Category: Unsecured Claims


Picture this . . .Widget Factory has been providing widgets to Small Business for 5 years.  In those 5 years, Small Business paid each invoice within 30 days of receipt.  The past 6 months of payments, however, have been a bit more suspect.  Small Business began making payments over 30 days past the date of invoicing and missed a few payments here and there.  But, Small Business doubled up on a couple of invoices in the last 90 days to catch up.  After struggling financially to keep up with creditors and the demand of its customers, Small Business filed for bankruptcy protection.  Upon review of Small Business’s schedules and questioning during the meeting of creditors, the trustee filed an adversary proceeding to recover the payments made to Widget Factory in the 90 days before the bankruptcy filing.  This is what the bankruptcy world affectionately refers to as a preference action.

The focus of this post, which is Part I of II in a mini-series on mediating preference actions, is to generally (very generally!) define and outline the elements of a preference action.

Preference claims customarily arrive as a demand to repay amounts the creditor received from its customer in the 90 days before the customer’s bankruptcy case . . . . To many creditors, preference claims come as surprises.  After all, there is no dispute that the customer owed the debt and the creditor earned the payment.”  Often, creditors view preference claims as unfair, asking why they should be required to repay monies that were legitimately due and owing to them. Under ordinary business circumstances, this position in well-taken.  But,”[t]he primary underlying principle supporting the return of preferential payments is the fair and equal treatment of all unsecured creditors.  Disgorging payments made is intended to redistribute the bankruptcy estate’s assets equitably among all of the unsecured creditors. . . . [C]reditors who repay preferences will hopefully recover at least a part of what they returned by participating pro rata in distributions with other unsecured creditors. . . . Section 547 does not require ‘intent‘ to receive a preference, notice of insolvency, fraud or any other subjective element.  Because the policy behind the preference statutes is equal distribution, intent or notice is irrelevant.”

So, how do we know if a payment is a preference?  Preferences are defined under Section 547 of the Bankruptcy Code by the following five elements:

  1. A transfer of an interest of the debtor in property to or for the benefit of a creditor;
  2. A transfer for or on account of antecedent debt owed by the debtor before such transfer was made;
  3. A transfer made while the debtor was insolvent;
  4. A transfer made during the preference period (the Bankruptcy Code presumes that a debtor was insolvent in the 90 days before the petition date and the reach-back period is extended to one year for insiders—family members, business partners, etc.); and
  5. The transfer enables the creditor to receive more than if the case preceded under chapter 7.

No, no you say, that isn’t right.  Shouldn’t the creditors have some defense?  Well, of course.  There are 10 of them:

  1. The transfer was made in a contemporaneous exchange of new value to the debtor;
  2. The transfer was made in the ordinary course of business;
  3. The transfer was a security interest in property securing a new value to the debtor;
  4. The transfer was made after the creditor provided new value;
  5. The transfer was a security interest in inventory or a receivable;
  6. The transfer was the fixing of a statutory lien;
  7. The transfer was of an alimony or child support payment;
  8. The transfer was of property with an aggregate value less than $600 in a case involving primarily consumer debt;
  9. The transfer was of property with an aggregate value of less that $5,475 in a case not involving consumer debt; or
  10. The transfer was pursuant to an alternative repayment schedule.

There are also several other defenses that are specific to particular industries, such as grain producers, fishermen and warehousemen.

As you would imagine, the assertion of preference claims and affirmative defenses, lead to a flurry of negotiations, charts, documents, calculations and other supporting evidence to whittle down what amount of the questioned payments are actual preferences, if anything.  This is why preference actions are often the subject of mediation.

Stay tuned for Part II on how mediation can be used in preference actions.

Sources:

Quotations and excerpts from Wheeler, David B., ABI Preference Handbook, American Bankruptcy Institute (2d ed. 2008), at 1, 3, 8–21, 29, 36–38.

