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Inside: Payment plan preference exposure under the Bankruptcy Code

A “bird in the hand” might later “clawback” if precautions aren’t taken

The bad news: You have a slow-paying customer who has run up a large amount of debt.

The good news: You negotiated a payment plan, and payments are beginning to arrive.

But, what if that customer files for bankruptcy? You could be left with a general unsecured claim for those old, unpaid invoices and, even more frustrating, you’ll likely be the target of a preference complaint for the payments that you did receive.

Your good news suddenly doesn’t look so good.

Section 547(b) of the Bankruptcy Code allows the debtor or trustee to “avoid” certain transfers made within 90 days preceding the bankruptcy, on the theory that such transfers represent an unfair “preference” of certain creditors over others who did not receive such payments. Fortunately, section 547(c) establishes certain defenses — including for transfers made in the “ordinary course of business.”

Unfortunately, bankruptcy courts tend to reject a creditor’s “ordinary course of business” defense where the “ordinary” payments were made pursuant to a workout agreement or payment plan like the one mentioned above.

For instance, in Bender Shipbuilding & Repair Co. v. Oil Recovery Co. (In re Bender Shipbuilding & Repair Co.), the court held that payments were not “ordinary” where they were consistent with the payment plan, but were nevertheless inconsistent with the parties’ 20-year payment history. In fact, the Bender court took the position that payments made under the plan were the result of unusual debt collection activities — a frequent death knell for the “ordinary course of business” defense.

Similarly, the court in Forklift Liquidating Trust v. Clark-Hurth (In re Forklift LP Corp.) held that payment plan transfers were not “ordinary” where the debtor had never before made consecutive weekly payments in such amounts. In reaching this conclusion, the court also noted that the debtor had never previously entered into a payment plan with this creditor.

But, sometimes even a history of earlier payment plans is insufficient to show that these transfers are “ordinary.”

In Burtch v. Prudential Real Estate & Relocation Services, Inc. (In re AE Liquidation, Inc.), the court held that two payment plans in the parties’ three-year relationship were merely the result of unilateral pressure by the creditor on the debtor to assure future payment — itself evidence that the payments were not made in the “ordinary course.”

What’s a creditor to do? You have several options:

1. Arrange for payment from a third party. One of the requirements of a “preference” is that the transfer involved property in which the debtor had an interest. Thus, if the source of the payment plan funds is a non-debtor third party rather than the debtor, then Section 547 is not triggered.

2. Utilize earmarking. Earmarking is similar to the above, except the payments technically still come from the debtor. Earmarking involves an agreement between the debtor and a non-debtor third party (such as a new lender), by which the third party provides new funds for the specific purpose of paying an existing antecedent debt. The debtor can have no dominion or control over these new funds; the debtor is effectively an intermediary for funds that flow from the third party to the creditor. The transaction must not diminish the bankruptcy estate in any way.

3. Challenge the debtor’s solvency. A debtor’s insolvency is a requirement for a preference, and insolvency is presumed in the 90 days leading up to bankruptcy. But creditors can sometimes overcome the presumption of insolvency. When documenting a payment plan, the creditor could demand copies of current financial statements to confirm whether the customer/debtor is solvent.

4. Pursue assumption of an executory contract. If the creditor has an executory contract (e.g., license agreement, equipment lease) that is assumed by the debtor, it is a complete defense to a preference action. In other words, a debtor or trustee cannot avoid payments that were made pursuant to an executory contract that a debtor assumed or assumed and assigned in bankruptcy.

5. Other defenses. Finally, it is important to remember that the “ordinary course of business” defense is, of course, not the only avenue for defending a preference action. There may be other defenses to assert, even if a court rejects a creditor’s “ordinary course of business” defense under a payment plan. These defenses apply not only to payment plan payments, but also to any additional payments made on account of any new value that may have been provided to the debtor. A separate legal analysis should apply to such payments.

Many creditors focus solely on getting payments in the door — the “bird in the hand.” But, if done incorrectly, those payments may come with the threat of future “clawback.” Accordingly, it is important to understand and prepare for the potential preference exposure that can arise from payment plan arrangements.

Contributing Author

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Kevin G. Schneider

Kevin G. Schneider is a bankruptcy attorney at Neal, Gerber & Eisenberg LLP (Chicago). He assists clients on a range of insolvency matters....

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