ANOTHER FEAR FOR CONTRACTORS: BANKRUPTCY COURTS MAY FORCE YOU TO RETURN MONEY RIGHTFULLY EARNED
Florida contractors are being sued in federal Bankruptcy Court for the return of hard-earned money. How can this happen? Either a “debtor” (the person or company that has filed for bankruptcy protection) or a “trustee” (the person assigned to oversee the bankrupt estate) can file suit against anyone who received payments from the debtor during the 90 days before the bankruptcy filing. Those payments are called “Preferences.” This 90-day period is called the “Preference Period.” The lawsuit to recover the money is called a “Preference Action.” The idea is to prevent the debtor from favoring some creditors (by paying them right before the bankruptcy) over other creditors that do not get paid.
How does this affect contractors?
In the past several years and in overwhelming numbers, developers have been filing for bankruptcy throughout the United States. For example, TOUSA Homes and WCI Communities have each filed for bankruptcy protection. The trustee in the TOUSA bankruptcy case recently filed suit against 1,200 creditors (mostly contractors) to recover Preferences. The trustee in the WCI Communities bankruptcy case has taken similar action. In this way, these bankrupt developers, or the trustees, are trying to take back money from the contractors that helped them build and sell homes – money earned by contractors who did nothing wrong.
If I did nothing wrong, why I am being sued?
Developers filing for bankruptcy only have to show five simple things to win a Preference Action against a contractor: (1) money was paid to the contractor; (2) the money paid was for money that was owed to the contractor; (3) the money was paid during the Preference Period; (4) that the developer was insolvent when the payments were made; and (5) that the contractor was paid more than the contractor would have been paid if it were just an unsecured creditor.
What defenses are available to the contractor?
Several defenses are available to contractors who are sued in Preference Actions. The most commonly used defense is known as the “ordinary course defense.” Under this defense, contractors may argue that all (or some) of the payments that they received during the Preference Period were made in the ordinary course of its relationship with the developer. For example:
Developer filed for bankruptcy on January 28, 2008. This would mean the 90-day Preference Period runs from October 31, 2007 until January 28, 2008. If Contractor A received one $100,000.00 payment (for an invoice 100 days old) from Developer during the Preference Period, then Developer could sue Contractor A for the return of the $100,000.00. If Contractor B received five $20,000.00 payments (for five separate invoices each 30 days old) from the Developer during the Preference Period, then Developer could also sue Contractor B for the return of $100,000.00. Assume that both Contractor A and Contractor B were normally paid (before the Preference Period) 40 days after is submitted an invoice.
Contractor A loses this argument against Developer, but Contractor B wins this argument against Developer. Each contractor wants to show that it received payments under the same payment terms that ordinarily applied between the contractor and the Developer. Here, Contractor A and Contractor B were both normally paid 40 days net invoice. Since Contractor A received the $100,000.00 for an invoice over 100 days old, then that payment did not follow the regular pattern between Contractor A and Developer. On the other hand, even though Contractor B was paid five separate times, because each payment was made for invoices that were 30 days old, Contractor B can prove a full and complete defense against the Developer.
There is an understanding that not all payments are made within the same amount of days following an invoice. Therefore, a Court will normally create a reasonable range that exists between parties. Typically, this range is typically 14 days before and 14 days after the average payment terms. In this case, only Contractor B falls within this range.
What is the Preference Action process like?
First, you are involved in a federal proceeding in bankruptcy court. Different rules and laws apply in bankruptcy court than in state court actions. You will need to find a lawyer approved to practice in bankruptcy court with real experience handling Preference Actions. Second, mediation is normally conducted before any exchange of information occurs. At mediation, your attorney should be prepared to show each invoice and the date of payments for the six to twelve months prior to the bankruptcy filing. Third, the lawsuit is filed in the Court where the debtor has filed its bankruptcy proceeding. In the case of WCI Communities, Florida contractors must defend these Preference Actions in Delaware Bankruptcy Court.
Practical Tips for Preventing and Handling a Preference Action
Frankly, contractors do not have a lot of options. Even if you wanted to prevent being sued in a Preference Action, do you really plan to return a check that you received during a Preference Period just because you MIGHT be sued to return those monies? Not realistic. But, here are some options to consider:
1. Try to Prevent the Claim. In the TOUSA bankruptcy, many people heard rumors that the company would be filing for bankruptcy before the company actually did. That is the time for you to exert your bargaining power. Refuse to do any further work unless you are being paid according to your ordinary business terms. For example, one contractor was regularly paid 20 days after it submitted its invoice. It had been working that way for the prior six to twelve months. When the debtor ordered that contractor to continue doing work (even though there were strong rumors of a bankruptcy filing), this contractor knew that it was safe and could continue doing work as long as it continued to do work on the same payment terms. On the other hand, the debtor ordered another contractor to do work during the Preference Period with the promise that that contractor would be paid for a six-month-old invoice. That contractor should have known that the payment for the six-month-old invoice could be collected later in bankruptcy court as a Preference. Depending upon the circumstances, it is sometimes better to walk away.
2. Know Your Risk. Your risk of being sued in a Preference Action may depend upon your trade. Generally, the debtor (or trustee) pursues the trades that perform work last on a project and paid last. For example, flooring, landscape, and painting contractors are paid after the cement and block contractors.
3. Share Resources. In the TOUSA and WCI bankruptcies, many of the contractors who were sued know each other. There are many similarities among those lawsuits. Legal issues overlap, and court hearings and mediations can be scheduled for the same time. Many contractors have agreed to pool their resources and share the costs and knowledge of a single law firm to defend them.
Bottom line, contractors do not have a magical crystal ball that will show when a developer is about to file for bankruptcy protection. But if you establish and maintain an “ordinary course” of dealing with the developer, if you start planning as soon as you hear rumors of bankruptcy, and if you understand the process, you have a better chance of keeping that money that you earned.
The West Palm Beach law firm of Bruce Loren & Associates specializes in the representation of businesses and management in the construction industry. Adrian Alvarez focuses his practice on issues affecting the construction industry.
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