Beware of Extending Credit Terms Far Beyond Your Custom and Trade

Author: Anne E. Braucher Date: 04/25/2010

Categories: Corporate and Business Law

Notice of a client’s or customer’s bankruptcy filing can strike fear in the heart of the most experienced business person. Even after the initial shock has worn off, the same business person may be served with a frightening complaint in which the bankruptcy trustee is attempting to avoid a preferential transfer by the client, now a bankruptcy debtor. Luckily, the law of preferences, which allows a trustee to reverse transfers made by a bankruptcy debtor prior to the date it filed its bankruptcy petition, offers many defenses.

Section 547 of the Bankruptcy Code provides that a bankruptcy trustee can avoid a transfer by a debtor (1) to a creditor; (2) on account of a debt already owed; (3) made while the debtor was insolvent; (4) on or within 90 days1 of the date the bankruptcy case was filed; (5) that allowed the creditor to receive more money than it would have received in a chapter 7 bankruptcy case. A transfer can take the form of a cash payment, creation of a security interest, or any other means of giving a creditor an interest in the debtor’s property that is superior to what the creditor had before the transfer. Accordingly, once a bankruptcy case has begun the trustee will examine the list of transactions entered into by the debtor within 90 days of its bankruptcy filing and demand that the creditors involved return those assets or avoid their interests. In the case of a transferred asset like cash, the trustee will return the cash to the bankruptcy estate and it will be redistributed to all creditors in accordance with their filed claims.

Creditors can defend themselves in preference actions by arguing that a pre-petition transfer is not preferential because it does not satisfy any one of the five elements listed above. For instance, many preference decisions are based on whether the debtor was in fact insolvent on the date of the transfer. Other preference decisions have hinged on whether the transfer at issue allowed the creditor to receive more money than it would have received in a chapter 7 case.

Creditors can also defeat preference actions by invoking a defense like the contemporaneous exchange defense. An otherwise preferential transfer, one that satisfies the five elements above, is not a preference if the debtor made the transfer at the same time that the creditor gave new value to the debtor, and the parties meant for the exchange to be contemporaneous. New value can take the form of money, services, new credit, or a release of property. This defense is available predominantly for situations in which one party delivers goods and the other party immediately pays cash upon delivery.

Another often-used defense available to creditors is the ordinary course defense. An otherwise preferential transfer is not a preference if it was (1) made by the debtor in payment of a debt owed to the creditor; and (2) it was (a) made in the ordinary course of business between the debtor and creditor or (b) was made according to ordinary terms of the business in which the debtor and creditor operate. The current structure of this defense presents an interesting change in bankruptcy law. Before the 2005 amendments to the Bankruptcy Code, a creditor invoking this defense needed to prove that a transfer by the debtor was both ordinary according to the parties’ practices and ordinary according to industry practices. Now, a creditor need only prove one of these and can often be successful by showing the history of the transactions between the debtor and creditor. For example, an otherwise preferential payment of cash made by a debtor ten days after receiving an invoice may not be a preference if the creditor has business records showing that the debtor, before the preference period, often paid its bills to the creditor ten days after they were due.

The new value defense is another one often used by creditors. An otherwise preferential transfer is not a preference if, after the transfer, the creditor gave the debtor new value (1) that was unsecured and (2) that was not repaid by another unavoidable transfer. Just as in the context of a contemporaneous exchange, new value can take the form of money, services, new credit, or a release of property. Each extension of new value by a creditor sets-off the creditor’s liability for the preferential transfer that it preceded. Trade creditors often use the new value defense in commercial cases when they have continued to provide goods to a debtor right up until the date the debtor files its bankruptcy petition.

After quickly considering these three preference defenses, creditors will appreciate the value of good business records in being prepared for a client’s bankruptcy filing. Even the contemporaneous exchange defense, which relies less on records of payments and invoices than the others, will be strengthened if the creditor has ledgers, receipts, and copies of checks that show that an exchange of goods and cash was simultaneous. In defeating a preference action, a creditor needs a good supply of business records to show how and when it exchanged cash, goods, services, and any other interest in property with its clients.

Creditors should be aware that the preference period is much longer when the debtor transferred property to an insider. A transfer to an insider may be a preference if it was made within one year of the debtor’s bankruptcy petition filing. The definition of insider includes, among others, individual debtors’ relatives, corporate debtors’ officers and directors, and partnership debtors’ general partners and general partners’ relatives.