December 1, 2009

I Earned It, I Spent It, Why Can’t I Keep It?


By Doug Cushing and Katie Jeremiah

Winter 2009

Bankruptcies are up 91 percent from this time last year — and so are sleepless nights for contractors.

In this economy, a contractor with work on the horizon is rare. The contractor who has work and can collect the money owed is among the lucky few. However, as fortunate as he may be, a contractor's sleepless nights do not end even when he has cashed the check and spent the money.

The unfortunate truth is that too often, a contractor cannot truly breathe a sigh of relief for at least 90 days — and sometimes as long as a year — after a debt is collected.

The Not-So-Preferred "Preferred Creditor" Status

When a debtor files a Chapter 7 bankruptcy, a trustee is appointed to represent the debtor's creditors as a group. The trustee serves to make certain that the debtor's remaining assets are distributed equitably among the creditors. To support this difficult undertaking, bankruptcy law arms trustees with a powerful weapon known as "preference avoidance." Preference avoidance powers under 11 USC 547 allow a trustee to take back money that contractors have legitimately earned and collected. If a trustee proves that a contractor received an unfair advantage over outside creditors, the contractor must forfeit the payment. That money will then be equitably distributed among similarly situated creditors. In a Chapter 11 reorganization, a successful debtor may or may not chase preferential payments but will often use them as bargaining points in plan negotiation.

But I Cashed the Check and Spent the Money — How Can They Take It Back?

Preference provisions were drafted to eliminate any incentive for creditors to attack a financially unstable debtor. If a creditor knows that a debtor is facing imminent financial demise, its first priority is to collect any outstanding debts. But the lengths to which some creditors are willing to go can create a situation in which other creditors are left with nothing to collect. Moreover, a debtor facing imminent bankruptcy may pay a contractor ahead of other creditors in the interest of salvaging an opportunity to do business in the future. Bankruptcy law voids such "preferred transfers" for the purpose of promoting equity among unsecured creditors. Preference provisions force all creditors to share the debtor's remaining assets on a pro rata basis.

The Path to Preferred Creditor Status

Legislators dressed bankruptcy laws in a heavy coat of armor to prevent creative devices that allow one creditor to collect more money than it would receive from bankruptcy proceedings. As a countermeasure, bankruptcy trustees critically evaluate all transfers of money or property that were made in the 90 days preceding the bankruptcy filing. If the contractor is an "insider" — a relative or someone with a business, professional, or personal relationship with the debtor — this period is extended from 90 days to one year.

Avoiding Preferred Creditor Status

Although there is often no way of avoiding preferred creditor status, there are a few steps that contractors may take to protect themselves from forfeiting payment.

First, if the transfer is in the form of a check, deposit the check immediately. The timing of the transfer depends on the date the check was honored, not when it was presented to the contractor. If a contractor waits too long to cash the check and the check is not honored until a date that is within the 90-day window, it is subject to forfeiture.

Second, a subcontractor with knowledge of a general contractor's financial instability should insist on payment by joint check. A joint check allows one party (a project owner) to pay a balance due by writing a check issued to two or more payees (general contractor and subcontractor). A joint check may also increase the odds that a subcontractor will be paid when it contracts with a financially unstable general contractor.

If the general contractor files for bankruptcy, there is a slight risk that a bankruptcy trustee will avoid the joint-check transfer. Even though the transfer is ultimately made by a third party to a contractor, if it passes through the insolvent general contractor, it may be subject to forfeiture, especially if the parties sign the joint payee agreement and endorse the joint check at the same time and both within the preference period. But courts will often find that the general contractor never had control of the money and therefore could not have executed a preferred transfer through the joint check.

Finally, the best way to prevent forfeiture of a transfer is to keep accounts current. One of the most common and successful defenses to a preference action is to prove that the transfer was made in the ordinary course of business. This can be shown as the "ordinary course" of either the debtor or contractor, so a contractor's own general collection practices may be called into question. Although each situation is unique, a contractor should be extremely cautious if he is being paid for a debt that has been outstanding for an extended time. Such transfers create red flags for bankruptcy trustees, as they appear to give the contractor an unfair advantage over outside creditors. The obvious best practice is to not let receivables go unpaid for too long and to secure lien rights immediately. Bankruptcy time limits are short. Do not delay if you receive a demand letter to repay a preference. Contact the trustee or your attorney promptly.

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