You performed professional quality construction work, billed the general contractor and got paid. Done deal. Now, three years later you get a letter from some attorney demanding that you return the funds! Are they insane? This is a horrible threat that you cannot avoid.
- Spiffy Construction, Inc. was a subcontractor on an unbonded project. They billed their client “Gigantic General Construction” for work completed: $262,800.
- The invoice was reviewed and approved. Gigantic sends Spiffy a check for $262,800. Awesome!
- Spiffy deposits the check. All the funds are used to pay bills and upgrade equipment.
- The next monthly requisition is held up and eventually never paid. Gigantic then declares bankruptcy.
- After incurring legal expenses, Spiffy is ultimately forced to write off this receivable. It has a severe impact on the company – but they manage to survive.
- Three years later Spiffy receives a letter from an attorney demanding that they return the last payment. The attorney says failure to return the funds can result in a “preferential lawsuit.” What the heck is going on?!
This is not an imaginary scenario. It is based on true facts. This happens all the time and can be very bad for the defendant (Spiffy aka the creditor.)
What is a Preferential Payment?
When a business declares bankruptcy, the court reviews payments made to creditors of the company in the period immediately preceding the bankruptcy to determine if any were (in the court’s opinion) inappropriate. They want to determine if any creditors were given extra favorable “preferential” treatment at the expense of others.
In our example, Spiffy was paid less than 90 days prior to the BK declaration, so the trustee is attempting to claw back the funds to be distributed as THEY see fit. Keep in mind, everything that happened prior to the demand letter was normal and legal. Spiffy did the work, billed the GC and got paid. Period, end of story. However, it’s not be the end of the story…
The trustee will attempt to prove that the payment received was more than would have been allowed if made through the bankruptcy proceedings. That’s bad because Spiffy collected the full amount they were owned, but in a BK, creditors are typically paid less than 100%.
Spiffy is now forced to pay a second round of legal fees to defend this claim. If they lose, they may be required to return the last payment they received. Add this to the final payment they never received and had to write off. This situation keeps getting worse.
What are some remedies available to companies caught in this untenable position?
Examples of Defenses to a Preferential Payment Claim
- Substantially Contemporaneous Exchange – this means the payment and delivery of product or services happened at the same time, such as a COD payment. A payment by check may also be included in this category if it cleared promptly.
- New Value – If a $100 account receivable was collected during the preference period, then an additional $75 AR was billed but not received, the preference amount could be claimed to be only $25, not $100.
- Floating Lien – This is a creditors security interest in present or acquired assets such as accounts receivable. The creditor would need to show that their collateral position has not improved during the preference period.
- De Minimus – Means debts that are too small to include in the BK analysis.
- Ordinary Course of Business – There is a history of accounts receivable showing invoices and payments with that debtor / client. The amount owed was in line with prior transactions.
The last example, “Ordinary Course of Business” may be the most natural response for Spiffy Construction and other contractors. However, in order to raise this defense, the creditor must have appropriate records. Copies of contracts, invoices, AR schedules and bank statements are critical documents. Good record keeping is needed with an efficient means of storing and retrieving the data, in this case three years after the original transaction. Without it, defendants like Spiffy have little chance of defending such claims.
Sometimes you do the right thing, but you get screwed anyway. At least now you know about the danger, protective actions you can take and potential legal defenses.
Reminder: We are not attorneys and are not intending to give legal advice. For that, call your ATTORNEY. For a bond, call us! 856-304-7348
KIS Surety is the national contract bond underwriting department for Great Midwest Insurance Company, a national, corporate surety with an A-8 rating. We throw all this underwriting talent at your bond opportunities and support contracts up to $10,000,000.
If you have a contract surety case that needs a fast, creative response, call us: 856-304-7348
(Don’t miss our next exciting article. Click the “Follow” button at the top right.)