Does My Company Have To Pay?
 
June 1, 2000
 
Samuel "Sam" Zusmann- Orlando

Twelve months ago your company sold goods – or provided services – on 30 days’ unsecured credit terms to Company X (X).  Although X did not pay within 30 days, it did pay in 90 days.  No further business was done with X.  Now, by way of a letter from the attorney for the bankruptcy trustee of X, you are advised that (1) just after payment was received X filed bankruptcy, (2) the payment is an “avoidable preference,” and (3) unless within 20 days the payment amount is repaid, suit will be instituted against your company to recover that amount.

Two questions immediately come to your mind.  What is an “avoidable [sometimes referred to as a ‘voidable’] preference?”  Do I have to pay?

Regarding the first question:  the Bankruptcy Code (Code), in general terms, defines an “avoidable preference” as a transfer of a debtor’s property [a payment of money] to or for the benefit of a creditor, on account of an antecedent indebtedness, made within 90 days before the start of the bankruptcy case (in some circumstances the time period could be one year rather than 90 days), while the debtor was insolvent, which enabled the creditor to get a greater recovery  than the creditor would receive in a Chapter 7 [liquidation]  bankruptcy case if the payment had not been made.

“Ok” you say.  “The payment may meet those requirements, but as the company simply got paid for what it provided, why does the company have to give it back?”  The answer, in part, is that the Code authorizes a bankruptcy trustee or a debtor-in-possession in a Chapter 11 [reorganization] bankruptcy case to recover avoidable preferences.  This provision effectuates the Code’s attempt to promote equality of distribution among similarly situated creditors.

If some creditors received no payments but other creditors received avoidable preference payments, similarly situated creditors have not been treated equally; by recovering the avoidable preference payments and redistributing them, including a distribution to your company on the amount repaid, greater equality of distribution is achieved.

The answer to the second question is “maybe.”  Just as the Code created a cause of action to recover an avoidable preference it also created defenses to having to repay.

One of these statutory defenses is that the payment was made in the “ordinary course of business.”  There are three elements to the “ordinary course of business” defense.  The first is that the debt was incurred in the ordinary course of business of both the debtor and the creditor.  The second is that the payment was made in the ordinary course of business of both the debtor and of the creditor.  If the debtor customarily paid all 30 day invoices in 90 days, perhaps the payment was “ordinary course” for the debtor; but is it “ordinary course” for your company to be paid in 90 days on its 30-day invoices?  If not, the defense fails because it was not “ordinary course” of both parties.  Similarly, if your company’s credit manager made numerous dunning calls, or insisted on payment by wire transfer, the “ordinary course” defense may fail.

The third element of the defense is that the payment was “made according to ordinary business terms.”  Courts have interpreted this to mean that the payment terms were consistent with industry standards; however, if there had been a long business relationship between the debtor and the creditor, more emphasis might be placed on the historical transactions between the parties than on industry standards.  If, for example, your invoice terms were payment in 30 days but for several years payments from this debtor had always been made in 90 days, the third element might be met if the payment in issue was made in 90 days.

The “ordinary course” defense is not the only statutory defense to avoidable preference claims, although it is probably the one most frequently asserted.

Determining that a provable defense exists is more complicated than is suggested by the foregoing explanation.  Like any other demand for the payment of money, an avoidable preference claim is a serious matter.  A delay in responding to an avoidable preference claim may result in your company being sued, and under the Code if the payment was of a commercial – as opposed to a consumer – debt of $1,000 or more, the suit may be brought where the bankruptcy case is pending, which may be a thousand or more miles from where your company is located.