Matters Column

Dealing with a cash-strapped business: Keep it ordinary

November 3, 2012
| By David Moss |
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One of the first lessons a child is taught is that you can't take things that belong to someone else. This lesson is pretty straightforward — no matter how severe the tantrum, you can't take the other kid's toy.

But every adult knows that things in our world 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 phenomenon occurs every day in the bankruptcy courts, through "preference" actions. During the recent economic downturn, it has become more important than ever for businesses to know how to protect themselves against preference liability.

Preferences and the ordinary course defense

If one of your debtor companies made payments to you during the 90 days before it filed for bankruptcy, then the trustee in charge of running the bankruptcy estate may be able to recover those payments as "preferences."

The Bankruptcy Code allows the trustee to recover these funds in order to level the playing field among creditors, thus preventing a bankrupt debtor from favoring — or "preferring" — one creditor over others on the eve of a bankruptcy filing. 

However, the Bankruptcy Code also provides defenses for creditors who received these "preferential" payments.

The "ordinary course of business" defense is a key defense against a trustee attempting to take back a preferential payment. In order to encourage creditors to continue dealing with troubled companies, thus ideally sparing those companies a trip to the Bankruptcy Court, the Code says that a trustee cannot recover payments made by the debtor in the ordinary course of business. 

There are two ways this can work.

Under the "objective test," you can show that the payment was made in the ordinary course of business in that particular industry. Or, under the "subjective test," you can show that the payment was made in the ordinary course of business between you and that particular debtor.

In either case, showing that the payment was made in the ordinary course of business will prevent the trustee from being able to reclaim it as a preference.

When considering the "subjective" version of the defense, there are a number of items businesses should be aware of when receiving payments from financially 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’

The first issue is timing. If a debtor's payments begin arriving earlier or later than normal, it is possible that a bankruptcy court may determine that these payments were made outside of the ordinary course of business. Therefore, if the debtor's payment schedule starts to change, it would be wise to find out why and address related issues early.

The second issue is the method of payment. A change in the debtor's method of paying may also signal to the bankruptcy court that payments fall outside the ordinary course. For example, if the debtor usually pays by check but suddenly begins paying by cash, or vice versa, that may provide grounds for denying the ordinary course defense.

The third issue is the amount of the payments. In essence, a court may consider 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. These payments may be deemed outside the ordinary course and thus subject to recovery by the trustee.

The fourth issue is terms of payment. A change in payment terms may indicate to a court that payments are outside the ordinary course. If the debtor requests a change in the terms of repayment, determine 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.

The fifth and final issue is regarding collection practices. In deciding whether payments are in the ordinary course, the bankruptcy 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 file for bankruptcy due to the depressed economy, actions to recover preferential payments will rise accordingly. There are no quick or easy fixes that would restore the economy to the prosperity of the late 1990s and early 2000s, 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 toy.

David Moss is an associate at the law firm of Varnum LLP.

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