This is the final part of our three-part series on revenue clawbacks. The scenario: a customer or teaming partner goes bankrupt and then they (or a trustee) demand you return money they already paid you for services or goods duly rendered. In the first entry, we discussed the definition of preferences and the policy purpose of preference actions. In the second, we identified five specific actionable items to take to limit your exposure to them. In this finale to the series, we discuss critical steps that should be taken if you find yourself formally threatened with a preference action.

How the Stage Is Set for an Actual Preference Demand

Once your customer or teaming partner (debtor) declares bankruptcy, a trustee or lawyer for the debtor (trustee) will be appointed to take control of the bankruptcy estate. This estate will include all legal or equitable interests the debtor has in any tangible or intangible assets. It initially will be up to the debtor to list all of these assets and certify that the list is accurate to the best of the debtor’s knowledge. Similarly, the debtor will have to list all actual and potential creditors whether secured or unsecured in its filing. The courts construe the scope of these assets and debts very broadly, and the trustee will move forward to itemize and value debts and assets from which to meet those debts. The trustee’s job is to ensure that creditors are treated fairly and that the debtor has not made preferential payments to particular creditors that might shrink the pot for the rest. Accordingly, one of the first steps the Bankruptcy Code permits the trustee to take is to look at all payments the debtor has made to anyone, whether listed as a creditor or not, in the 90 days preceding the bankruptcy filing. It is presumed under the Code that the debtor was in reality bankrupt 90 days before filing, so the trustee is actually looking to see if the debtor was paying out money to individuals or entities in that time period that should actually be in the estate for the benefit of all creditors (preferential payments). Once the trustee identifies such payments, they will decide whether and how to try and recover those funds.

What to Do when a Trustee’s Preference Demand Arrives at Your Doorstep

If the trustee has identified a payment made to you by a bankrupt customer or teaming partner within the 90-day preference period and seeks to recover these funds, the most likely next step will be a formal written demand letter addressed to you. This letter usually will: point to some of the law we have discussed in this series; state that you appear to have received preferential payments, including the amounts and dates; outline the trustee’s understanding of the circumstances of such payments including what they were for; and make a formal demand that you promptly return such payments or else face a lawsuit in the bankruptcy proceeding. The trustee should also invite you to respond to the letter with any factual or legal defenses that support the notion that all or some of the payments are not in fact recoverable preferential payments.

Now that you are at this stage, here are the most critical first steps you should take (and not take) in response to this demand:

1. Do not ignore, do not panic, and do not automatically pay: it is fair to assume that the trustee has sent this demand letter to every single entity or person who received a payment in the 90-day window. You are not alone. Moreover, the trustee in almost all cases does not want to bring numerous court actions against all these parties. Accordingly, settlement is almost always an option and in fact the most likely outcome. What is critical is that you examine the letter for accuracy and begin developing your response strategy. Ignoring the letter risks unnecessary and costly litigation. Immediately paying deprives you of the opportunity to test the trustee’s facts, explore defenses, and potentially settle the demand for a fraction of the initial amount or even no payment at all.
2. Retain an attorney if possible: it is most advisable to contact counsel immediately upon receiving the letter. Your attorney will guide you through the specifics of the legal issues on the table and what is needed to defend the company. This can often be quite cost effective, with an experienced attorney frequently resolving this through phone calls or short response letters.
3. Conduct an internal review: this is time to take advantage of some of the work you hopefully did in documenting your relationship with your now bankrupt customer or teaming partner. Working with your attorney, collect written correspondence, emails, notes, contracts, invoices, evidence of payments, bank records, and other materials created over the course of the business relationship. With these materials, you will first be able to determine if the trustee got their facts right. For instance, they may have been incorrect in identifying the time payments were made, such as whether they were actually made in the critical 90-day lookback period. You also will be able to assess whether you have any legal defenses.
4. Identify potential defenses: there are a number of statutory defenses to preference actions. With the facts you have gathered, your attorney can assess which if any may apply. Here are the three most common defenses:
   1. Ordinary Course of Dealing: if you can show that the questioned payments were made in the ordinary course of your business with your customer, the payments made to you are not recoverable. Establishing this includes noting records that show you behaved consistently towards the customer, did not act unduly aggressive towards them in collecting late payments, did not make punitive changes to contract or collection terms as they fell into financial distress, and that ideally, you had a long, non-tumultuous relationship. Most companies that establish these facts were in fact surprised when their customer declared bankruptcy.
   2. Contemporaneous Exchange for New Value: if any of the payments made in the 90-day window were made in exchange for goods or services contemporaneously provided, they should not be subject to a clawback. A classic example would be a cash on delivery transaction made within the preference period. There the payment is literally made at the same time the debtor has received new goods or services from you.
   3. Subsequent New Value: in this situation, the debtor has made a payment to you in the 90-day window, and then after that payment, you provide something of new value such as goods and services to the debtor. In other words, you continued to do business with the debtor after a payment was made. The notion here is to encourage people to continue doing business with the debtor, which is something that benefits all creditors by potentially keeping the debtor afloat.
5. Respond to letter and push back on payment: once all records are reviewed and you have evaluated the facts and any legal defenses, you can draft a letter back to the trustee spelling out your position. This letter may state that you have defenses or alternative facts and formally refuse to return any or all of the identified funds. The letter generally should invite a follow-up communication.
6. Negotiate settlement: during subsequent discussions, your lawyer, within your authority, will attempt to resolve the dispute in a manner most financially beneficial to you. In the vast majority of these situations, the matter will be resolved at this stage with a payment meaningfully less than the original demand, or possibly even with the trustee determining that you have a complete defense and owe nothing.
7. Litigate: in the rare circumstance a deal cannot be reached, the trustee will bring a suit against you in the bankruptcy proceeding, and your attorney will litigate it much like claims in ordinary trial courts. Thankfully, this is a rare occurrence.

Conclusion

This series has provided a high-level overview of preference actions. There are numerous additional and more technical issues that arise in clawback disputes that are outside the scope of these three segments. Accordingly, if possible, it is best to seek the advice of experienced counsel to fully protect your interests.