods and the customer pays you right then; there is no old debt left owing. It only makes sense if your customer does not have another supplier willing to extend credit. One caveat: if you charge an extra fee toward old invoices, you can still be caught, just to a smaller amount. Still, it is safer to sell cash plus a little toward the old balance than sell on credit and then apply one big payment to the oldest invoice.

Those two are the most practical. The others take more effort: you can include a security interest in a supply agreement, as long as you file a UCC-1 form before the 90 day window. Another option is an up-front deposit. Or there is the possibility of a Letter of Credit. Those are most often international. Those defenses work because payments on secured claims are not preferences; a deposit from a debtor is not payment on an old debt; and where you are paid with a Letter of Credit, the Bank pays, not the debtor.

The best practice is just to watch customer payment trends closely. If they seem to worsen, take the steps above, as you deem best. Just remember, it is best to do this early. Many creditors wait until it is too late, and then complain their choices are too few.