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When Your Brick-and-Mortar Customer Files Bankruptcy: A Brief Analysis of Preference Actions and Common Defenses

Posted by Attorney David J. Espin in Bankruptcy / Comments

The proliferation of online retailers like Amazon has come at the expense of many traditional brick-and-mortar stores. As a result, many are turning to chapter 11 reorganizations in an effort to prolong the inevitable slide towards shutting their doors for good. This poses unique challenges for many of these stores' suppliers, especially when it comes to the complicated issues surrounding preference actions.

For anyone that has been on the receiving end of a letter threatening a preference lawsuit, it can often be a perplexing experience, riddled with questions and confusion. What is a preference payment? How can I be sued if I haven't done anything wrong? Do I need a lawyer? What is this going to cost me? The answers to some of these questions are more straightforward than others, but it is helpful to have an overview of what a preference action actually entails, as well as some common defenses.

The underlying dual purpose of the Bankruptcy Code's preference provisions are to deter creditors from exerting pressure on struggling debtors to pay them at the expense of other creditors, and to discourage debtors from favoring certain creditors over others. The basis for a preference action is set out in section 547 of the Bankruptcy Code. First and foremost, the payments received by the creditor have to be made on account of an “antecedent debt." This essentially means that the debt has to be for goods or services that were already provided by the creditor, and not some type of prepayment. In addition, it must be shown that the payment(s) in question (1) were made while the debtor was insolvent, (2) were made within 90 days from the date the debtor filed for bankruptcy, and (3) provide the creditor with more than it would receive if the debtor were liquidated in a chapter 7 bankruptcy.

If a plaintiff establishes that all of these elements have been met, there are still several “affirmative defenses" that can be used to defend against the action. The most common defenses are the the ordinary course of business defense, and the contemporaneous exchange for new value defense, and the new value defense.

Ordinary Course of Business Defense. This defense is probably the most commonly used, and provides that a payment is not considered preferential if it was made in the ordinary course of business, and according to ordinary business terms.

Whether the transaction in question was made in the ordinary course of business depends on whether the debt was incurred in a typical, arm's length transaction. Even if the type of transaction was unusual for the debtor or was not a part of its core business, the court will focus on whether the terms of the transaction are similar to the terms ordinarily found in similar transactions.

In order to determine whether the payment was made according to ordinary business terms, courts will examine the contract terms and payment history of the parties. They will look back at the parties' previous dealings (prior to the 90 day lookback period) in order to come up with a historical baseline for how soon from the invoice date payments were made. Then, the court will compare the alleged preferential payments to this baseline to determine whether the payments were in line with the parties' prior credit terms.

Contemporaneous Exchange for New Value Defense. This defense requires a creditor to show that the parties intended the transaction in question to be a contemporaneous exchange for new value, and that it was in fact a substantially contemporaneous exchange.

While the name may imply that the payment and the exchange of goods or services must be instantaneous, payment may under certain circumstance still be made on credit terms without losing the defense.

However, creditors must be careful to apply the payments to the invoice connected with the goods or services that they actually provided during the preference period. While many creditors will as a normal business practice apply payments to the oldest outstanding invoices first, this will terminate the contemporaneous nature of the transaction.

New Value Defense. This defense is available to creditors that receive a preferential payment, but then subsequently provides new value (usually in the form of additional goods or services) to the debtor. The creditor is then able to reduce its preference exposure by the amount of “new value" it has provided.

For example, if a creditor receives a $25,000 payment that is preferential, and then subsequently ships another $15,000 worth of goods that it is not paid for prior to the debtor filing its bankruptcy case, the total preference exposure for the creditor is reduced to $10,000.

In conclusion, while the surest way for a supplier dealing with a company teetering on the edge of bankruptcy is to demand COD terms, this option is not always available. Sometimes the customer will not agree to COD, and if they are a large enough account, you may not have a choice other than to acquiesce to whatever payment terms the customer demands. In that case, you should consult with a knowledgeable bankruptcy attorney in order to come up with a game plan to limit your preference exposure.

Attorney David J. Espin

Dave focuses his practice on business law, with an emphasis on business formation, corporate transactions, business bankruptcy, and work-outs. Dave has acted as general counsel for businesses of all sizes, and understands the various legal and practical issues that companies face every day.

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