Preferences Are “In the Eyes of the Beholder”
by Douglas G. Fox, Bosch Rexroth Corporation, Lehigh Valley, Pa.
One of the problems facing trade credit managers is that efforts to help a troubled debtor may backfire later due to preference issues. This is often the case where the sale is taking place on unsecured terms, as does the majority of commerce in America.
Generally speaking, when a debtor stops making payments on time, most trade credit managers known to the author place the debtor on shipping hold. The concept is fairly simple. If the debtor is unable to pay its bills on time at a certain dollar level, why incur greater cost (and thereby become an unwilling source of often free working capital) and increased risk of financial loss (possible bankruptcy) at a higher level of credit extended?
Despite this general concept, circumstances often arise where a trade creditor’s products and/or services are of such crucial importance to the successful operation of the debtor’s business that the debtor may fail if the flow of supply is interrupted or terminated.
For example, this dilemma may occur with specialized and/or technical equipment (or services) where the trade creditor’s product (or services provided) is an integral part of the debtor’s sales. In the event that the trade creditor terminates shipments, the debtor will eventually get to the point where it ceases being able to sell its products or provide its services.
Although in this era of global competition there are usually alternative sources of supply, sometimes other considerations (such as time, delivery, price and quality) prevail. The result is that the debtor finds itself in dire straits, often on short notice. Further, other sources may not be willing to extend trade credit due to the debtor’s deteriorating payment record as reported by credit agencies.
Trade creditors often try to “work with” the debtor during these difficult financial times. However, doing so may create greater risk. By the time the severity of the problem is realized by the trade creditor, the debtor’s payments are usually beyond the ordinary course of business (with the result being that the creditor has already lost that preference defense).
With money in short supply, the debtor may not be able to exchange payment for product (or services), nor pay on a cash-in-advance basis. The trade creditor is placed in the difficult position of continuing to ship products (or provide services), thereby increasing the credit exposure (and risk of loss)—or stop shipments (and/or stop proving services), possibly causing the debtor to fail! Frequently, it is a “no win situation!”
In the event that the debtor fails, the trade creditor may find itself being asked to repay funds back into the estate. If so, the trade creditor must consider spending additional funds trying to defend itself against the preference action—with little or no ability to estimate the cost of the defense, nor chance of success. Also, to add insult to injury, the burden of proof is on the trade creditor!
Clearly this is an un-level playing field! Trade creditors should not be penalized for trying to help the debtor survive. Perhaps the best way to do so would be to eliminate as preferences any payments to unsecured trade creditors (absent evidence of fraud or abuse).
Is this an equitable solution? Well, as attorneys are fond of saying, “that depends.” “Beauty is in the eyes of the beholder,” and so are preferences! (Extending trade credit is, too.)
Doug Fox, Co-Chair of the Unsecured Trade Creditors Committee, has more than 25 years of trade credit management experience.