Customer Filing Bankruptcy – How to Get Paid by a Financially-Troubled…

Dealing with financially-troubled customers is a fact of life in these challenging economic times. Nowadays, it is hard to find a supplier of goods or sets that does not have more than a few customers whose accounts are seriously in arrears, and are likely to be in the same serious situation with other suppliers, in addition. The circumstances are all too shared. You have done business with a customer for years, it represents a healthy chunk of business, and it has implored you to continue to extend it credit. however, you do not wish to dig the accounts receivable hole any deeper by continuing to do business with the customer until it makes a substantial payment on account in order to reduce that old accrued debt. However, you have been told that if the customer files for bankruptcy relief, the bankruptcy trustee may sue you to retrieve the money it paid to you, arguing that it is a preferential payment. You are not certain what course of action to take. Understanding what consists of a preferential payment, and the most shared exceptions, is basic in weighing the risks associated with making the difficult decisions of “if” and “how” to continue to work with your financially-troubled customers.

What is a Preferential Payment?

The United States Bankruptcy Code allows a bankruptcy trustee to “avoid”, or retrieve, payments to creditors made within 90 days closest preceding the commencement of the filing of the debtor’s bankruptcy case when the payments are made on account of an “predecessor”, i.e. old, debt, and the payment enables the creditor to receive a greater percentage of his claim than he would have otherwise received were the bankrupt business assets liquidated and the proceeds fairly distributed amongst its creditors. It is important to observe, and you will not be surprised to learn, that this rule specifically does not apply to the payment of a debtor’s tax limitations. As with any rule, there are several very important exceptions. In today’s harsh business ecosystem, an understanding of these exceptions can make the difference between for a long time the receivables storm or sinking along with your troubled customer. The following are two of the more meaningful exceptions.

New Value

One exception to the rule that a bankruptcy trustee can retrieve preferential payments to a creditor is that of “new value”. Specifically, if the facts indicate that the parties intended that the payment for goods or sets be a “contemporaneous exchange” for new value, then the bankruptcy trustee is out of luck. A simple example would be the issuance of a check corresponding to the value of the goods or sets provided, either closest preceding or followed shortly thereafter by the actual delivery of the corresponding goods or sets. It is useful to observe that according to the Uniform Commercial Code, a move involving a check is considered to “significantly contemporaneous” if it occurs within 30 days after presentment for payment.

Ordinary Course of Business

A second exception protects creditors to whom have been made in the “ordinary course of business.” consequently, a payment is not preferential and cannot be avoided by the trustee if the debt on account of which a payment is made was incurred in the ordinary course of both the debtor’s and the customer’s businesses, was made according to ordinary business terms, and was made within 45 days after it was incurred. This is a shared sense exception, designed to leave intact customary and normal financial relations between parties, such as the payment of utility bills, payments for needed inventory and the like.

The objective of the preference provision of the Bankruptcy Code is to discourage extraordinary behavior by a debtor or its creditors in anticipation of the debtor’s descent into formal bankruptcy. The inner assumption is that, for all intents and purposes, the debtor is insolvent in the 90 days preceding the filing of the bankruptcy. An understanding of the rules associated with preferential payments in bankruptcy, and its exceptions, can provide your company with guidelines for dealing with troubled customers, and help you avoid the expense of costly litigation with bankruptcy trustees seeking to retrieve those payments.

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