For design professionals who run their own business, it is never a good feeling to find out a client has filed for bankruptcy. In many cases, there are warning signs—slow payments, missed payments, or nonpayment—so when you receive the ultimate news, it may not come as a surprise. However, what may come as a surprise is when a customer files bankruptcy, your design or specifications firm may not only lose out on any unpaid debt, but also be forced to return money already received.
Being subjected to returning monies received in a bankruptcy action is a called a ‘preference action.’ To understand if you or your firm could one day face such a situation, it is helpful to examine a fictional, yet typical, example of what it looks like, what defenses exist, and how it can be avoided entirely with certain proactive steps. (Any similarities to any actual person or entity is completely unintentional and coincidental.)
Henry, the operations manager of an architectural firm is reviewing accounts payable. He notices one of his larger clients, GZD, a fast-food franchisee, who used to pay invoices within two weeks, has now been paying between 20 and 60 days. GZD also has an outstanding balance of $20,000.
Henry talks to the managing member of GZD and discovers the company has been barely holding on for the last few years and has actually been insolvent for months. After emptying his own individual retirement account (IRA) and exhausting his company’s credit, the owner has decided to put the company in Chapter 7 bankruptcy. He tells Henry he is sorry—he won’t be able to pay the balance owed. After the bankruptcy is closed, he further states, Henry will not be able to collect anything from the company’s assets.
A month after the bankruptcy is filed, Henry receives a letter from an attorney who works for the Chapter 7 bankruptcy trustee for GZD’s case. He opens it in the hopes there might be news a portion of the $20,000 is forthcoming. Instead, he is informed that not only will he not be getting paid, but his company also has to give back $15,000 within 10 days or be subject to a lawsuit in bankruptcy court. Henry and the firm’s managers are outraged.
This is a classic example of what is known as a preference action. Under Section 547 of the United States Bankruptcy Code, a creditor can be sued for payments received in the 90 days prior to a debtor’s bankruptcy filing. The payment must also be for the benefit of a creditor, for a pre-existing debt owed by the debtor, and made while the debtor was insolvent, among other elements.
Fortunately for creditors, the Bankruptcy Code offers relief when certain criteria are met. For example, it exempts certain debtor payments made within the ordinary course of business or on a collect-on-delivery (COD) basis, where new value was given by the creditor, where a security interest is created, or those totaling under a statutory minimum dollar amount.
In Henry’s case, where the payments were made while GZD was insolvent, in the 90 days before bankruptcy, and outside the ordinary course of business, his firm is dangerously exposed to liability.
What can be done to limit a company’s exposure to a preference action? When one sees warning signs from a customer, it is critical to be proactive and take the following actions:
- Check your documentation (e.g. contracts, security agreements, and lien perfection). If your debt is properly secured, it is generally safe from preference actions.
- Ship or perform services only after payment is received.
- Don’t provide services more than for payment received.
- Be stringent in collection efforts. Payments made within terms are generally safe from collection actions.
- Switch to COD.
- Get deposits, collateral, or some other type of security, and hope the distressed customer lasts 90 days before filing.
- Request to see financial statements before extending more credit. Look at cash flow, including accounts payable, looking for red flags.
- Those with substantial control should demand the customer hire an approved business advisor to look at its processes and procedures to see whether improvements can be made before extending more credit.
- Generally, credit applications should require personal guaranties from the owner and his or her spouse. It should also include the right to review financial statements.
Had Henry taken these steps, his company might have avoided the situation entirely. They will now have to consult with their attorney to determine if they have a preference defense under the Bankruptcy Code.
Brant Feltner is a member of the Bankruptcy and Creditors’ Rights Team Practice Group at Danna McKitrick PC. He represents business clients with matters related to out-of-court work-outs, bankruptcies (on behalf of both creditors and debtors) and other general commercial litigation. Feltner has previous experience as a financial and budget analyst with a national manufacturer in St. Louis and as a budget analyst with a major nonprofit organization in Chicago. He can be reached at email@example.com.