Avoid Exposure: Creating a Defense Against Preference Payments

According to Robert Mercer of Powell Goldstein, the process for a company trying to protect itself from preference and fraudulent transfer exposure can be a tightrope walk. There must be balance between what makes the most business sense for the grantor’s firm, while not destroying that firm’s access to powerful tools like the ordinary course of business defense.

"There is one thing that I have learned from representing trade creditors and that is the absolute frustration at dealing with fraudulent transfers and preferences," Mercer told attendees during "Preferences and Fraudulent Transfers: The Basics and Beyond," part of NACM’s Audio Teleconference series.

A preference is a payment from a customer on an existing debt during the 90 days before the customer files bankruptcy, provided that the customer is insolvent at the time of the payment. Fraudulent transfers are a payment from any entity other than the company’s customer at a time when such an entity is insolvent, such as when a corporate affiliate of a customer pays that customer’s invoice. In either case, the ultimate goal is maintaining a "business-as-usual" course.

"The first thing is, when looking at the payments that were received during the 90 days before your customer filed for bankruptcy, you want to see if those payments were consistent or were ordinary when you compared them with the historic payment pattern before your customer filed for bankruptcy," said Mercer. "The main focus is how many days after the invoice day do you normally receive payment."

The recent change in the Bankruptcy Code has made it substantially easier for firms to protect themselves against preference and fraudulent transfer exposure. If a customer’s underlying bankruptcy was filed on or before October 17, 2005, to establish an ordinary course of business defense, a firm had to prove that the payment received in question was "ordinary" in respect to the customer’s historical payment pattern and with that of the relevant industry. Now, firms just need to prove one of those elements, with 95% of cases decided by the first-mentioned prong.

According to Mercer, companies and credit department members need to think about minimizing preference exposure, while maximizing the ordinary course of business defense, by approaching the matter in three separate phases: pre-bankruptcy, bankruptcy and receiving of the demand letter. But being practical up front can be the most effective and can avoid a lot of headaches later.

He noted that the single most effective way to reduce exposure on the front end is by simply getting paid in advance, not only by a customer that a grantor feels might be financially distressed or possibly at risk for filing for bankruptcy, but for all customers if possible.

"Why is that so important?" said Mercer. "Because, if you’re getting paid in advance, you’re not getting paid on a debt, so it will not constitute a preference. Second, if you’re getting paid in advance by your company’s customer, you won’t have any fraudulent transfer exposure either."

Though that approach is extremely difficult, and not likely to be obtained across the board, the next best practical solution for a grantor is to apply customers’ payments in a way that strengthens the ordinary course of business defense. For example, a firm has three outstanding invoices of $100,000 each from a particular customer: one that is 30 days old, the second that is 60 days and the third is 90 days old. When that customer calls and says they are going to send a payment of $100,000, and in fact they do, more than likely, 99% of companies will allocate that payment to the 90 days invoice.

Mercer also advised that companies don’t apply payments too soon, because that payment can also be considered a preference.

Other simple tactics like making a phone call instead of writing a collection letter can also keep a company from destroying its chances of protecting itself from making a preference repayment.

Mercer continued to lay down basic strategies like weighing the risks of changing payment methods with a customer, for example changing from a check to a wire transfer, because this dilutes that ordinary course of business defense. He also suggested that a firm never let a customer dictate how a received payment is to be applied.

Before there is even the hint of bankruptcy, there are even more tools companies can use to set up ramparts. In terms of credit documents, Mercer suggested that all guaranties include a provision that for whatever reason, if a debtor’s payment gets disgorged, through a preference lawsuit or otherwise, the guarantor remains liable. He said that some courts have already held that this is the case.

"But you don’t want there to be any room for doubt," said Mercer. "You need to have a provision in your guaranty that says that the guarantor is responsible for making sure you get paid, and almost as importantly, that you stayed paid."

The final pieces of building an initial defense so that a company won’t have to be faced with painful preference repayment demands is to ensure in a letter of credit that the issuing bank is using its own funds, and not the customers’ funds, to make payments and that credit applications contain an arbitration provision.

During the bankruptcy phase, Mercer suggested that a company might not want to rush ahead and file a proof of claim, especially if that company has large preference or fraudulent transfer exposure. If a company files a proof of claim, it waives the right to a jury trial, and that may lead to not being able to have the case transferred from bankruptcy court to district court.

And finally, after companies have received a demand letter, Mercer suggested that a company might want to challenge the insolvency of a debtor, because such a presumption can be rebutted. Once insolvency is rebutted, it is more expensive for the trustee to pursue the litigation and will encourage the trustee to settle because it could hurt all of the trustee’s avoidance actions and may require the trustee to retain an expert to establish insolvency.

Source: Matthew Carr, NACM staff writer

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