VideoThe numerical news from the corporate bankruptcy front has been relatively good. Since 2003, the number of businesses filing for bankruptcy has dropped by 36 percentage points, finishing at 23,887 for the year ending June 30, 2007. That's 24 percentage points below last year's total for the same time period. But the reported numbers don't tell the whole story. What's missing is the tally for preference claims, the lawsuits filed by trustees of bankrupt companies against the ailing company's vendors -- the suppliers that tend to be unsecured trade creditors.
Governed by the U.S. Bankruptcy Code, preference claims are meant to prevent an insolvent company from favoring one creditor at the expense of another. Basically, the bankrupt company has the right to sue vendors to force them to return payments that were made within 90 days of the bankruptcy filing. While the law's rationale may not make immediate sense, its aim is clear. Its purpose is to stop failing companies from doling out payments to preferred vendors just before they go broke.
The number of preference claims on bankruptcy-court dockets, however, is hard to estimate because the courts don't identify the suits per se. But attorney A. Dennis Terrell, a bankruptcy-practice partner at Drinker Biddle & Reath, reckons that preference suits can number as few as 30 for small-company bankruptcies or as many as 10,000 for the multi-billion-dollar insolvencies.
Unfortunately for creditors, preference claims represent a double whammy. First, vendors lose a customer to bankruptcy. Then, they must defend against a lawsuit that aims to grab back any recent payments the insolvent company may have made. More troubling, because of the protracted nature of most preference claims, the suit often takes a company by surprise. Preference claims are usually launched two years after the initial bankruptcy is filed—just before the preference claim statute of limitation expires.
Thus, the preference claims creditors will see this year are likely to be associated with Chapter 11 petitions and Chapter 7 liquidations filed in the second half of 2005, as well as 2006. That list includes some big cases, including Delta Airlines, Northwest Airlines, Tower Automotive, Meridian, and Delphi.
The vendors hit with the greatest number of claims tend to be in industries suffering through a downturn, such as perennials like the airline, auto, and subprime-mortgage sectors. Companies that do business across many sectors, such as telecoms and computer companies, are also likely to absorb many preference claims. "It's not that they are in a lousy industry, it's just that they do business in every industry," says Hal Schaeffer, president of D&H Credit Services, a trade-credit-analysis firm that specializes in preference-claims research.
While both large and small companies have been besieged by trustees looking to collect preferential payments, Schaeffer predicts that smaller companies will be more of a target over the next few years. That's because law firms that hired preference-claims specialists during the early part of the decade – when the Internet bubble burst and corporate scandals produced record-breaking bankruptcies – are now trolling for business because the number of filings are down. That means plaintiffs' attorneys are searching for business—and are thus apt going after claims as low as $10,000, Schaeffer says.
Small companies with diminutive legal teams are, at the same time, likely to feel the pain a whole lot more than big companies are. Once the claim is launched, a vendor can be tied up in court or mediation for years. For instance, several preference claims against creditors of Enron, which filed for bankruptcy in 2001, remain unresolved. The same is true for suits brought by the trustees of retail chain Service Merchandise and lawn equipment maker Murray Inc., which filed for bankruptcy in 1999 and 2004, respectively, says John Rowland, a partner in the bankruptcy practice of Baker Donelson Bearman Caldwell & Berkowitz who is involved in the cases.
Rowland represented 60 preference claimants in the $3.7 billion bankruptcy of Service Merchandise and 30 claimants in the Murray case. Murray's assets were eventually sold to Briggs and Stratton for $150 million in 2004. Rowland didn't divulge the total number of preference claims related to each of those cases. But most often, the tally grows in direct relation to the number of creditors that can be dogged for payment.
Consider that when Bethlehem Steel filed for Chapter 11 protection in 2001, it had recorder $2.6 billion in revenues for the first nine months of that year. On the heels of the bankruptcy, 6,000 preference actions were filed, says Terrell, who represents the steel maker's retirement committee. The committee, one of the beneficiaries overseeing payments to retirees, is Bethlehem Steel's second largest creditor—trailing only the Pension Benefit Guaranty Corporation. So far, retirees have gotten two payouts from Bethlehem Steel, which eventually had to liquidate its assets after a merger deal aimed at pulling the company out of bankruptcy fell through. Terrell says the trustees "envision" two more payments for retirees—and some of that money will be collected via preference payments.
Despite the potential flood of preference suits, there is one bright spot for vendors. The new amendments to U.S. bankruptcy law will make it "easier to defend against these actions," contends Terrell. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCP) lessened the burden of proof for companies defending against preference claims.
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