Under 11 U.S.C. Section 547 of the Bankruptcy Code trustees and debtors in possession have the right to recover a payment made to a third party in the ninety day period prior to the commencement of a bankruptcy. This is known as a “preference action.”
As a result of the increase in preference litigation, the language of Section 547 was recently amended in the Small Business Reform Act to include a due diligence requirement. The requirement calls for the Trustee or the Debtor in Possession to assess the claim “based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses under subsection” prior to bringing a preference action.
Defendants in preference actions can assert various defenses. The three most common defenses are: 1) the “ordinary course of business defense;” 2) the “contemporaneous exchange for new goods and services defense” and, 3) the “new value” defense.
To prove the “ordinary course of business defense,” the creditor must show that the preference payments were: 1) not the result of any blatant collection activity on the part of the creditor and 2) were made in a similar amount of time and under similar terms and conditions of other payments to the debtor. Often, creditors retain forensic accounting specialists to do this due diligence and to help defend preference actions by reviewing accounting records, questioning the debtor at a meeting of the creditors, or reviewing the debtor’s communications and financial records with creditor’s before the bankruptcy case. Specifically, the forensic accountant can assist in supporting this defense by establishing that the payment was received pursuant to a course of dealing established by the parties before the preference period or that the payments were made on terms and conditions prevalent in the respective industry.
In a “contemporaneous exchange for new goods and services defense” or a “new value” defense the debtor’s business and/or financial records should identify delivery of goods and services by the creditor during the ninety day period and show that the deliveries provided a dollar for dollar offset for transfers made on or before that date. The primary example of a “contemporaneous exchange” is cash-on-delivery (“COD”) payment. Additionally, as an example, if the creditor receives a payment for $500 and delivers goods worth $500 and the creditor intended for the $500 payment to be for the $500 in new goods, then the contemporaneous exchange defense applies. However, if the parties intended for the $500 to pay for a prior invoice, then the contemporaneous exchange defense is not applicable.
In the midst of the current challenges presented by the spread of COVID-19 and the surge of bankruptcies, business owners and/or creditors need to take steps to protect their business from customers that are facing financial hardship. Suppliers should consider changing payment terms to cash-on-delivery terms and should be aware of minimizing the risk of getting a preference claim. Businesses should collaborate with their accountants and attorneys in understanding the various options they have in protecting their assets.