While a number of common defenses are available to help protect creditors who are involved in a preference lawsuit, many companies find it a wise business practice to limit their risk of exposure to preference litigation as much as possible in the first place. The following strategies can help creditors reduce their risk of incurring preference claims, and hold on to their rightfully owed payments.
Use cash transactions.
A creditor can avoid credit exposure by eschewing credit transactions and ensuring all dealings with the debtor are conducted on cash-only terms. “Cash” may also include cashier’s or certified checks. In addition, creditors should be aware that ordinary checks may not constitute a cash transaction.
Do not delay in depositing checks.
For creditors who accept ordinary checks from debtors, good business practice is to deposit such checks as soon as possible after receiving them. Creditors must remember that payments received from a debtor in the 90 days prior to the filing of a bankruptcy petition may be subject to a later preference claim. When determining whether or not a payment falls within this 90-day preference period, courts do not look at the date that a check was issued, but rather at the date on which the check cleared the debtor’s account. Therefore, the longer a check is held before cashing, the greater the risk that it may fall within the preference period if the debtor later files for bankruptcy.
Consider secured transactions.
Only unsecured transactions are subject to preference claims; no secured transaction is considered to be a preferential transfer. If possible, depending on the relationship with the debtor and the nature of the business, creditors may wish to establish a security interest in any goods or services provided to a customer.
Businesses in some industries, such as raw material suppliers or subcontractors, are permitted to establish liens against a debtor to enforce payment. For creditors who have this option, creating such liens wherever possible can be a very effective method of decreasing preference claim risk. Creditors who choose this method should be careful to consult the appropriate laws in the state or states in which they do business, as the specifics of creating a lien vary in different jurisdictions.
Avoid non-ordinary transactions.
In preference litigation, the most common defense, and often the most effective one, is the “ordinary course of business” defense. Transactions are not considered preferential or avoidable if they arise out of the creditor’s ordinary business dealings with the debtor. Such transactions may include recurring credit transactions made on a consistent basis. Where possible, creditors should avoid any behavior or activities that could be considered “non-ordinary”: examples of such behavior can range from simply changing payments terms to making threats of litigation or sending multiple dunning letters in an attempt to collect payment. Creditors should also keep debtors on an ordinary payment history, if at all possible; a sporadic payment history is more likely to be viewed by a court as evidence of a preferential payment. To accomplish this, creditors may find it helpful to check with other businesses to determine what customer payment terms are considered to be ordinary within their industry.
Keep clear records.
One of the biggest challenges for creditors in preference litigation is that the burden of proof of preferential payment does not rest with the debtor; rather, the creditor is required to prove that payments received from a debtor are not preferential. To establish an effective defense against preference claims, it is therefore essential that a creditor be able to show clear and up-to-date records outlining the prior dealings between the creditor and the debtor. Items such as a current account ledger, correspondence with the debtor, and copies of cancelled checks can all be key pieces of evidence, whether used at informal negotiations or during trial.
Use pre-litigation time wisely.
Before filing a preference lawsuit, a debtor will typically demand repayment of alleged preference payments via a letter to each of the creditors in question. Creditors wishing to contest a preference claim should seek legal counsel promptly after receiving this demand. If action is taken quickly, it may be possible for creditors to either convince the debtor not to proceed with the lawsuit, or to negotiate a settlement before the suit is filed. Either of these options will help save creditors significant time and money by avoiding the numerous filings and other proceedings that would be required if the case were to enter litigation.