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In difficult economic times, companies must worry about the financial condition of their customers. The classic problem is simply delivering products or services to a customer who does not pay. But if your customer goes bankrupt, it can get even worse— you can be required to pay back to the bankruptcy trustee payments previously received from the customer.

That is the bad news. The good news is that you can protect your company and reduce the risk of having to return payments to bankrupt customers.

Payments that a bankruptcy trustee can reclaim are called “preference payments.” Only certain payments by a bankrupt customer are preference payments. To be a preference payment, the payment generally must be: made to a creditor; on account of a pre-existing debt; while the customer was insolvent; within 90 days before the bankruptcy filing; and enabled the creditor to receive more than it would have through the normal bankruptcy process.

What happens?

A preference claim is the claim that the bankruptcy trustee files against your company, claiming that you have received a preference payment that you must pay back. If the claim is valid, then your

company must return the payment to your bankrupt customer. The amount that you pay back will be used, together with any other assets that the customer has, to satisfy all of the customer’s outstanding debts. Your company will have a bankruptcy claim against your customer for the amount you paid back. You may recover some of that amount in the bankruptcy proceedings, but you will typically get only a fraction of the amount, if anything.

What do you do if a preference claim is filed against you?

If a preference claim is made against you by a bankruptcy trustee, that certainly does not mean that the claim is valid. You need to contact an attorney familiar with preference claims. That attorney can determine whether or not the payment in question is a preference claim and advise you of what you need to do to respond. If you do not respond in a timely manner to a preference claim, you can lose your ability to contest the claim—which means that trustee can obtain a judgment against you for the amount of the payment even if it really was not a preference payment. Because of this, you should contact an experienced bankruptcy attorney if you are contacted about a preference payment, even if the trustee merely sends you a letter rather than filing a formal claim.

How do I avoid this?

Probably the two most effective strategies for protecting yourself against preference claims are switching payment to cash-before- delivery and ensuring that you receive payments from customers

in the “ordinary course of business.” With cash-before-delivery transactions, goods or services are paid for before they are shipped or provided. Because payment occurs prior to performance, the payment is not “on account of a pre-existing debt,” which is one of the requirements for a preference payment. Obviously, you may find it impossible to get cash-before-delivery terms except in unusual circumstances. The more readily available defense therefore is the “ordinary course of business” defense. That defense is available when the payment at issue was made in the ordinary course of business between you and your customer or in accordance with ordinary business terms. This means that if no unusual circumstances accompanied the payment – such as a change in credit terms or unusual pressure from the creditor – the payment likely would not be subject to a valid preference claim. The cleanest situation is when you and your customer have agreed on payment terms in writing, and you can show that all of the payments that you have received from the customer were made in accordance with those terms. Changing payment terms, formally or in practice, when a customer is in difficult circumstances can make it more difficult to use this defense.