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A Better Partnership

Ahead of the Curve Auto Supplier Blog

October 04, 2017

The Preference Payment Predicament

Most companies extend unsecured credit to their customers as a routine and often daily part of their business—a supplier ships parts to its customer along with an invoice and, at some point thereafter, the customer submits payment. Life is good.

Imagine a scenario, however, where a supplier ships $1,000,000 worth of parts to its customer. An invoice is sent and sometime thereafter the supplier receives payment. Shortly after payment is received and applied, the supplier receives a letter from a U.S. Bankruptcy Trustee informing the supplier that its customer has filed for bankruptcy protection and demands the return of the $1,000,000 because such payment was made by the customer in the 90 days preceding the customer’s bankruptcy filing. The trustee’s letter also accurately points out that under the Bankruptcy Code (Code) a trustee may avoid and recover such “preferential” payments for the benefit of the bankruptcy estate. Finally, the letter indicates that failure to return the $1,000,000 will result in the trustee filing a lawsuit against the supplier, as creditor, for the return of the $1,000,000 paid by the customer, as debtor. All of a sudden life has become a bit more complicated.

All is not lost, however. If you find yourself in this situation as supplier/creditor, you should, upon receipt of such a letter demanding the return of alleged “preference” payments, immediately begin a detailed analysis to determine whether such payments were indeed preferential or whether you may have defenses to such an action. Maintaining excellent records of transactions with your customers will greatly aid in the analysis.

The first step in an analysis is to determine whether the payment meets all the statutory elements of a “preference” payment. Generally speaking, a trustee may recover payments made by your customer which were made on account of antecedent debt. The payment must occur while your customer is insolvent and within the 90 days preceding your customer’s filing for bankruptcy. All of these elements must be met by the trustee or no preference case exists. For example, if you receive a “cash on delivery” or “cash in advance” payment during the 90 days preceding your customer’s bankruptcy filing, no preference payment exists. The payment would not be considered “on account of antecedent debt” (i.e. a debt existing before the transfer was made).

If all preference elements appear to be met, you should proceed to the next step in the analysis to determine whether to avail yourself of any of the various statutory “defenses” to a preference claim under 11 USC 547(c). This includes determining whether the payment was made in the ordinary course of business between the parties, 11 USC 547(c)(2), or whether you gave subsequent new value to your customer following the alleged preferential transfer, 11 USC 547(c)(4). For the “ordinary course” defense, you must prove that the debt was incurred in the ordinary course of business between the parties and that the transfer to pay such debt was either (1) made in the ordinary course, or (2) made in accordance with ordinary business terms. You may use your account history, or course of dealing with your customer to prove this defense, or show the transfers were made within industry payment standards. The “subsequent new value” defense allows you to set-off the alleged preferential transfer amount by receiving credit for additional goods shipped to your customer following receipt of preferential payment during the 90 day preference period. Again, good record keeping is essential to prove credit.

Since it is impossible to predict when your customer might file bankruptcy, you can never truly avoid the preference problem. Of course, you should never turn down a payment from your customer out of fear that your customer may soon go bankrupt. The reality is that, despite legitimate concerns, your customer may never go bankrupt or, even if they do, the payment may not happen within the preference period (i.e. during the 90 days preceding the bankruptcy filing). Worst case scenario, even if your customer goes bankrupt and you have received payments during the preference period, good records will help quickly determine which payments are truly preferential and which ones may be protected. A preference action may be brought after the later of: (a) two years after the bankruptcy filing; or (b) one year after the appointment of a trustee. Therefore, retaining account histories and related information for at least four years is best.
Warner’s Automotive Industry Group attorneys regularly assist our supplier clients with financially troubled customer situations, including the defense of preference recovery actions. To learn more, please contact a member of our Automotive Industry Group.

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