April 24, 2014

Dealing With a Cash-Strapped Business

One of the first lessons a child is taught is that you can't take things that belong to someone else. This lesson is pretty straightforward - no matter how severe the tantrum, you can't take the other kid's toy.

But every adult knows that things in our world are a bit more complicated.

Anyone who has paid taxes knows that, like it or not, other people sometimes get to take what you have earned.

Another, perhaps less well-known example of this phenomenon occurs every day in the bankruptcy courts, through "preference" actions. During the recent economic downturn, it has become more important than ever for businesses to know how to protect themselves against preference liability.

Preferences and the ordinary course defense

If one of your debtor companies made payments to you during the 90 days before it filed for bankruptcy, then the trustee in charge of running the bankruptcy estate may be able to recover those payments as "preferences."

The Bankruptcy Code allows the trustee to recover these funds in order to level the playing field among creditors, thus preventing a bankrupt debtor from favoring - or "preferring" - one creditor over others on the eve of a bankruptcy filing.

However, the Bankruptcy Code also provides defenses for creditors who received these "preferential" payments.

The "ordinary course of business" defense is a key defense against a trustee attempting to take back a preferential payment. In order to encourage creditors to continue dealing with troubled companies, thus ideally sparing those companies a trip to the Bankruptcy Court, the Code says that a trustee cannot recover payments made by the debtor in the ordinary course of business.

There are two ways this can work.

Under the "objective test," you can show that the payment was made in the ordinary course of business in that particulary industry. Or, under the "subjective test," you can show that the payment was made in the ordinary course of business between you and that particular debtor.

In either case, showing that the payment was made in the ordinary course of business will prevent the trustee from being able to reclaim it as a preference.

When considering the "subjective" version of the defense, there are a number of items business should be aware of when receiving payments from financially troubled companies. Being aware of these issues and addressing problems early will help to ensure that the payments you receive are not later taken back as preference.

© 2014 Varnum LLP

About the Author

David M. Moss, Varnum Law Firm, Litigation Attorney

David is a litigation and trial law attorney who is currently focusing his practice on commercial litigation.


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