Bad news:  A customer who owes you a substantial debt files bankruptcy.

More bad news:  The customer's bankruptcy trustee demands that you return the only payment you received from the customer in recent months.

Let's say a customer files for bankruptcy after paying only Squeaky Wheel.  Is it fair to let Squeaky Wheel keep the payment and to leave other creditors with nothing?  Bankruptcy preference laws say "no" in many circumstances.  These laws permit a bankruptcy trustee to require the return of certain payments on an unsecured debt received from a bankrupt company during the 90-day pre-bankruptcy "preference period."

The intricacies of bankruptcy preference laws are many, but the following tips provide a starting point for assessing and perhaps reducing your bankruptcy preference exposure: 

1. Keep the money.  There is nothing improper about keeping a preferential payment until its return is demanded.  If you believe you've received a preference, keep it (bearing in mind that it eventually may have to be returned). 
2. Avoid credit transactions.  Avoiding credit transactions avoids preference exposure, so consider dealing on a cash-in-advance or cash-and-carry basis if possible.  "Cash" here means cash or cashier's or certified checks.  Transactions involving ordinary checks can be a problem in terms of both credit risk and preference risk because the check might be dishonored.
3. Cash all checks promptly.  The longer you delay in cashing a customer's check, the later it clears the customer's account and the more likely it is that the check will be considered to have been "paid" within 90 days prior to the customer's bankruptcy filing.
4. Consider secured transactions.  Only unsecured transactions give rise to preferences.  Your customer may agree to pledge unencumbered assets or provide other security for the payment for future shipments.
5. Discourage sporadic payment patterns.  You can reduce your preference exposure if you can prompt your customers into a routine of paying your invoices like clockwork.  Preference laws immunize certain "ordinary" payments.  Payments that vary from prior payment patterns are not as likely to be "ordinary."
6. Keep payment records.  Keep payment records and related purchase orders for at least five years to help prove the "ordinariness" of the payments you received.
7. Think twice about extending credit terms that are better or worse than your industry norm.  Bankruptcy laws include an industry standards defense to preference claims.
8. Establish a low credit limit.  The lower your credit limit, the less preference risk you face.  If you establish a credit limit and enforce it strictly, your credit limit should roughly approximate your total bankruptcy exposure.
9. If you need to tighten credit terms, do so definitively.  If you sense trouble from your customer and want to tighten credit, consider tightening it all the way to cash in advance or on delivery.  Any time you modify your credit terms or credit limit, subsequent payments are less likely to be "ordinary," at least for a while.
10. Be aware that "dunning" letters increase exposure.  Use of dunning letters may allow the bankruptcy trustee  to claim that the payment was not "ordinary."  Even "payment reminders" may be problematic. 

Defenses to preference claims range from simple to complex.  If you are named as a defendant in a preference lawsuit, you should consult with a lawyer familiar with these defenses.
 
Few laws have baffled and angered suppliers of goods and services as much as bankruptcy preference laws.  Preference recoveries often seem unfair, especially when the supplier is still owed a substantial debt incurred because the supplier tried to help a customer in difficult times. 

Until the laws are changed – and no change is imminent or likely – suppliers should consider these steps to reduce preference exposure.

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Timothy Hurley is a partner in the Cincinnati office of Taft Stettinius & Hollister.  He co-chairs the firm’s Business Restructuring, Bankruptcy and Creditor Rights Group.