The Economy

Trade Creditors Getting Skunked in Bankruptcies

“Of the near $3 million I returned in one case, I didn’t see three dollars.”

While trade creditors have never had much clout when their customers went bankrupt, what little they had they’re losing, according to credit managers. Increasingly, companies that modify terms for customers on the brink of bankruptcy are getting skunked by other claimants, recovering little or nothing on unsecured claims when a firm goes belly up. At least that’s the view of several corporate credit managers who spoke before a bankruptcy reform commission last week.

Current  U.S. bankruptcy law makes it prudent for creditors to cut off distressed customers, instead of extending payment terms and continuing to ship product to preserve the businesses, the executives said. Part of the problem: too many secured lenders with rights to a company’s assets. Credit managers are aligned against secured lenders on many issues of reform, and they are focused in particular on two parts of the bankruptcy code.

The first is preference claims, which are intended to prevent near-insolvent companies from favoring one creditor over others in the run-up to a filing. These lawsuits are brought to force vendors that were paid within the 90-day window of a filing to return the funds.

As CFO reported in 2010, in the current cycle of bankruptcy claims, debtor estates are atypically aggressive. In 2008 and 2009 in particular, bankruptcy estates went after even the smallest payments made to vendors. The recovered money is supposed to go into the pool for unsecured creditors, but the trade credit managers said that it rarely does.

“In all the cases I have been involved in, or those that I have closely watched through filings, I have never seen any of the trade-credit preference recoveries going into the unsecured creditors’ pool for distribution,” said Valerie Venable, director of credit at Ascend Performance Materials, at the American Bankruptcy Institute hearing in Las Vegas. “Of the near $3 million I returned in one case, I didn’t see three dollars.”

Defending against preference actions is time consuming and expensive, pointed out Kathleen Tomlin, regional credit manager at Central Concrete Supply. “We have to examine the books and records which establish the relationship, the payment history, any defaults in payment, all notes regarding communication with the customer and any notes, liens or security interests that may have been granted.”

Trade creditors feel that in the current climate they are guilty until proven innocent. One of the defenses against a preference claim, that the payment was received in the “ordinary course of business,” is particularly difficult to prove. Bankruptcy estates are going after any cases in which the near-bankrupt firm pays on any terms other than net 30.

In addition, Venable says, she often must prove her case to a person unfamiliar with billing cycles or industry-specific payment terms in manufacturing.

Thomas Demovic, senior manager of corporate credit at Sharp Electronics, said that customer payments are often delayed by returns, claims for discounts and chargebacks, and terms ­can be as varied as 30, 45, 60 and 75 days for one customer “depending on what type of product was purchased and where the product was coming from.”

Creditors in bankruptcy cases are also having a hard time reclaiming goods sold to customers in the run-up to bankruptcy. So-called reclamation claims, which were supposed to be more effective with the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), are “no longer a remedy that protects a seller of goods,” said Paul Calahan, senior credit consultant at agricultural commodities company Cargill.

Since 2005, Cargill has been owed $19.2 million in goods subject to reclamation in 43 bankruptcy cases, Calahan said, but did not recover any of it. Cargill’s “last major collection when the use of reclamation was successful was in the early 1980s, when Lane Processing filed for bankruptcy and we were able to recover 100 percent of the value of a corn train,” he said.

Some of the problems: Most debtors have secured lenders who have a lien on all inventory, Calahan says, and often inventory subject to reclamation is commingled with other inventory and cannot be identified.

But trade creditors have found another part of the bankruptcy code useful in reclaiming goods. That’s section 503(b)(9) of BAPCPA, which gives trade creditors a step-up in priority, because the claim is categorized as “related to costs that are necessary to preserve the estate.”

“Our ability to rely on Section 503(b)(9) allows us to continue selling to a customer that might be circling the drain,” said Sandra Schirmang, senior director of credit at Kraft Global Foods. “We can be certain that whatever we ship in that 20-day period [prior to a filing] has a good potential for recovery.”

Secured lenders are arguing that 503(b)(9) should be repealed to restore balance to the relationship between secured and unsecured creditors. But Calahan said lenders should support the provision, because it allows trade creditors to “deliver value to the business. This in turn helps lenders protect the value of their collateral.”

The ABI commission on reform is holding a series of hearings to generate a detailed proposal on U.S. bankruptcy reform. It has four more hearings scheduled between June and November.