Risk Management

Burn Prevention for Creditors

Changes to the bankruptcy law make it easier to fend off attempts by insolvent customers (or their creditors) to claw back payments they made befor...
Helen ShawOctober 31, 2006

The bankruptcy law that went into effect last year is beginning to deliver benefits to creditors, especially small businesses.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) changed the so-called “preference” provisions of the bankruptcy code. That, in turn, is making life a little easier for creditors that had the bad luck to be doing business with a company right before it went bankrupt.

Preference provisions are intended to prevent management of companies that are teetering on the brink of bankruptcy from making payments to preferred creditors before the court steps in. Once a company files for Chapter 11, the provisions allow the trustees or management of a company to try to recoup any payments that the company made to vendors in the 90-day period before it filed for bankruptcy. If any of those payments show that a vendor was treated differently — either from the “ordinary course of business” between the creditor and debtor, or according to ordinary business terms (the industry standard) — lawyers for the bankrupt company can demand that vendors return the payments so that the funds can be distributed equitably to all creditors via the bankruptcy proceedings.

Preference is a no-fault statute, explains John Penn, a partner at law firm Haynes and Boone and the immediate past president of the American Bankruptcy Institute. “It has nothing to do with intent. People get sued for preferences because they cashed a check from someone who owed them money,” he explained.

That didn’t sit well with many companies. Before the new law, critics of the preference payment provisions said that clawbacks of vendor payments were growing increasingly common. The National Association of Credit Management, in particular, complained that the law, intended to provide equal distribution among unsecured creditors, was actually being used to drive money back into the estate to fund secured creditor payouts. Others complained darkly that preference payment claims had become a cottage industry for lawyers who indiscriminately sent claims to every payee on the bankrupt company’s ledger. And vendors said the provisions discouraged them from trying to help a struggling customer with looser terms, since changing terms could undermine any future defense against preference claims.

Before the changes to the bankruptcy code became effective in October 2005, vendors defending themselves against a preference action under the “ordinary course of business” defense had to separately establish three facts to the court’s satisfaction: a) that the debt was incurred in the ordinary course of business; b) the payment was made in the ordinary course of business between the debtor and creditor (for example, the payment was made by check); and c) it was paid according to the industry standard (in terms of payment timeliness, for instance). “The new [law] is A, and either B or C,” explained John Penn, a partner at law firm Haynes and Boone and the immediate past president of the American Bankruptcy Institute.

“It is a significant benefit to small companies who had minor dealings with companies that filed for Chapter 11,” says Carl Lane, Midwest leader of the reorganization services group, Deloitte Financial
Advisory Services. “I know in the cases I’ve been involved in, the number of preference actions filed and the recovery will be lower [under this amended defense].”

Previously, defending all three parts of the ordinary course of business defense entailed a detailed analysis of every vendor invoice, the payment due date, and the length of time it took to be paid, said Penn. Some firms hired outside experts to testify on industry standards of bill payments. The changes should make it easier and less costly for creditors to defend against claims, added Lane.

Companies are beginning to see the impact of this law now because debtors pursue preference payments months or years after they file for bankruptcy, remarked Mark Houle, a corporate bankruptcy attorney at Pillsbury Winthrop Shaw Pittman. “Vendors should be aware of their increased settlement or litigation strength,” said Houle, “For debtors, they are in a weaker position.”

What can finance chiefs do to protect their companies against preference attacks? They must monitor the companies they do business with, advises Lane. “Get the financial information, track all public information, and when you think they are in an insolvent situation, you need to do a much better job of trying to collect,” said Lane. Documenting any agreements between the companies also places a vendor in a much better position, he added.

“Even if you think [a payment] may ultimately be considered a preferential payment down the road, it is better to receive it, even if you have to give it back later,” commented Lane.