Under Pressure: What Vendors Need to Know About Payment Pressure and its Potential Impact on Preference Liability

Vendors know too well the warning signs of a customer in distress: slower customer payments, delayed shipments, distress in financial reporting, and rumors that the customer is experiencing financial difficulty and may be headed for bankruptcy. Naturally, under these circumstances, a vendor’s priorities shift to ensuring payment of outstanding balances and decreasing future financial exposure. However, where the customer’s future involves bankruptcy, vendors should be aware of one countervailing concern: the potential for being sued for a “preference” after the bankruptcy case is filed. As it turns out, the efforts a creditor undertakes to mitigate its credit exposure in the days, weeks, and months prior to a bankruptcy filing may actually increase a creditor’s eventual preference exposure.

Section 547 of the Bankruptcy Code permits a trustee or debtor-in-possession to avoid and recover from creditors’ payments made within the 90-day period before the bankruptcy filing (the “preference period”). A “preference” is defined by Section 547 of the Bankruptcy Code as payment: (1) on an “antecedent” (meaning a previously incurred – e.g., on account of credit terms) debt; (2) made while the debtor was insolvent; (3) within 90 days of the filing of the bankruptcy (or one year if the creditor is an insider); (4) that allows the creditor to receive more on account of its claim than it would have received had the payment not been made and had the claim been paid through a hypothetical liquidating bankruptcy proceeding. The preference statute is designed to dissuade the debtor and its creditors from engaging in unusual payment practices or collection activities that may result in certain “preferred” creditors being paid at the expense of others.