Avoiding a bankruptcy clawback: shield your business payments

A business owner learns that one of her customers has filed for bankruptcy. She rushes to check her books and breathes a sigh of relief after seeing that the customer paid all of their outstanding invoices just days before going bankrupt. Unbeknownst to the business owner, those payments may have to be paid back to the bankruptcy estate as a clawback.

Clayton Ketter

Clayton D. Ketter is a Director and a litigator whose practice involves a wide range of business litigation in both federal and state court, including extensive experience in financial restructurings and bankruptcy matters.

One of the principal policies underlying bankruptcy law is fairness to creditors, which attempts to ensure that similarly situated creditors are treated equally. To promote this goal, creditors in a bankruptcy are placed into classes, with members of each class sharing proportionally in distributions of a bankrupt debtor’s assets.

This policy can be hampered when a debtor pays a preferred creditor immediately before a bankruptcy, to the detriment of other creditors. To ensure that a debtor’s limited money does not disappear to creditors favored by the debtor, the Bankruptcy Code allows a bankruptcy trustee to claw back such payments.

A payment is considered a preference if it meets five criteria: It is made to a creditor; for a debt owed prior to the payment being made; while the debtor was insolvent; during either 90 days before the bankruptcy filing for ordinary creditors or one year for insiders of the debtor; which allowed the creditor to receive more than it would have received in distributions from the bankruptcy estate.

If a payment is a preference, it must be paid back to the trustee unless a valid defense can be established.

Several defenses are available to creditors, including for substantially contemporaneous exchanges. Typically, point-of-sale transactions and those that involve cash on delivery will meet this defense. Another common defense exists for payments made in the ordinary course of business, which analyzes the typical transactions between the parties and in the relevant industry. If it is common for a debtor to pay invoices within 60 days of delivery, for example, those payments may meet the ordinary course defense.

Businesses can take steps to shield payments received from financially troubled customers from being subject to bankruptcy clawback or preference liability. The most effective means is to require prepayment, COD, or point-of-sale transactions only. Businesses can also strategically apply payments to invoices in a manner designed to fit within preference defenses.

To recover a preference, the bankruptcy trustee must commence a lawsuit within the bankruptcy case, typically preceded by a demand letter. Any business that receives such a letter should consult with bankruptcy counsel to determine whether they have valid defenses to the claim. Consulting with a bankruptcy attorney is also advisable prior to entering into sizable business transactions with a financially troubled company to attempt to eliminate preference risk. Doing so can help reduce the risk that a business gets embroiled in a bankruptcy, and worse, has to repay money that it was owed due to bankruptcy clawback.

Gavel to Gavel appears in The Journal Record. This column was originally published in The Journal Record on September 13, 2018.

By Phillips Murrah Director Clayton D. Ketter

Clayton D. Ketter is a litigation attorney at Phillips Murrah P.C. who specializes in financial restructuring.

What are involuntary bankruptcies?

Gavel to Gavel appears in The Journal Record. This column was originally published in The Journal Record on May 12, 2016.

Clayton D. Ketter is a Director and a litigator whose practice involves a wide range of business litigation in both federal and state court, including extensive experience in financial restructurings and bankruptcy matters.

By Phillips Murrah Director Clayton D. Ketter

Bankruptcies are on the rise. Expectations are that, unless oil and gas prices reverse course, related bankruptcy filings will continue.

The majority of these filings will be commenced by a debtor seeking shelter from creditors, known as voluntary filings. Used much less frequently are involuntary filings, where one or more creditors initiate a bankruptcy case without a debtor’s consent.

Two requirements must be met to force a debtor into an involuntary bankruptcy. One pertains to the number of creditors involved. Debtors with less than 12 creditors require only one creditor holding at least $15,325 in aggregate unsecured claims to file the petition to start an involuntary case. Debtors with 12 or more creditors require a petitioning group of three or more creditors holding the same amount. The second requirement is that the debtor is generally not paying its debts as they become due. When these requirements are met, an individual or business (farmers are the exception), can be compelled into bankruptcy.

Involuntary bankruptcies can be used strategically by creditors in certain situations. The most common is to initiate creditor protections afforded by the Bankruptcy Code, which apply equally whether a case is voluntary or involuntary. Creditor protections include stopping a debtor from paying select debts to the detriment of other creditors, and allowing preferential and fraudulent transfers, made pre-bankruptcy, to be reversed in certain situations. The ability to potentially remove incompetent or bad-acting management is another compelling creditor protection.

Another motive is control of venue. Bankruptcy law permits a proceeding to be commenced in various jurisdictions, including an entity’s state of formation. Thus, a corporation incorporated in Delaware may file bankruptcy there, even if its headquarters, operations and creditors are in Oklahoma. Such filings can increase costs for other interested parties located in Oklahoma. To prevent such a filing, a creditor may wish to commence an involuntary case in its preferred jurisdiction.

While involuntary bankruptcy can be an effective tool for a creditor, it is not without costs and risks. A debtor can challenge by arguing that the debts of the creditor are not valid or that the debtor has been paying on time. Resolution of these issues can require expensive litigation. These potential costs should be carefully considered when strategizing on whether an involuntary bankruptcy may be advisable.