Third Party Payors: What You Don't Know Could Hurt You

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The Trendset, Inc. Bankruptcy Case

Third party payors oftentimes provide valuable functions for companies by, among other things, enabling them to outsource labor and cost-intensive functions such as payroll and accounts payable services. But, as the case below illustrates, doing business with a third party payor or customer who uses a third party payor to process and pay your company's invoices, can expose your company to unnecessary risks.

The recent bankruptcy case of Trendset, Inc. (In re Trendset, Inc., Case No. 13-02225-hb), which was filed in South Carolina, provides an illuminating view into the dangers of dealing with third party payors. Trendset, Inc. (the "Debtor") was located in Greenville, South Carolina and operated an audit and freight payment service company for customers who used third party freight carriers to transport goods all over the world.

Generally, the Debtor's services involved

i. the audit and review of its customers' carrier invoices, and
ii. for certain customers, the Debtor paid or made arrangements to pay the customer's freight carriers after notifying customers of amounts due and receiving customer funds for purposes of making the freight carrier payment.

Prior to an involuntary petition for relief under Chapter 11 of the Bankruptcy Code (11 U.S.C. § 101 et seq.) being filed against the Debtor on April 15, 2013 (the "Petition Date"), the Debtor processed and audited over 1 million carrier invoices annually and distributed funds in excess of $1 billion annually for its customers who used the Debtor's freight payment services.

Many of the Debtor's customer agreements stated that the funds provided to the Debtor by the customer for the purpose of paying the customer's freight carriers were to be held in trust (i.e., the funds were not supposed to be the Debtor's property) and that the customer's freight carrier invoices would be paid within 48 hours of the Debtor's receipt of its customer's funds.

The problem, of course, arose when

i. customer funds were commingled in accounts with the Debtor's own funds as well as the funds of other customers jeopardizing the trust nature of the funds,
ii. the commingled funds were used to pay the Debtor's operational expenses as well as the personal expenses of the Debtor's owner and his brother and other insiders (such as for the purchase of a Ferrari, Lamborghini, lake condos, recreational land and cabin, and to sustain an unprofitable local nightclub),
iii. funds were embezzled,
iv. the Debtor used amounts refunded to it by carriers for the benefit of customers to cover its operational expenses; and
v. the Debtor was unable to pay carriers within the required 48 hours and, consequently, delayed payment to carriers.

While over time, some customers and their carriers became aware of and complained about delays in carrier payments, they likely were not aware that customer funds were being commingled and that the Debtor was using commingled customer funds to cover its operational shortfalls and pay for exotic cars, night clubs, and land ventures. In addition, they probably were not aware that the Debtor did not have a CFO, did not hire an outside accountant to prepare its financials or conduct an independent audit of its financial affairs, or that the Debtor's owner and CEO submitted self-prepared tax returns for the Debtor.

As of the Petition Date, the Debtor owed its creditors approximately $68 million -- the vast majority of which (or approximately $67 million) was owed to the Debtor's customers. In other words, the Debtor's customers had paid, in aggregate, more than $67 million to the Debtor for purposes of paying their carriers and the Debtor never paid those customers' carriers. Shortly after the Petition Date, the Bankruptcy Court entered its order granting the relief requested in the involuntary petition and also entered an order appointing a Chapter 11 Trustee.

Aside from the lessons that can be drawn from the facts of the case that precipitated the Debtor's bankruptcy filing, companies and their credit managers should also be aware of potential preferential transfer exposure resulting from the bankruptcy filing of a customer's third party payor.

Preferential Transfers Generally and Related Issues in Third Party Payor Bankruptcy Cases
Credit managers are likely already familiar with and have exposure to the concept of preferential transfers as a result of dealing with customers, who either voluntarily or involuntarily, wind up in bankruptcy. The Bankruptcy Code permits a trustee (or debtor-in-possession) to avoid and recover a transfer of an interest of the debtor in property

  1. to or for the benefit of a creditor,
  2. for or on account of an antecedent debt,
  3. made while the debtor was insolvent,
  4. made within 90 days before the petition date (or within 1 year before the petition date if the creditor is an insider), and
  5. that enables the creditor to receive more than it would receive if the case were under chapter 7 of the Bankruptcy Code and the transfer had not been made.

The Bankruptcy Code also sets forth certain affirmative defenses that, when applicable, can except a transfer from avoidance. Defenses commonly asserted by transferees of alleged preferential transfers include the ordinary course of business (11 U.S.C. § 547(c)(2)) and subsequent new value (11 U.S.C. § 547(c)(4)) defenses.

Issues that can arise in third party payor bankruptcy cases with respect to preferential transfers include

  1. whether the transferee received an interest of the debtor in property (as opposed to trust funds provided to the debtor by its customer for purposes of making the payment the trustee seeks to avoid); and
  2. the applicability of section 547(c)'s affirmative defenses where only the customer (as opposed to the actual transferee) has the contractual relationship with the third party payor.

