It seemed like a fairly routine business transaction comparable to what most any distributor would undertake.

Hub City Industrial Supply shipped materials to a fence company in Alabama. They extended the company a line of credit even though the Alabama company was struggling financially at the time. Eventually, the company paid Hub some of what was owed. However, the financial struggles worsened and, in mid-2003, they filed for bankruptcy.

No sooner had Hub City decided they'd have to write off the company as a bad debt, though, that they heard from bankruptcy lawyers. Hub City was thus informed that they were being requested to pay back what the bankrupt company had paid them—under what is called the "preferential payment" part of the bankruptcy laws.

Hub City Supply president Mark Magstadt described it as "a sinking feeling you get in your stomach—particularly when [you feel] it is unfounded."

He began fighting a "preferential payment" legal proceeding that he felt was both unfair and unwarranted. In the end, it was cheaper for Hub to settle the dispute than to fight it to a favorable verdict.

Hub City Industrial Supply, a tool and abrasives distributor, is based in Lake City, Fla. Magstadt explained that the Alabama company was a new client when this started. Early indications were positive, as they tend to be with most new accounts, he recalled.

But after delivering the fourth order of parts, Hub City still had not received payment. At that time, Magstadt says, they informed the company that future orders would only be completed on a COD basis.

The company agreed to this and even paid some of what was owed in order to keep their account current, Magstadt recalled. Some 90 days later, though, the company filed for Chapter 11. Hub City was owed $23,000 in payments, Magstadt explained. About a year later, though, the company filed for Chapter 7 bankruptcy.

Then Magstadt received a letter from an Alabama law firm, telling him that Hub City needed to justify why it received a payment within 90 days before that Chapter 11 filing. "Justified," in this context, meaning that Magstadt had to explain why this payment did not qualify as "preferential."

The "preferential payment" concept is a legality that "has been on the books for nearly a century," said attorney George Keeley, attorney with Keeley, Kuenn & Reid of Chicago.

The federal bankruptcy law permits the trustee for a bankrupt company or person to recover certain "transfers" made by the bankrupt company for an antecedent debt (i.e., existing at the time of transfer) within the 90-day period before the bankruptcy petition is filed. A transfer includes a payment made by the bankrupt business to payoff a bona fide debt, Keeley explains. "Recover" means the company that got paid has to give the money back to the trustee, even though by contract the payment was due and owing.

"The general idea, from the bankruptcy court's standpoint, is to recover the money paid to creditors within the last 90 days, mount a bankruptcy estate and divide it more equally among all the creditors of that company," Frederick Mendelsohn, attorney with Burke, Warren, MacKay and Serritella in Chicago, explains.

In Hub City's case, Magstadt had to spend a great deal of time backtracking its paperwork and invoices to show how the payments transpired. Other records from other Hub customers were also used, he recalled, in order to show that extending credit to struggling customers, like the Alabama company, was not unusual on Hub City's part, "just to show that there wasn't anything 'preferential' here," Magstadt said.

As an attorney, Mendelsohn can see the frustration that Hub City experiences here.

"It must seem completely unfair from the standpoint of the distributor or company who did business with the bankrupt company and then finds it has to forfeit, if you will, the payment for their goods and services," he said.

Keeley, too, is sympathetic to the situation Hub City found itself in here. But adds that the bankruptcy laws offer minimal flexibility.

"Anytime an unsecured creditor receives a payment within that 90-day prior-to-filing window—if it's being paid on an old debt, and is beyond the normal terms of payment—there's a very good chance the money will have to be returned, even though it was owed," Keeley explains.

A company in a situation such as Hub City does have some legal options, Keeley explains. One option is to demonstrate that "you got paid in the ordinary course of business, which means you got paid on your terms, and on terms that are customary in the industry."

Compounding the situation for Hub City was that Magstadt's company is what is referred to in legal parlance as an "S corporation"—which in this case meant that Magstadt was not allowed to represent himself in the proceedings. Hub did, in fact, settle in February of this year, in part, because it would have cost less to settle than to fight the case to a conclusion.

The Alabama company's case was the second of such "preferential" cases that Magstadt and Hub City had been involved in. Hub also settled the first one. It adds to Magstadt's frustration, as he feels bankruptcy lawyers file such "preferential" cases knowing that settling is cheaper than fighting. It is something that Magstadt would like to see addressed by Congress.

Is a scenario such as described by Hub City an example of shady legal practices? Keeley doesn't necessarily think so.

"The trustee in bankruptcy has a duty to the creditors: to make sure the creditors get as much as they're entitled to," he said. "The trustee is really obligated to go after preferential transfers, and get the money back into the estate, so that the non-preferred unsecureds get more than they otherwise would have...."

He appreciates the tough situation this creates for companies such as Hub City and he is not unsympathetic, adding that since Hub's payment was on a COD order, they should be OK, legally.

"But it's very, very difficult to explain to a business person, because all they did is get paid for what they were owed," he says. "But the difference is they got paid for what they were owed ... when other people in the same situation didn't get paid. And that is the [legal] distinction."