Publication

Bankruptcy preference lawsuits on the rise, so know your best defense

Baltimore Business Journal, May 2007

Imagine this: you perform work or sell supplies to a customer, you are then paid for the work, and one month later your customer files for bankruptcy.

One year later you receive a demand from the bankruptcy trustee for the return of the money that the customer paid you. Worse yet, when you refuse to return the money, the bankruptcy trustee sues your company where the customer filed its bankruptcy case, not where your company is located.

How can this be? Why should you have to return money paid for work you performed?

The answer is a federal law called the “bankruptcy preference statute.” If a creditor receives payment from a debtor within 90 days before the debtor files for bankruptcy, the payment is a preference and may be recovered by the bankruptcy trustee. The theory underlying the law is that a bankrupt debtor should not be able to prefer one creditor to the detriment of other creditors.

The bankruptcy preference statute has resulted in a massive number of lawsuits being filed to recover money. In 2003, there were approximately 60,000 bankruptcy preference lawsuits filed in the United States, according to the Administrative Office of the United States Court. In recent years, the failures of large companies, such as Bethlehem Steel and Enron have resulted in thousands of bankruptcy preference lawsuits.

In 2005, Congress turned the tide somewhat, imposing certain limits on a bankruptcy trustee’s ability to recover preferential payments. Is there anything you can do to prevent preference claims against your company or to defeat the claims when made?

Yes. Two common defenses are referred to as the ordinary course of business defense and the substantially contemporaneous exchange defense.

With the ordinary course of business defense, if the payments were in the ordinary course of business between the creditor and the debtor and made in accordance with normal industry terms, then the trustee will not be able to recover the payment.

The substantially contemporaneous exchange defense works as follows: If your customer pays you at the same time that work is performed, then the trustee will not be able to recover the payment.

How do the above defenses help you? First, know your debtor. If you are aware that your debtor is in financial straits, consider demanding cash up front or payment at the time the service or supplies are delivered.

Second, monitor and work your account receivables to avoid a customer paying you long after the due date. By doing this, you can qualify for the ordinary course of business defense.

The demand from the bankruptcy trustee is typically worded in a way which would lead one to believe that there is no alternative other than to remit payment. But there are alternatives.

One or more defenses may apply. As soon as the demand is received, conduct a detailed analysis of the business history between the debtor and your company and compare that history to the payments at issue, to determine if the payments were made in the ordinary course of business.

After the analysis is complete, you will know the strength of your case and be in a position to decide whether to fight or negotiate a settlement.

Glenn D. Solomon is a partner at the law firm of Offit Kurman. He can be reached at gsolomon@offitkurman.com