When a company’s customers declare bankruptcy, the company faces significant risk. These risks range from the obvious—for example, nonpayment of past-due invoices—to the not-so-obvious—e.g., preferential and voidable transfer actions. Given that multiple industries, including retail and food service, have been sidelined due to COVID-19, businesses will likely find many of their individual and commercial customers in vulnerable situations for the immediate and intermediate future.
However, there are ways to minimize vulnerability by following a reasonable action plan. First, companies should carefully review their existing contracts with distressed customers in view of the concepts discussed below. Companies may want to renegotiate contracts with distressed customers to include the following (to the extent possible): 1) payment guarantees from third parties; and 2) grants of security in any unsecured assets. Such arrangements may limit credit risk and bankruptcy risk.
The significant concern when dealing with a distressed customer is the potential for a preference claim in bankruptcy. Generally, preference law permits avoidance of any payment made by a debtor to a vendor on account of a preexisting debt within ninety days of filing a bankruptcy petition (the “preference period”). However, a vendor may assert an affirmative defense if:
The payment was made as a contemporaneous exchange for new value;
The debt and payment were incurred and paid in the ordinary course of the debtor’s business; or
The debtor subsequently received new value from the vendor.
A. Companies should make sure they are receiving payment from the entity that purchases the goods.
As a threshold matter, a company cannot avail itself of these defenses unless the company actually receives its payment from the customer to whom it is selling its goods. Many large retailers have multiple subsidiaries and parents, and the source of a customer’s payments may not be the particular entity to whom the company sold the goods.
In those situations, the company may not have provided any value to the entity that actually made the payment. When the company notices that it is receiving payments from an entity different from the entity that purchased the goods, they should document the following points:
The paying entity is making the payments on behalf of the purchasing entity; and
The paying entity is making the payments with funds received from the paying entity.
B. A contemporaneous exchange generally means cash-on-delivery.
Moving to the three preference defenses, the primary example of a “contemporaneous exchange” is cash-on-delivery (“COD”). COD eliminates both credit-risk and preference-risk and is legally the safest way to deal with a distressed customer. Business concerns, however, often make COD impractical.
Considering the possibility of a significant number of retail bankruptcies in the immediate and intermediate future, companies may desire to examine and tighten their credit controls.
If a company switches customers to COD, they should apply customer payments received to the goods sold COD. Internally applying a payment on an old debt will defeat the COD nature of the transaction and eliminate the contemporaneous exchange defense to preference liability.
C. Ordinary course defenses are difficult to prove.
Successfully asserting an ordinary course defense includes two steps. First, the company must show that the debt was incurred pursuant to the parties’ routine operations in a typical, arms-length commercial transaction. Second, the company must establish that the payment was received pursuant to either a course of dealing established by the parties before the preference period or an objective industry standard.
In practice, this means that companies must review their documented payment terms. Customers should be paying their bills within the stated payment terms. Unfortunately, and almost by definition, distressed customers generally take longer and longer to pay their bills. Consequently, a distressed customer will pay its bills significantly later than a financially-sound customer. The significant increase in the length of time between the invoice and the receipt of payment will often doom an ordinary course defense. Companies should diligently monitor their customer payment histories to minimize credit risk.
D. The prototypical new value defense involves new unsecured credit.
Companies may defend against preference avoidance by asserting a subsequent advance of new value if, after the debtor’s payment, the company provided new unsecured credit that remains unpaid. In the Fourth Circuit, the extent of any new value is calculated as the difference between the total preferences and total advances, provided that each advance is used to offset only prior preferences. This is the majority rule with respect to the proper new value defense calculation.
In short, when a company ships goods to a customer after receiving a payment from the customer, the payment is free from preference liability to the extent that the value of the goods shipped equals or exceeds the prior payment. Of course, companies are increasing their credit risk when they continue to ship goods to distressed customers.
E. Other exotic defenses available to companies.
For customers that pose a significant bankruptcy risk, companies may want to consider restructuring their relationships with such customers. A company can reduce its risk through at least two avenues: true consignment sales and critical vendor settlement agreements. That said, these transactions will almost certainly be subject to a trustee challenge, and the transactions must be properly documented to have any chance of withstanding scrutiny. Thus, companies should engage outside counsel before attempting to implement either approach.
Companies also should know that vendors are entitled to a priority administrative expense claim for the value of any goods a debtor receives within twenty days of filing so long as such goods were received in the ordinary course of the debtor’s business. To establish a priority claim, a creditor must show that the goods sold were actually received by the debtor—as in, in the debtor’s possession—within the twenty-day prepetition period.
Note that any value asserted for an administrative claim cannot also be asserted as a new value defense. However, a trustee must show that the creditor received more than it would have otherwise received in a liquidation to prove preference liability. Because administrative claims are paid before general unsecured creditors, amounts owed by the estate pursuant to an administrative claim provide some amount of preference protection.
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