This is part two of our three-part series on revenue clawbacks. Once again, the scenario: 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 for protecting your company against these revenue “clawbacks” and how to implement these strategies before and after a customer’s or teaming partner’s bankruptcy filing. In part one, we discussed the definition of preferences and the policy purpose of preference actions. In this part, we discuss five specific actionable items to take to limit your exposure to them.

Now that we know a debtor can sue to recover payments it already made to a creditor in legitimate business transactions, the next step is to set up formidable business practices to avoid this scenario before a customer goes bankrupt. Bankruptcies and financial distress for companies of all sizes are increasing due to the COVID-19 pandemic, and as a matter of prudence, it is always critical that you securely structure your financial arrangements, make observations of your customers’ and teaming partners’ financial condition, and assess your billing and collections practices with regard to each.

Preference Actions

The Bankruptcy Code permits a debtor or a bankruptcy trustee to recover payments to creditors made within the 90-day period before a bankruptcy filing. These payments are known as “preferences,” and the procedure for recovering them is referred to as a “preference” or clawback action. It is crucial to remember that this is not meant to be punitive. The goal is to make sure that all legitimate creditors share in all funds that are available for distribution by identifying and recovering payments made to certain creditors that are deemed unfair preferential payments. The court is primarily trying to avoid rewarding or inciting highly aggressive creditors who might take untoward actions to extract the last bit of funding a debtor has. The court is also trying to avoid allowing a debtor to play favorites by paying creditors with whom it has a cozy relationship, only to subsequently declare bankruptcy to the detriment of the rest.

Five Steps to Mitigate or Eliminate Preference Actions Before They Arise

In general, the risk of a clawback increases if you ignore clear signs that a customer is in financial distress, significantly change billing and collection policies and practices over time, or act in a manner that a bankruptcy court could find excessively aggressive to increase the pressure on a customer to seek relief through bankruptcy. Fortunately, a few simple prophylactic business practices can pay significant dividends in the event of a later bankruptcy. Here are our top five:

1. Keep tabs on a customer’s or teaming partner’s financial condition: while creditworthiness might be assessed before entering into a new customer or teaming relationship, it is not always the case that follow-up observations are routinely made. Such observations may be made formally or informally. As an example, your employees may read media stories, hear rumors from their colleagues or the grapevine, or become aware of actions such as layoffs, each of which may indicate a customer or teaming partner is heading toward financial peril. This may be true even if the customer or teaming partner continues to pay invoices within a reasonable time. It is important that such observations are noted because courts do not look favorably on creditors that have reasons to foresee financial distress but nonetheless continue to extend credit to further indebt future bankrupt entities.
2. Maintain a consistent course of business: once you have established the financial and operational terms of your relationship with a customer, stick to it. If your customer or teaming partner is paying on the same schedule (even if consistently late by a couple of weeks), you are fulfilling your orders consistently, and you are issuing similar and reasonable demands where payments are late, you may have defenses that payments you received throughout the course of the relationship were made in the ordinary course of your business relationship. In other words, it can be a difference maker if the record shows that you acted consistently, in good faith, and never attempted to game the relationship to gain a preference relative to other creditors.
3. Avoid punitive collection activities: while you certainly are entitled to pursue customers who are unduly late, make sure that such pursuits are consistent with the terms of the contract and do not appear overly aggressive. Courts generally are more likely to clawback payments where creditors have abruptly changed payment terms midstream (such as refusing to deliver goods unless payments are made up front, shifting key personnel off projects, etc.), or have acted more like stereotypical debt collectors (e.g., constant threating phone calls, letters and e-mails, and even in-person collection attempts). If a customer breaches the terms of a contract, it is perfectly fair to demand compliance and ultimately pursue termination of the contract. However, using strong-arm tactics that extract funds as a customer nears bankruptcy will likely entice a court to demand return of those funds for the benefit of all creditors.
4. Consider letters of credit: while not always practical, requiring a third-party letter of credit from a bank to cover customers’ or teaming partners’ invoices due to you specifically can add significant protection against preference actions. This is so because the payment will then be remitted from the assets of the financial institution or entity issuing the credit line as opposed to those of the customer itself. As such, courts are more likely to view those payments as outside of the scope of a customer to creditor preferential payment action.
5. Document, document, and document some more: lastly, and most importantly, document the above in customer files and keep those files updated. This will be invaluable in the event you are in the unfortunate position of having to defend against a preference action. There is nothing better than proof in a lawsuit, and you and your attorneys will have an immeasurable advantage with that information at your fingertips.

What’s Next?

In the third and final part of this series, we will discuss what to do tactically and legally if you are ever enmeshed in a preference action.