Working with Distressed Oil and Gas Customers: Tips on How to Mitigate Your Preference Liability

In this distressed market environment, companies that best maintain customer relationships, continue to provide quality goods and services, and timely collect payment in full for such goods and services will be the companies best positioned to survive and thrive.  Many oil and gas producers and other industry participants are struggling to maintain sufficient liquidity to pay their accounts payable and slowing payment, and may be on the verge of seeking bankruptcy protection.  The Bankruptcy Code, in an effort to promote equal treatment among similarly situated creditors and discourage creditors, especially those with significant influence over the debtor, from consuming the debtor’s available assets prior to bankruptcy, provides broad powers to clawback or avoid “preferential” payments.  Preferential payments are payments made by the debtor within the 90-day period prior to the date it filed bankruptcy or, for payments made to insiders, within the one-year period prior to the filing date (known as the “preference period”). 

Many distressed energy companies may now be inside of their preference period, and therefore, you need to be cautious about how you proceed with these customers.  Cooperation with your customers will be key to industry survival and resurgence.  This article provides tips for credit personnel, accounts receivable collection departments, and in-house counsel on how to continue to work with customers while mitigating against and even avoiding preference liability so as to maximize and accelerate cash flows.

Preferential Transfers under the Bankruptcy Code

Section 547 of the Bankruptcy Code permits a trustee or debtor-in-possession to recover preferential transfers for the benefit of the bankruptcy estate.  The elements of a preferential transfer are:

1. the debtor transferred an interest in the debtor’s property (such as cash);
2. the debtor transferred that property to or for the benefit of a creditor;
3. the transfer was for or on account of an “antecedent debt” (e., an obligation that existed before the transfer);
4. the transfer was made while the debtor was insolvent (there is a rebuttable presumption that the debtor is insolvent within the 90 days prior to the bankruptcy filing);
5. the transfer was made within the 90 days before the filing of the bankruptcy petition (or within one year if the transfer was made to an “insider”); and
6. the transfer allowed the creditor to receive more than it would have if the debtor had been liquidated.

Tips to Mitigate Against Preference Liability, Strengthen Your Defenses, and Maximize Your Cash Flows

1. Always Take Payment

You should always accept payments on debts owed even if you suspect that a bankruptcy filing is in the customer’s near future.  Cash in hand is always preferable to simply having a claim to the funds later and, as discussed herein, the existence of potential defenses could result in a settlement at a discounted value.

2. Maintain Complete Records

It is important to maintain careful records over the entirety of the customer relationship in order to demonstrate your defenses against any clawback.

3. Ordinary Course Defense

The most common defense to an avoidance action is that the payment was made in the ordinary course of business.  A trustee may not avoid a payment (a) of a debt incurred by the debtor in the ordinary course of business or financial affairs, and (b) that was made either (i) in the parties’ ordinary course of business or financial affairs, or (ii) according to ordinary business terms.  

Many issues can arise in raising this defense and it is a fact-specific analysis.  Questions to ask include:  What is your “baseline of dealing” with your customer before the preference period?  In what form and manner do you accept payment?  How and when do you issue invoices?  What are the industry payment standards?  You must establish regular and consistent processes and policies and then consistently maintain those processes even as the customer approaches insolvency.

In a preference action, the Bankruptcy Court will look at, among other things, the length of your relationship with the customer, whether any alleged preferential payments were larger than usual, whether the manner of payment was different than usual, whether payments were made later than usual, whether there was any unusual collection activity (i.e., incremental collection efforts not previously used during the baseline period), and whether you gave yourself an advantage over other creditors, such as obtaining extra collateral, or whether payments were made according objective, industry standards.  Any changes to your approaches or processes within the preference period will receive enhanced scrutiny, and could increase the likelihood of the court determining that the payments you received were not in the ordinary course and therefore subject to avoidance.

4. Cash on Delivery (COD) Terms

Another defense to preference actions is to structure transactions as a contemporaneous exchange for new value.  When confronted with a customer experiencing financial distress, COD terms can be a useful tool to insulate payments from a preference clawback because the payment is made contemporaneously with delivery (rather than in payment of an already existing debt).

5. Providing Goods and Services After Receiving a Preferential Payment

If, after receiving a preferential payment, you continue to provide goods or services to the customer on an unsecured basis, you should be permitted to offset the value of those subsequently provided goods and services against that otherwise avoidable payment and retain those funds.

6. Cash in Advance Terms (Prepayment)

Finally, implementing advanced payment terms is an additional method of mitigating preference liability.  Advance payment terms are, by definition, not a preferential transfer because the payment is not made on account of an antecedent debt, which is a required element of preferential transfers. 

Conclusion

As the oil and gas industry continues to face unparalleled headwinds, cooperation and collaboration are key aspects of the industry recovery.  It is prudent for creditors to assess ongoing relationships, keep the lines of communication with debtors open, and implement collection strategies that provide protection against preference liability and ensure maximum cash flow. 

For additional guidance on this and other restructuring issues, we recommend our recent presentation on the topic, which is available here.

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