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Business Law Bulletin: Why must I give back the money?

Peter Bronson

No one likes to be sued. But there is one type of legal action that seems to generate particular outrage (not to mention disbelief) because it just doesn’t seem fair. Consider the following hypothetical fact situation.

Unsuccessful Corporation of America has owed $50,000 to your company since 2001. It is now late 2004. UCA has made a string of promises to pay its debt, but those promises have all been broken. In 2003, UCA sent you a check, but it bounced. They sent a replacement check a few months later but “forgot” to sign it; you returned it, but UCA never replaced it. And so on and so forth. Despite all the excuses, you’ve simply been “stiffed” by this wretched deadbeat. Meanwhile, you have read in the newspaper that UCA’s CEO has just given $500,000 to a local arts group.

Finally, you are so angry and desperate that you retain high-powered legal counsel to help you collect this debt. A few tough letters from the lawyers have yielded nothing. Finally, your counsel files a lawsuit against UCA seeking massive damages.

Eventually – say, on March 1, 2005 – UCA finally coughs up a check for $25,000 – exactly half of what you are owed. This time, the check is even signed. You race to your bank to deposit the check, and miraculously, the check clears!

Nearly three months later – around the end of May 2005 – UCA files for bankruptcy under Chapter 7. At least I collected half my money before they went “BK,” you tell yourself with a sigh. At least they’re out of my life for good.

Not so fast. In May 2007, nearly two years after UCA’s bankruptcy filing, out of the blue comes the bankruptcy trustee for UCA. The trustee sues your company to get the $25,000 back, claiming that the payment was a “preference” that you must return under U.S. bankruptcy law. You shriek in disbelief. You worked hard to collect this money, and the debtor never contended for a moment that the debt wasn’t legitimate. Is there no justice? After all, the debtor still owes you $25,000! Do you really have to give back the $25,000 you managed to collect?

The answer, sadly enough, is “You probably do.” (Don’t be upset with me – I’m only the messenger.) Let me explain why this is so.

The American bankruptcy system is not intended solely to give the deserving debtor a “fresh start.” It is also designed to protect creditors by ensuring that, to the extent possible, they are treated equally (“equally badly,” some would say) in the event of a bankruptcy. When a company becomes insolvent, it does not have the legal right to selectively choose – on the eve of bankruptcy – which creditors get paid and which do not. In other words, it cannot “prefer” one creditor over another. Hence the concept of the “preference.”

A “preference” is a payment (or other transfer, such as a security interest or a deed of trust) made to a creditor against a pre-existing debt made by an insolvent person or company within 90 days prior to bankruptcy (or, if the transfer is to an “insider” of the debtor, within one year prior to bankruptcy). [It is presumed that a debtor was insolvent for the 90 days preceding its bankruptcy filing.] The bankruptcy trustee – or the “debtor in possession,” if the debtor is still operating its own business in Chapter 11 – can recover preferences from the innocent creditors who received them. The trustee usually has two years from the date of the bankruptcy filing within which to sue for a preference.

In the case of real estate, even transfers made earlier than 90 days before bankruptcy can be set aside if the transfer was “perfected” (for example, by recording a deed) within the 90-day period.

However, there are exceptions to the preference rule. For example, if the debtor receives sufficient new value from the creditor (such as new inventory, for which he has never paid) contemporaneously with the “preferential” transfer, the transfer is generally not recoverable by the trustee. Likewise, payment of a domestic support obligation is not considered a preference.

In addition, if the transfer was made in the ordinary course of business of the debtor and the transferee, or “made according to ordinary business terms,” it is not a preference. “Ordinary business terms” could, conceivably, be different from the typical 10- or 30-day terms that might appear on an invoice. What constitutes “ordinary business terms” in any particular case is frequently decided on the basis of testimony by professional expert witnesses with experience in the industry in question.

There are other exceptions and defenses, too numerous and complex to discuss here.

Frequently, a creditor first finds out about a preference claim when he receives a letter from the trustee or the trustee’s agent, laying out facts that show a possible preference and offering to compromise for, in many cases, 70 to 80 percent of the amount in question. Absent a prompt agreement on settlement terms, a lawsuit may follow. (And sometimes the legal action comes without any prior letter or warning.)

The lawsuit is filed in the court where the bankruptcy is pending. So if the bankruptcy is in Delaware, preference claims will be litigated in Delaware regardless of where the defendant is located. Obviously, it can be very expensive and impractical for a defendant in, say, California, to defend against a preference case in a court across the country.

The ability of a trustee to force a defendant to defend against a tiny preference claim in a distant state has been diluted by the 2005 bankruptcy reform legislation. Now, a transfer of less than $5,000 in payment of a business obligation (or less than $600 in the case of a consumer debt) is no longer considered a recoverable preference. Nevertheless, it is seldom cost-effective to go to trial in preference cases, and the vast majority of them are settled out of court, often for just a small percentage of the amount in controversy.

One cannot always anticipate a bankruptcy filing by a customer or client, but the best strategy (although it’s often easier said than done) is not to let debts grow too old; do your best to collect them on a timely basis. Also, talk to your accountant or business advisor about whether it should be your policy to apply payments from debtors to the most recent invoices rather than the oldest ones when possible; while this might make sense from the standpoint of minimizing preference exposure, there may be other tax-related reasons to apply payments to older invoices.


Peter C. Bronson of Nevada County is a partner in the Sacramento offices of Kelly Lytton & Vann LLP in creditors’ rights, insolvency, commercial litigation and mediation. Write him at pbronson@klmvlaw.com. This column is not intended as legal advice in any specific business situation or dispute.

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