Fortunately for creditors, at least one court recently held that a transferee in a third party payor bankruptcy case can apply its customer's subsequent advance of new value to the third party payor as a defense to the trustee's efforts to avoid and recover preferential transfers. See Stoebner v. San Diego Gas & Elec. Co. (In re LGI Energy Solutions, Inc.), 746 F.3d 358 (8th Cir. 2014).

The Avoidability of Transfers Made to Customers' Freight Carriers in the Trendset, Inc. Bankruptcy Case
In the Trendset, Inc. case, the Chapter 11 Trustee determined that transfers made from the Debtor's accounts to freight carriers within 90 days of the Petition Date exceeded $400 million. However, the Chapter 11 Trustee recognized that a split of authority exists among Circuit Courts of Appeal as to whether the types of transfers at issue in the case were avoidable. Compare Lyon v. Contech Construction Prods., Inc. (In re Computrex, Inc.), 403 F.3d 807 (6th Cir. 2005) (reh'g en banc denied Sept. 9, 2005) (a case, like Trendset, Inc., involving the bankruptcy of a third party payor that processed and paid customer freight charges and which held that the transferee did not receive an interest of the debtor in property even though the source of payment was commingled funds of debtor's customers) with Stoebner v. Consumers Energy Co. (In re LGI Energy Solutions, Inc.), 460 B.R. 720 (BAP 8th Cir. 2011) (a case involving the bankruptcy of a utility invoice audit and third party payor in which the court rejected the Computrex holding where transferee received payment from commingled funds).

Lessons learned and takeaways from the Trendset, Inc. bankruptcy case to help manage the risk of dealing with third party payors:

  1. Identify company's and its customers' use of third party payors.
  2. Obtain and review copies of agreements with third party payors.
  3. Are funds required to be held in trust by third party payor?
  4. If so, is the trust nature of those funds preserved?
  5. Are the bank accounts into which funds are deposited setup as trust accounts and segregated from other customers' funds?
  6. Is the third party payor required to pay invoices within a certain amount of time from receipt of customer funds?
  7. If so, are the payments being remitted timely or is there evidence of delay in payment by the third party payor?
  8. Does company require that the third party payor obtain and provide copies of independently prepared and audited financials?

Although the Chapter 11 Trustee in Trendset believed a good faith basis existed to seek to avoid and recover the transfers made from the Debtor's accounts to its customers' carriers within 90 days of the Petition Date, the Chapter 11 Trustee realized that a significant amount of estate funds would be expended arguing these issues through multiple levels of appeal. In addition, the Chapter 11 Trustee recognized that pursuing the freight carriers would create additional financial exposure for the Debtor's customers (who held 98.5% of the unsecured claims in the case) because the carriers likely would sue or seek reimbursement from the customers for whom they provided services. The Trustee also recognized that even if the litigation were successful, it would substantially increase the amount of unsecured claims filed against the estate (with the additional unsecured claims being based on the amounts actually avoided and returned to the estate). Finally, pursuing the customers' carriers would have immediately threatened the Debtor's customers' distribution networks.

Consequently, the Chapter 11 Trustee, with input from the Debtor's customers, created a concept in the Chapter 11 Trustee's Plan of Liquidation (the "Plan") to resolve the preferential transfer issues against the Debtor's customers and their freight carriers. Specifically, the Plan provided that the Debtor's estate would waive any and all avoidance actions (including preferential transfers) against its former customers and their freight carriers in exchange for (1) the Debtor's customers' waiver of any claim to certain commingled funds that remained in the Debtor's bank accounts as of the Chapter 11 Trustee's appointment (approximately $1.2 million) and (2) the subordination of the customers' unsecured claims to those of other unsecured claims in the case. The Chapter 11 Trustee's Plan, which provided the Debtor's customers and their carriers with assurance that they would not be pursued for any preferential or fraudulent transfers, received unanimous support from creditors and was confirmed on August 6, 2014.

The Trendset, Inc. case is a reminder of the risks that companies face when using third party payors or when its customers use a third party payor to process and pay invoices. The obvious risk is that the third party payor will misappropriate funds and not pay the proper invoices. Credit managers should also be aware of increased financial exposure if a third party payor files for bankruptcy and subsequently seeks to avoid and recover preferential transfers. Although the Chapter 11 Trustee's Plan in Trendset, Inc. resolved the issues surrounding the avoidability of transfers the Debtor made to its customers' carriers in the months and years leading up to the Petition Date, the result was a product of the unique facts of the case and the outcome may differ significantly when the next third party payor seeks bankruptcy relief.

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