Do The Right Thing / Get Screwed Anyway: Secrets of Bonding #144

You performed professional quality construction work, billed the general contractor and got paid.  Done deal. Now, three years later you get a letter from some attorney demanding that you return the funds!  Are they insane?  This is a horrible threat that you cannot avoid.


  • Spiffy Construction, Inc. was a subcontractor on an unbonded project. They billed their client “Gigantic General Construction” for work completed in October: $262,800.
  • The invoice was reviewed and approved. Gigantic sends Spiffy a check for $262,800. Awesome!
  • Spiffy deposits the check. All the funds are used to pay bills and upgrade equipment.
  • The next monthly requisition for November is held up and ultimately never paid to Spiffy. Gigantic then declares bankruptcy.
  • After incurring legal expenses, Spiffy is ultimately forced to write off this receivable. It has a severe impact on the company – but they manage to survive.
  • Three years later Spiffy receives a letter from an attorney demanding that they return the last payment. The attorney says failure to return the funds can result in a “preferential lawsuit.”  What the heck is going on?!

This is not an imaginary scenario.  It is based on true facts.  This happens all the time and can be very bad for the defendant (Spiffy aka the creditor.)

What is a Preferential Payment?

When a business declares bankruptcy, the court reviews payments made to creditors of the company in the period immediately preceding the bankruptcy to determine if any were (in the court’s opinion) inappropriate. They want to determine if any creditors were given extra favorable “preferential” treatment at the expense of others.

In our example, Spiffy was paid less than 90 days prior to the BK declaration, so the trustee is attempting to claw back the funds to be distributed as THEY see fit.  Keep in mind, everything that happened prior to the demand letter was normal and legal.  Spiffy did the work, billed the GC and got paid.  Period, end of story. However, it’s not be the end of the story…

The trustee will attempt to prove that the payment received was more than would have been allowed if made through the bankruptcy proceedings. That’s bad because Spiffy collected the full amount they were owned, but in a BK, creditors are typically paid less than 100%.

Spiffy is now forced to pay a second round of legal fees to defend this claim. If they lose, they may be required to return the last payment they received. Add this to the final payment they never received and had to write off.  This situation keeps getting worse. 

What are some remedies available to companies caught in this untenable position?

Examples of Defenses to a Preferential Payment Claim

  • Substantially Contemporaneous Exchange – this means the payment and delivery of product or services happened at the same time, such as a COD payment. A payment by check may also be included in this category if it cleared promptly.
  • New Value – If a $100 account receivable was collected during the preference period, then an additional $75 AR was billed but not received, the preference amount could be claimed to be only $25, not $100.
  • Floating Lien – This is a creditors security interest in present or acquired assets such as accounts receivable. The creditor would need to show that their collateral position has not improved during the preference period.
  • De Minimus – Means debts that are too small to include in the BK analysis.
  • Ordinary Course of Business – There is a history of accounts receivable showing invoices and payments with that debtor / client. The amount owed was in line with prior transactions.


The last example, “Ordinary Course of Business” may be the most natural response for Spiffy Construction and other contractors.  However, in order to raise this defense, the creditor must have appropriate records.  Copies of contracts, invoices, AR schedules and bank statements are critical documents.  Good record  keeping is needed with an efficient means of storing and retrieving the data, in this case three years after the original transaction.  Without it, defendants like Spiffy have little chance of defending such claims.

Sometimes you do the right thing, but you get screwed anyway.  At least now you know about the danger, protective actions you can take and potential legal defenses.

Reminder: We are not attorneys and are not intending to give legal advice.  For that, call your ATTORNEY.  For a bond, call us!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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Secrets of Bonding #41: Escaping the Stigma of Bankruptcy

BKs come in a couple of flavors – all nasty tasting for surety underwriters.

Chapter 7: This is a liquidation bankruptcy, which means that a trustee sells off all non-exempt assets held by the debtor so that the debts can be repaid to the fullest extent possible. Businesses generally try to avoid Chapter 7 because it is impossible to conduct business operations.

Chapter 11: Business operations continue during this process.  Chapter 11, the most complex bankruptcy filing, is the one that most troubled businesses file. The debtor continues to function, maintains ownership of all assets, and tries to work out a reorganization plan to pay off creditors.

Chapter 12 is exclusively for farm operators.

Chapter 13 is like Chapter 11 but is for individuals instead of businesses.

It would be an understatement to say it is harder to qualify for surety bonds if you have a BK in your past.

Bonding companies typically use a structured method of decision making where each underwriter works within a framework.  The details are described in a Letter of Underwriting Authority which may say things like “All clients must have been in business at least three years” (*why?) or “Do not approve bonds for environmental remediation work.”

A common restriction would be: “Do not bond companies that have previously declared bankruptcy.”

Such rules are handed down by senior management of the surety company and their reinsurers. They just want the field underwriters to avoid such applicants – end of story!

Why is the BK a significant black mark? Why does this one checkbox effectively end the underwriting process with many sureties? We can only guess it is because surety underwriting uses credit analysis as a key element. So the ultimate bad credit event, a BK, is an automatic deal killer with those markets.

Escape the BK

When a construction company comes out of Chapter 11, what is the next step if surety support is desired?  Over the years, we have seen many cases where the owners decided to form a new company.  It’s a fresh start. But is this the best step?

Every bonding questionnaire asks about prior BKs, not only for the company involved, but also the individual people.  For example, ours says:

 “Has the company, any affiliate or subsidiary, or any owners / spouse or companies in which they have had an ownership interest or managerial role ever experienced a bankruptcy?”

That’s pretty broad. Note that forming a new company doesn’t change a bad “Yes” to a good “NO.”  Can it help at all with bonding?  Actually it may do more harm than good.

As we have discussed, the prior BK is likely to be revealed through the questionnaire and also the credit reports. And what the applicant company loses is the history, which is very important to bond underwriters.  The ability to say we have been in business for years and completed a long list of projects carries tremendous weight in the underwriting process. To a large extent, you throw all that away when you start a new firm.

* Remember the underwriting restriction above? Most sureties are reluctant to bond companies until they have a few successful years under their belt – so being new is always a disadvantage.


So how does a company escape the stigma of a BK?  The answer is you don’t.  The BK becomes a part of the company and personal credit history that may not be avoided or erased.

However, there may be a solution with the surety.  The contractor and agent need to select a surety with the flexibility and expertise to evaluate the details surrounding the BK.  The underwriters must be open-minded and willing to identify the strengths of the applicant, despite the BK.  Key points to develop:

  • Responsibility for the factors causing the BK
  • Final disposition of the BK debt
  • Continuity of ownership and key management
  • Current financial strength and trends
  • Current banking and other credit relationships

The reality is that most “prior BK” companies are not bad applicants for bonds. But agents need a surety with the ability to appreciate the value of these clients and support them without requiring collateral.

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

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