11 U.S.C. § 547(b) (Elements of Preference Claim).

11 U.S.C. § 547(c) (Affirmative Defenses).

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Consider this scenario:

Critical Vendor  (“Critical”) has been doing business with Great Expectations Theater of International Talent  (“GETIT”) for over 20 years.  Actually, Critical has been in the trenches with GETIT since its opening.  Over the years, Critical has supplied dance shoes (i.e. ballet slippers, tap shoes, jazz shoes), leotards, tutus (similar to the multitude of taffeta and mesh skirts trending now), stage make-up, lighting, props and music (on cassette, CD and MP3 formats).  There was never a time when Critical could not meet GETIT’s supply demands.  For the first 15 years of the business relationship, GETIT timely paid every invoice and used Critical for all theater and production-related needs.  GETIT provided Critical with so much business that GETIT was always Critical’s top customer and frequently its only customer.  The owners of each operation also became close friends and often took family vacations together.  Their children were around the same ages and attended the same schools.

The last five years, however, have not been as copacetic.  You see, with the combination of in-home entertainment, the nearly bottomed-out economy and sundry reality TV options, audiences were no longer flocking to GETIT’s productions.  Sales receipts and annual memberships were down.  GETIT went from nightly shows and matinees on each weekend day to three shows per week.  Then, eventually, one show per week.  During that phase, Critical’s owner donated supplies, heavily discounted bills and offered to invest in GETIT, all to save the company she essentially helped to build for 15-20 years.  Plus, she wanted to help her friend, to whom she attributed much faith and loyalty, and could not bare to see GETIT collapse.  Even in light of her willingness to help, Critical’s owner was still a “savvy” businesswoman and often felt foolish for financially helping a friend’s company.  She knew that could be a significant mistake and could negatively impact Critical.  But she did it anyway, while periodically asking GETIT’s owner if she was contemplating bankruptcy.  GETIT’s owner always shrugged off such inquiries, but offered a trifling bit of reassurance, saying, “If I do decide to file, you’ll be the first to know.”

Turns out, Critical’s owner was not the first to know.  Indeed, she did not learn of GETIT’s Chapter 11 filing until she received a copy of GETIT’s petition and schedules in the mail.  Critical was listed in GETIT’s schedules and a related motion as a critical vendor with a sizable prepetition unsecured claim.  Although the practical benefits of retaining a critical vendor in restructuring and reorganization proceedings is to avoid the disruption of the debtor’s business, Critical wanted out.  Critical’s owner knew that her prepetition unsecured claim could be zeroed out, or at best, receive only pennies on the dollar.  If GETIT’s motion was granted, Critical would have to continue to meet GETIT’s supply demands.

Therein lied the dispute.  Critical heavily objected to GETIT’s motion to approve its proposed critical vendor status, which led to thousands of dollars of motions practice and litigation.  Prideful and equally humiliated, the parties refused to speak during the contentious time, but eventually agreed to mediation.

The bankruptcy court-approved mediator worked diligently with the parties to guide them to a resolution.  Upon the parties’ impasse on several occasions, the mediator continued the mediation and followed up with the parties after the failed sessions, which brought the parties back to the table each time.  Frustrations, anger and even rising prejudices by Critical’s and GETIT’s counsel, stalled each attempted mediation session.  Not to be deterred, the mediator took one last shot at getting the parties to a potential resolution and pondered what method or tactic might work best.  Finally, she believed she knew the true basis of the contention.

She went into a caucus, or private meeting, with each party.  In the caucus with Critical’s owner and counsel, she looked Critical’s owner squarely in the eyes and said, “I think what you are seeking from this is something deeper yet more basic and personal than all of the legal issues you all have tossed back and forth for months.  Tell me what that is.”  Critical’s owner peered back at the mediator; her eyes revealed the competing emotions of perplexity, anger and relief.  Finally, she said, “All this time, I just wanted GETIT’s owner to apologize.  She never said, I’m sorry.  She drug me into this.  I asked many times if she was planning on a bankruptcy and she gave me no heads up.  She told me she would.  I took her word.  Now, my business is on the brink of collapse, and she never even said, ‘I’m sorry.'”

At the end of the day, GETIT’s owner delivered the long-awaited words, “I’m sorry,” and the parties moved forward to an agreement.
So, what’s the moral of the story?  Sometimes, the legalities, the substantive law, bankruptcy code and rules are not enough.  Often, the “Golden Rule” wins out.  When faced with these types of circumstances as a mediator, or practitioner representing emotionally torn, humiliated and embattled parties, start with that rule first.  You’re likely to avoid the complexities of pride and prejudice.  Get it?

Let me know how you would you have handled this situation.

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