Is a credit memo to your bankrupt customer a preference? (Credit Column).(Column)

Managing deductions and charge-backs can be time consuming for a credit professional. Credit memos can also be involved, especially in an active trade relationship with a distributor. But how are credit memos treated when your customer files for bankruptcy? Can the credit memo you issue later be deemed a preference? Suppose you assist in the negotiation of a distributor agreement with a key distributor. Under the distribution agreement, you invoice the customer for the product sold. Throughout the trade relationship, you issue credit memos to the customer, which allows for the customer to reduce invoices by specific amounts based on a portion of the customer's qualifying advertising expenditures. However, the customer runs into financial difficulty and files Chapter 11. Two years later, you receive a preference demand for payments you received during the 90 days prior to the bankruptcy filing. The preference demand also seeks to recapture the value of the credit memos. Are the credit memos preferential? What are your defenses?

A bankruptcy court (1) recently considered whether a vendor must disgorge credit memos as a preference. The court ruled that a credit memo is not considered a preference. The court's ruling and its meaning to vendors is considered below.

The Trade Relationship

The vendor manufactured computer monitors, and the debtor had been a long-term distributor of the vendor's products. The vendor and the debtor entered into a distribution agreement prepared by the vendor. Throughout the trade relationship, the vendor issued credit memos to the distributor, which allowed for the distributor to reduce invoices by amounts based on the portion of the distributor's advertising of vendor's products. Under the distribution agreement, the distributor earned advertising claims, where the claims were awarded credits that could be deducted against the invoices. As with a typical vendor agreement, the customer here would submit an advertising claim to the vendor, and upon review of the documentation, the vendor would issue credits to the customer.

The debtor filed Chapter 11 .The debtor sued the vendor to recover payments within 90 days of the bankruptcy filing, as well as the recovery of the cash value of credit memos as preferences and preferential setoffs.

The Preference Action

The Bankruptcy Code vests the debtor (or trustee if one is appointed) with far-reaching powers to avoid transfers of assets and monetary transactions prior to a bankruptcy filing. The power to avoid preferential transfers is one of the most powerful weapons a trustee has. The Bankruptcy Code defines a preference expansively to include nearly every transfer by an insolvent debtor 90 days prior to bankruptcy. The purpose of the preference provision is twofold. First, unsecured creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, debtors are deterred from preferring certain unsecured creditors by the requirement that any unsecured creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment so that like creditors receive an equal distribution of the debtor's assets.