Chapter 11: A Primer on Preference Claims


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"Chapter 11: A Primer on Preference Claims, " published in the Spring Edition of Eurofenix (INSOL Europe)

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Chapter 11: A Primer on Preference Claims

  1. 1. USA Chapter 11: A primer on Preference Claims A consequence of the global Under Section 547 of the the criteria set forth above for recession is the increase of Bankruptcy Code, a preference is a determining whether a payment is Chapter 11 filings by transfer of property of a recoverable as a preference, to United States based companies. bankruptcy debtor that (1) was to avoid liability, the vendor must For non-US vendors of such or for the benefit of a vendor; (2) establish one or more of the Chapter 11 debtors, it is important was on account of an antecedent Bankruptcy Code defences. There to understand the key provisions of debt; (3) was made while the are three defences that apply most Chapter 11 to mitigate risks and debtor was insolvent; (4) was made often, “subsequent new value”, potential losses. A prominent within 90 days of the filing of the “ordinary course of business” and feature of Chapter 11 cases in the bankruptcy petition; and (5) “contemporaneous exchange for United States is the debtor’s ability allowed the vendor to receive more new value”, all set forth in Section to recover “preference payments,” than the vendor would receive in a 547 of the Bankruptcy Code. essentially payments made to hypothetical liquidation of the Subsequent new value occurs DAVID H. CONAWAY debtor. when a vendor provides additional vendors 90 days prior to the Shumaker, Loop & Kendrick, LLP (USA) Chapter 11 filing. For vendors, this A debtor normally issues a goods or services (or the release of is a particularly unpopular aspect written demand for payment on a security interest or lien) after the of Chapter 11 cases, since the the preference claim prior to alleged preferential payment to the vendor has likely already sustained commencement of an adversary vendor. This defence acts as a a write-off of accounts receivable proceeding. Often debtors offer to dollar for dollar credit against existing at the time of the Chapter discount the claim to receive potential preference exposure. 11 filing. After imposing that loss immediate payment without the Since subsequent shipments are on a vendor, the debtor has two need for litigation. If the parties readily identifiable, this defence is years after the Chapter 11 filing to cannot resolve the claim in this objective and easy to prove. sue the vendor to recover manner, the debtor may file an The ordinary course of payments that were made by the adversary proceeding against the business applies if payments were debtor in the 90-day period prior vendor. Vendors are well advised ordinary compared to prior to the Chapter 11 filing. As a result to not pay a preference demand transactions between the vendor of this, vendors must evaluate without first performing an and the debtor (paid roughly the potential preference exposure to analysis of the defences, for claims same number of days after invoice understand the full potential loss can often be resolved for a fraction date and paid in the same manner, arising from a US customer’s of the demand amount. such as by check) or if the Chapter 11 filing. If a debtor is able to establish payment was made according to40 Spring 2011
  2. 2. USA “Companies doingordinary business terms in the commonly used by financially preference claim, vendors oftenindustry. Changing invoice terms, troubled debtors to gain more time choose to waive the potentialeither formally or informally, may to pay the obligations owed. claim dividend as credit topreclude the ordinary course of Courts have routinely found that reduce the potential preference business with US-business defence. Moreover, where workouts are common in a exposure.payments made sooner than usual particular industry, payments • Payments made by a debtor to a based companiesor before their due date are often made to vendors pursuant to a vendor pursuant to an assumed need to be awareconsidered to not qualify for the workout plan are not preferable. executory contract are notordinary course of business “Contemporaneous exchange preferential. Section 365 of the of the laws relatingdefence. Debtors will generally for new value” is a defence that Bankruptcy Code defines an to preferences ”argue that a payment was not in arises when the debtor and the executory contract as anythe “ordinary course of business” vendor intended to exchange contract where both partiesif it is more than a few days payment for new value in the form have performance obligations tobeyond the due dates of the of goods or services, and the the other, and would includeinvoices being paid. However, if exchange was in fact substantially leases and sales contracts.the payment history shows that the contemporaneous. The classic • Payment of a vendor’s pre-debtor historically paid the vendor example of this defence arises petition claim as a criticalmuch later than stated invoice when a customer requests goods or vendor is a “remedy” that allowsterms, then late payments during services from the debtor, but the debtors in Chapter 11 cases tothe preference period would be in vendor refuses to provide them voluntarily pay a vendor’s pre-the ordinary course of business unless there is first a payment. As petition claim since the vendor’sbetween the parties. The standard this defence hinges on the parties’ ongoing goods or services arefor “ordinary business terms” in intent, there must be evidence that “critical” to the debtor’sthe industry has been broadened there was an agreement that the survival. As part of a criticalby court rulings in recent years, so payment and the shipment were vendor agreement, vendors mayterms are generally considered dependent on one another. negotiate a waiver of anyordinary if they are not so preference claims.idiosyncratic as to fall outside the Other considerations If a Chapter 11 debtor pursues abroad range of business practices. preference claim against a non-US • Pre-payments are not Payments made in response to vendor, one possible outcome is preferences since they are nota vendor’s enforcement of a credit the Chapter 11 debtor would on account of an antecedentlimit can also be considered obtain a judgment against the debt.ordinary course of business. If a “foreign” vendor. If such vendor • Payments to a secured creditorcustomer is operating near its has no assets in the US, the debtor are not preferences since thecredit limit and wishes to increase must then proceed with an extra- vendor would have been paid inits level of orders, but the vendor is territorial enforcement of the a liquidation in any event.not willing to increase the credit judgment, usually through an • Payments to a vendor pursuantline, then by necessity the debtor applicable treaty such as the to a letter of credit are notmust pay open invoices sooner Hague Convention on the preferential since they are not athan normal. An actual reduction Recognition of an Enforcement of transfer of the debtor’s property.of the credit line is generally fatal Foreign Judgments. Whether or • A payment of an account by anto the ordinary course of business not a Chapter 11 debtor would entity affiliated to the debtordefence, but it has been allowed in actually pursue the judgment in would similarly not be a transfersome cases where the credit line this manner may influence the of the debtor’s property.fluctuated frequently in the past. foreign vendor’s decision on how However, if the paying entity Another factor that courts vigorously to defend the preference itself later files bankruptcy, thehave considered in applying the claim in the US. For non-US- payments might be recovered asordinary course of business based vendors with assets in the a fraudulent transfer becausedefence is whether there was any US, it is likely prudent to defend the entity making the paymentunusual action by the vendor to material preference claims since it may well have received no valuecollect the debt or whether the is easy for Chapter 11 debtors to in exchange for the payment.vendor did anything to gain an transfer judgments with the US’s • Vendors facing preferenceadvantage in light of the debtor’s Federal Judicial System. claims usually also hold andeteriorating financial condition. Companies that do business with unsecured claim against theFor example, threats of legal US-based companies need to be debtor. The Bankruptcy Codeaction or cutting off sales can be aware of the laws relating to allows a debtor to withhold anyconsidered undue pressure for preferences, because they can dividend on such claim pendingpayment, although enforcing a result in a material increase in the payment of the preference. Thisconsistent credit line is generally potential loss associated with a provides the debtor leverage tonot considered undue pressure. customer’s Chapter 11 filing. negotiate the resolution of the “Ordinary business terms” preference claim. In connectioncan sometimes include workout or with the settlement of aalternative payment arrangements, Spring 2011 41