Even my 2-year-old knows that you can’t take things that belong to someone else. On the playground, this policy is pretty straightforward — no matter how hard you cry, you can’t take the other kid’s ball.
However, in our grown-up world, things are a bit more complicated. Anyone who has paid taxes knows that, like it or not, other people sometimes get to take what you have earned.
Another, perhaps less well-known, example of this same phenomenon occurs every day in the bankruptcy courts, through “preference” actions. It has become more important than ever in today’s economy for businesses to know how to protect themselves against preference liability.
Preferences and the “ordinary course” defense
If you are a creditor to a company that files for bankruptcy and that company made payments to you during the 90 days before filing, then the trustee in charge of running the bankruptcy estate may be able to take those payments back from you as a “preference.”
The Bankruptcy Code allows the estate to recover these funds in order to level the playing field among creditors, thus preventing a debtor from favoring — or “preferring” — one creditor over others on the eve of a bankruptcy filing.
Some good news is that the Bankruptcy Code also provides defenses for creditors who received these “preferential” payments.
One important defense against a trustee seeking to take back a preferential payment is commonly known as the “ordinary course of business” defense. In order to encourage creditors to continue dealing with troubled companies — thus, ideally, sparing those companies a trip to bankruptcy court — the code says that a trustee cannot recover payments made by the debtor in the ordinary course of business.
This can work two ways. You could show that the payment was made in the ordinary course of business in that particular industry, which requires passing an “objective test.” Or you could show that the payment was made in the ordinary course of business between you and that particular debtor, which involves a “subjective test.”
In either case, showing that the payment was made in the ordinary course will prevent the trustee from being able to take it back as a preference.
As to the “subjective” version of the defense, there are a number of items businesses should be aware of when receiving payments from troubled companies. Being aware of these issues and addressing problems early will help to ensure that the payments you receive are not later taken back as a preference.
Keeping it “ordinary”
Timing — If a debtor’s payments begin arriving earlier or later than usual, then a bankruptcy court may determine that these payments were made outside of the ordinary course of business. Thus, if the debtor’s payment schedule begins to fluctuate, it would be wise to find out why and address related issues early.
Method — A change in the debtor’s method of paying may also signal to the bankruptcy court that payments fall outside the ordinary course. For instance, if the debtor usually pays by check but suddenly begins paying by wire transfer, or vice versa, there may be grounds for denying the ordinary course defense.
Amount — The court may also consider the amount of payment — that is, whether the debtor is paying invoices in whole or in part — when determining ordinary course status. Beware when a debtor who usually pays invoices in full begins paying only part of the balance. Such payments may be deemed outside the ordinary course and thus subject to recovery by the trustee.
Terms — A change in payment terms may also signal to a court that payments are outside the ordinary course. If the debtor requests a change in the terms of repayment, find out why it is requesting the change. If the debtor is seeking the change because of financial difficulty, then this may be grounds for the court to deny the ordinary course defense, thus allowing recovery of the payment as a preference.
Collection — In deciding whether payments are in the ordinary course, the court will also look to the collection methods used. Changes in collection practice could put payments outside the ordinary course. Although it may sound counterintuitive, you should thus avoid using extreme or “unusual” debt collection practices when dealing with a troubled company. Doing so could put whatever payments you do receive outside the ordinary course, thus subjecting them to recovery as a preference.
As more companies succumb to the current economy and file for bankruptcy, actions to recover preferential payments will rise accordingly. There are no quick fixes for ending the recession, but following the above guidelines when dealing with troubled companies will help your business preserve a defense against potential preference actions.
The idea is to make sure that someone else doesn’t get to leave the playground with your ball.
Mike Jones, who attends law school at the University of Michigan, is a summer associate at the law firm of Varnum LLP.