When a major customer gets into financial trouble, its problems become your problems. Knowledge of your rights and early action can help minimize the impact on your business.
Molded Acoustical Products Inc. (MAPI) had been doing business with Fiber Lite for about 18 months before MAPI's insolvency. When MAPI began to show signs of financial problems, Fiber Lite's president pressured MAPI to make larger payments than usual, which it did more than $450,000 during the 90 days prior to MAPI's bankruptcy filing (the crucial period under the Bankruptcy Code). Meanwhile, Fiber Lite shipped MAPI goods in excess of $275,000 in fact, some were still in transit when MAPI filed for bankruptcy.
After MAP1 filed for bankruptcy, it asked Fiber Lite to repay the $450,000 that its president pressured MAP! to make within 90 days prior to the bankruptcy filing. Such payments, MAPI alleged, were voidable "preferences." Fiber Lite refused to repay the money, denying any "preferences." The law voiding preferences tries to prevent favoritism toward particular creditors. ("Preferences" are explained below in more detail.)
Fiber Lite argued that slow and late payments was how business was routinely done in this industry, and, more particularly, it was the accepted way of doing business between MAPI and Fiber Lite. Therefore, Fiber Lite argued, MAPI's payments did not constitute a preference that it should have to give up ("disgorge").
The bankruptcy court agreed with Fiber Lite on part of its argument: It found that the industry norm for payment of bills was about 45 days and that before the bankruptcy filing, MAPI's accepted practice was to pay Fiber Lite in about 58 days. This longer period was not too different from the industry norm, especially in light of an 18-month history of such payment practices. Under such circumstances, these terms constituted "ordinary business terms," an exception to the preference statute.
But, the case went on to rule, Fiber Lite had taken a number of steps just before MAPI's bankruptcy to pressure MAPI to make larger payments-- and this was not business as usual. In addition, during this period MAPI was paying 89-day-old bills, much longer terms than either the general industry norm or the parties' practice. Again, not business as usual, the court ruled.
And so Fiber Lite had to pay back all the money that MAPI paid during the 90-day period prior to MAPI's bankruptcy filing, less the bill for the shipments it made during that period. This bill constituted a permitted setoff for "new value," which it provided to MAPI during this time of financial trouble.
A basic principle of bankruptcy practice is to prevent the "race to the courthouse"--the avoidance of the so-called grab law, where the first creditor to grab cash or assets or to be paid keeps what he can get and the others are left out in the cold. Bankruptcy law looks for a fair division of the debtor's assets among all creditors and will undo many of such grabs.
Let's oversimplify the complex laws of preferences: The Bankruptcy Code says that if the payment you receive from your debtor is made within the 90 days before the bankruptcy filing; if it is on account of an "antecedent" or old debt (it's not a current account paid in the ordinary course of business or in accordance with the ordinary business terms between you and your customer, or a cash sale); and if the debtor is insolvent at the time, then the payment may be a preference that you'll have to pay back.
When you ship goods in exchange for immediate payment, you've engaged in a "substantially contemporaneous exchange," which, like the "ordinary course of business" concept, is an exception to the preference rules. Similarly, if during the 90-day preference period and after you've gotten a payment, you then ship goods on credit to an insolvent customer, you've provided "new value." This is another exception …