Protecting Your Company Against Revenue Clawbacks: Preference Actions (Part 1 of 3)

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A customer goes bankrupt and then they (or a trustee) demand you return money you were already paid for services or goods duly rendered. In this three-part series, we discuss strategies to protect your company against these revenue “clawbacks,” and how to implement these strategies before and after a customer’s bankruptcy filing. In this blog, we discuss the definition of preferences and the policy purpose of preference actions. In the second, we discuss specific actionable items to take to limit your exposure to them. Finally, we will discuss what to do legally if you are ever enmeshed in a preference action.

It is commonly understood that when a debtor legitimately files for bankruptcy it can often have certain unpaid debts completely or partially discharged or restructured. What is less frequently discussed is the fact that a debtor can even sue to recover payments it already made to a creditor in legitimate business transactions. For government contractors, this could include refunds for payments a prime contractor properly made to a subcontractor for work satisfactorily performed pursuant to a valid subcontract agreement.

While the notion that a customer that paid you for products or services you duly provided can later reach into your company’s bank accounts and clawback significant amounts of money may seem alarming, the Bankruptcy Code clearly provides an avenue for such relief. These are called “preference actions” or “clawbacks.” Companies must always be mindful of them and strategically manage the risk of falling into their grip. Fortunately, there are business practices and ultimately legal defenses available to significantly reduce the risk and protect your coffers.

Preferences Under the Bankruptcy Code

The Bankruptcy Code permits a debtor or a bankruptcy trustee to recover from creditors payments made within the 90-day period before the bankruptcy filing. These payments are known as “preferences,” and the procedure for recovering them is referred to as a “preference” or clawback action.

Clawbacks can have a devastating effect. Revenue that was already deposited, accounted for, and likely spent, including to pay vendors or employees, is now an unexpected item that must be reimbursed promptly and unexpectedly. The amounts can be staggering, and the timing just as bad.

A “preference” is defined by the Bankruptcy Code as:

Payment:

  1. on an “antecedent” debt (e.g., a customer pays you for services you performed before payment);
  2. made while the debtor was insolvent (meaning at the time you were paid, the customer’s assets are less than its liabilities);
  3. to a non-insider creditor, within 90 days of the filing of the bankruptcy;
  4. that allows the creditor to receive more on its claim than it would have, had the payment not been made and the claim paid through the bankruptcy proceeding (meaning that you were paid more during that 90 days than you would have gotten paid through the bankruptcy proceeding).

The Bankruptcy Code allows the debtor, your customer, or a bankruptcy trustee to avoid and recover any preference payments by filing a preference action against you.

The Policy

Clawbacks, however devastating they may be, reflect one of the major policy purposes of bankruptcy—to make sure all creditors are treated fairly. Once a customer declares bankruptcy, there probably will not be enough money to make all creditors whole. So the next best thing, under bankruptcy law and policy\, is to ensure that all creditors are treated equally. Imagine a case where a debtor, just prior to bankruptcy, decides to make payments to a bank that he just believes has been nicer to him instead of his landlord. In such a preference case, the Bankruptcy Code permits a debtor or trustee to recover those funds if it believes they should be in the debtor’s estate and distributed to all creditors fairly.

What’s Next?

In the second part of this series, we discuss business strategies to limit your exposure to clawbacks. In the final part, we will discuss what to do legally if you are ever enmeshed in a preference action.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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