Preferential Payments and Their Impact on Your Business

For a roofing contractor, there is perhaps no better feeling than receiving that last payment draw or retainage check at the end of a long project. Issues with the general contractor, concerns over change orders and pesky building inspections seem to disappear along with the check as it slides into the ATM. You breathe another sigh of relief when the check clears and the funds hit your account. You quickly pay your crew and suppliers and cross your fingers that you turned a profit. Just as quickly, you close your file and move onto the next job.

Months or years later, you receive an ominous letter in the mail bearing a green certified sticker. Peeling open the envelope, you find a letter, advising you that the contractor or developer you worked for 10 jobs back has filed bankruptcy. Not your problem, right? You read on and see the bankruptcy trustee is demanding you return the last payments that contractor made to you or risk being sued in federal court. Assuming you even made money on the job, those dollars are long since spent. What now?

This situation is all too real for thousands of roofing contractors around the country. How can a bankruptcy trustee take your hard-earned money or, worse, require you to pay back money on a job where you didn’t even make a profit? It all comes down to Section 547 of the Bankruptcy Code. When a company files for bankruptcy, a trustee is often assigned to administer that company’s assets and liabilities. In certain circumstances, the code allows a bankruptcy trustee to seek return of “Preferential” payments made to creditors within the 90-day period before the date the bankruptcy petition was filed (the “Preferential period”). This is also known as “clawing back”; the bankruptcy trustee is essentially attempting to take back payments made during the Preferential period while the company was insolvent. As unfair as this may seem, bankruptcy trustees in many instances are entitled to pursue these payments and commonly institute federal lawsuits against their claw-back targets

Your Defense

What can the target of a claw back demand do? Fortunately, the code provides several defenses to these actions. For the purpose of this article, I’ll focus on the most common, the “ordinary course of business” defense. In effect, the bankruptcy trustee may not claw back payments made in the ordinary course of business or financial affairs of the debtor (the company in bankruptcy) or made according to business terms (often a written contract). While it seems simple enough, the manner in which the court determines the normal course of business is something all contractors should be aware of.

To determine if a payment was Preferential and can be clawed back, the court may look at whether the parties’ business dealings changed during the Preferential period as compared to before the Preferential period. Here, seemingly innocuous changes in the parties’ behavior can often be all it takes for the court to mark a payment as Preferential and require the creditor to return it to the bankruptcy trustee.

One of the most common scenarios occurs when the debtor (typically the owner or general contractor or whoever owes you the money) makes late payments. For example, consider a situation where the contract between the parties called for payments to be made within 30 days and in fact all pre-Preferential period payments were received within the allowable timeframe. The debtor then begins making late payments, 35 days, 45 days, etc., and shortly thereafter files for bankruptcy. Under this scenario, the court may determine these late payments were made outside the normal course of business and thus you as the creditor would be forced to pay the bankruptcy trustee back for each such payment. However, if you could perhaps show you previously worked on other jobs with this debtor and late payments were not uncommon, you may succeed in defeating the attempted claw back.

Another typical scenario deals with unusual debt-collection efforts by a creditor. In this situation, if the court determines that you as the creditor undertook atypical debt-collection practices (for example, refusing to deliver supplies until payment of outstanding invoices is made), it may consider it evidence that the Preferential period payments made in response to the collection efforts were made outside the ordinary course of business. Once again, if you could show the court that this scenario typically occurred on other jobs with this debtor you may still defeat the claw back.

Protect Yourself

So what can we learn? Claw back situations should be a very real concern for roofing contractors as they often do not manifest themselves until months or years after a particular job or contract was completed. Although there is no fail-safe mechanism to prevent claw back scenarios, roofing contractors can protect themselves in several ways, including continually monitoring the financial condition of those they contract with, requiring payment on delivery of service or materials, keeping detailed records, strictly adhering to the ordinary course of business, and requiring a letter of credit when the entity with whom they contract is utilizing a bank or financier.

About the Author

William Woods
William Woods is an attorney with the law firm of Trent Cotney P.A., Tampa, Fla.

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