When a Client Files for Bankruptcy


Staffing firms can minimize loss by understanding and applying the legal details of the U.S. Bankruptcy Code.

By Lee W. Stremba, Esq.

When a Client Files for BankruptcyA client bankruptcy can leave your staffing firm with unpaid bills for services rendered and eliminate a source of continuing business. And in some cases, you may have to return payments that you did receive, adding to your firm’s losses.

The U.S. Bankruptcy Code permits the bankrupt client (often referred to as the “debtor”) or a bankruptcy trustee, the court-appointed official who administers the client’s bankruptcy estate, to recover payments made under certain circumstances. Typically, the debtor or trustee will send letters to the creditors, demanding the return of payments. To substantiate the demand—known as a preference claim—the trustee must prove these five conditions:

  • The payment was made from property (i.e., funds) of the debtor
  • The payment was to or for the benefit of a creditor
  • The payment was for a debt that arose before the date of the payment
  • The payment was made while the debtor was insolvent
  • The payment was made within 90 days before the bankruptcy filing, which is known as the preference period

In some instances, staffing firms may be able to convince the client or trustee that the preference claim is invalid or subject to one or more defenses.

Whose Property Is It?

Often, debts of a distressed company are paid by an affiliated entity or principal, or by an independent third party such as a bank obligated under a letter of credit. Even though the payment was made for the benefit of the debtor, the trustee may be unable to prove that the payment constituted property of the debtor. If so, the trustee cannot prove one of the necessary elements of a preference claim.

For staffing firms, this issue may arise if a client uses a vendor management system (VMS) and the VMS firm bills and collects from clients, keeps its service fees, and passes the balance on to staffing firms. If the VMS firm goes bankrupt, as Ensemble Chimes did in 2008, would payments made to the staffing firms constitute transfers of the VMS firm’s property?

Staffing firms would argue that such payments never belonged to the VMS firm, and therefore were not its property. This argument should be successful if the staffing firm and the VMS firm have clearly agreed in writing that funds collected by the VMS firm (with the exception of its service fees) do not become its property, and if the VMS has segregated its funds from those collected for the staffing firm in a trust or escrow account.

Who Benefits?

For a staffing firm to be required to return a payment, it must be the beneficiary of the payment, or the transferee. In most cases, the beneficiary is easy to identify, but not in all cases.

For example, if a staffing firm client goes into bankruptcy, are payments made by the client to a VMS firm considered transfers from the client to the VMS or to staffing firms? The greater the degree of control over the payments exercised by the VMS, the more persuasively a staffing firm could argue that the VMS was the beneficiary.

This is not to suggest that it is a good practice to permit a VMS to commingle funds paid by clients with its own funds or to otherwise treat those funds as its own. However, if a VMS insists on maintaining significant control over funds received from clients, a staffing firm may argue that the VMS should pay the preference claim.

If your client files for bankruptcy before your staffing firm provides the services, you may have to refund the unearned portion of the advance, but you won’t be paying back your own money.

Which Came First—Debt or Payment?

The bankruptcy trustee must also prove that the payment was made for a debt that was owed before the payment was made. Staffing firms can therefore avoid having to return payments by obtaining payment from the client before providing services to the client.

If your client files for bankruptcy before your staffing firm provides the services, you may have to refund the unearned portion of the advance, but you won’t be paying back your own money.

Defenses Against Preference Claims

Even if a client’s bankruptcy trustee can prove a preference claim, the staffing firm may still be able to avoid having to return payment.

Service and payment at the same time. A staffing firm may be able to defend against a preference claim by establishing that the payment received was intended to be made as a contemporaneous exchange for new value provided to the client, and was in fact a substantially contemporaneous exchange.

Simply put, the staffing firm and client agree that services and payment will be exchanged at essentially the same time.

To establish this defense, a written agreement or correspondence confirming the understanding between the parties would be useful.

In addition, the staffing firm would have to prove that the payment was actually made “substantially contemporaneous” with the provision of services. Since there is no bright-line test, or unambiguous guideline, in the Bankruptcy Code or in case law for determining how quickly a payment must be received to qualify as a contemporaneous exchange, staffing firms should invoice clients as frequently as practical, with an express understanding between the staffing firm and client that payment will be made on specified terms as close to cash on delivery as possible.

Business as usual. Congress has provided another defense to creditors. This defense is available when the debt that is paid was “incurred in the ordinary course of business or financial affairs of the debtor and the transferee,” and the payment was made either in the ordinary course of business or “according to ordinary business terms.”

It is reasonable to assume that debts incurred for staffing services are incurred by the client in the ordinary course of business. The more likely bone of contention will be over payment of those debts, judged either by comparison with the history of billings and collections between the staffing firm and client or by comparison with industry standards.

Thus, this defense puts a premium on consistency in business practices, including billings and collections. The defense is most easily invoked where a client and staffing firm have a clearly written agreement on credit terms and the staffing firm and client have consistently complied with those credit terms.

Subsequent services. The Bankruptcy Code provides an additional defense that applies when a staffing firm has provided new value, or additional services, subsequent to those at issue in the preference claim, and has not been paid for them.

In essence, the new value can be netted against any payment the staffing firm might have to return in a preference claim. This defense is not one that creditors plan for. It simply mitigates the unfairness of a staffing firm being left with unpaid invoices and also having to return payment.

Employee wage protection. Staffing firms may question whether they are protected from preference claims on the theory that payments from a bankrupt client would constitute payments of employee compensation, which are protected under the Bankruptcy Code.

Unfortunately, because temporary and contract employees generally are employees of the staffing firm, and not employees of the client, most debtors or trustees would be quick to argue that such protection does not apply.

Infinite Variability

The facts and circumstances relevant to the application of the legal principles outlined here are infinitely variable, making the principles difficult to apply. As a result, most preference claims can be settled in the demand stage (i.e., before trial).

Lee W. Stremba is a partner at Troutman Sanders LLP in New York. This material is not intended, and should not be relied on, as legal advice. ASA members should consult with their own counsel about the legal matters discussed here. Send feedback on this article to s******@americanstaffing.net. Follow ASA on Twitter @StaffingTweets.

<span class="publication-name"><em><em>Staffing Success Magazine</em></em></span> <span class="publication-separator">-</span> <span class="publication-issue">November-December 2014</span>
Originally Published In

Staffing Success Magazine - November-December 2014

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