by Scott Schuster

There is perhaps nothing more frustrating than when one of your customers files bankruptcy and avoids paying money that they owe your company. However, anyone that has dealt with a “preference action” knows that merely writing off a debt as uncollectible is not the worst thing that can happen when a customer enters bankruptcy. A preference action has the potential to be much worse, because it is a lawsuit by the debtor or the bankruptcy trustee against your company, seeking to recover payments that were made by the debtor to your company before the bankruptcy. Fortunately, the Bankruptcy Code provides creditors with certain defenses that can be used to defeat a preference action.

The Bankruptcy Code permits the trustee to avoid and recover from creditors payments made within the 90-day period before the bankruptcy filing. The policy behind this provision is to prevent aggressive collection activities that often force the debtor into bankruptcy. 

A “preference” is defined by Section 547 of the Bankruptcy Code as:

1. Payment on an “antecedent” (meaning a previously incurred as opposed to current) debt;
2. Made while the debtor was insolvent (meaning its assets are less than its liabilities);
3. To a non insider creditor, within 90 days of the filing of the bankruptcy;
4. That allows the creditor to receive more on its claim than it would have, had the payment not been made and the claim paid through the bankruptcy proceeding.  

Section 550 of the Bankruptcy Code allows the trustee to avoid and recover any preference payments by filing a lawsuit against the creditor.

Typically, a preference action is often preceded by a “demand letter” from the debtor or the trustee. The demand letter sets forth the trustee’s claims and demands immediate payment. Often times the trustee is willing to settle the preference action for an extremely reduced amount if the settlement is reached before the lawsuit is filed. Consequently, when the creditor receives a “preference demand letter,” the creditor should always have experienced bankruptcy counsel review the case to determine whether the creditor has valid defenses. Bankruptcy counsel can often negotiate a favorable settlement and allow the creditor to avoid having to expend large sums of money in litigation.

If the parties do not reach a settlement, the preference action is initiated with a complaint filed with the bankruptcy court. The preference complaint is similar to any other lawsuit with the exception that its filed in bankruptcy court, rather than federal district or state court.

Many bankruptcy attorneys are concerned about the efficiency of their process. By definition, at least the debtor has limited funds to pay for an engagement. This impacts the creditors who may not see a full recovery on their claim. As a result, many bankruptcy practitioners are leery of spending any resources on electronic discovery. This podcast was created to share the experiences of Bob Bernstein, a bankrupcty practitioner in Pittsburgh, PA with Bernstein Law Firm and Jeffrey Ritter, an electronic discovery consultant from the Waters Edge who has just written a book on electronic discovery and the bankruptcy process called Discovering the Digital Record-The Questions for Examination. 

Click link to listen to Podcast: http://www.esibytes.com/?p=718

Click on this link to see Bob Bernstein talk with Kevin Miller on WPXI’s NightTalk about Bankruptcy and Get P.A.I.D.: A Guide to Getting Paid Faster (and What to do if You Don’t!)

http://www.youtube.com/watch?v=vsgGf2RIig4

Please feel free to share this link with people.

by Robert S. Bernstein, Esq.

Since the late 1970s, the public really started to learn about Chapter 11 and how it works in “big companies.”  Through the 80s and 90s with the airlines and the steel companies, it became more “routine” for big companies to file Chapter 11 bankruptcy.  Today, of course, we are hearing about the Chrysler Chapter 11 and the likely GM Chapter 11.  Whether the cases are quick (as promised) or longer (as likely), it would be good to revisit the basics of Chapter 11 so we can all better understand what is happening.

In light of the newsworthy filing by Chrysler and the probable filing by GM, having a basic understanding of Chapter helps explain some of the maneuvering.

It is Bankruptcy.  The Bankruptcy Code is a federal statute (Title 11, United States Code – the “Code”).  Chapter 11 is the business reorganization chapter of the Code.  Chapter 7 is the straight liquidation chapter.  Chapter 13 is the wage-earner reorganization chapter.

Who is who?  The company that files (Chrysler) is the Debtor.  If the Debtor is still in control of its business (as in most Chapter 11 cases), it is called a Debtor-in-Possession or DIP.  The people who are owed money are called creditors.  The people (or companies) who own the debtor (stockholders or otherwise) are called interest holders.  The Judge is the Judge or the Court.  Everyone has a lawyer (or several).  In large and complex cases, the Court often appoints an Examiner (to investigate) or a Trustee (to examine and control).  If a Trustee is appointed, he or she takes control of the assets and the business.  The Debtor is then out of possession and is no longer a DIP.

Chapter 11 allows Court-supervised restructuring.  The Code permits the changing of contracts over the objection of the other parties.  Debts are contracts, supplier agreements are contracts, and dealer agreements are contracts, to name a few.  The Court supervises the process.  The parties (all of the stakeholders) all get to have their say and the Court tries to balance the interests under the Code.

Debts.  Debt comes in different flavors.  Senior (or secured) debt has the right to take specific assets if not paid.  This is similar to a home’s mortgage loan.  If property filed and perfected, the debt is secured.  Priority unsecured debt is that debt which has no right to specific property, but has been given priority under the Code.  Consumer deposits, wages, and some employee benefits are examples of things that get paid before other, regular, unsecured debt.  Non-priority unsecured debt would be things like amounts owed to suppliers for deliveries prior to the bankruptcy.  Since nothing is that simple, there are some supplier deliveries that are given priority under some circumstances.  Debts with no special treatment are referred to as general unsecured debts.

Administrative Debts.  The costs of running the Chapter 11 and the Company are usually entitled to a very high priority in a distribution.  These include expenses incurred in the ordinary course of business, as well as the professional fees of representatives of “official parties” in the case.  These include the lawyers, financial advisors, and investment bankers for the Debtor, any official committees, and any Trustee or Examiner.

Contracts.  If a contract has already been performed by one side or the other, the other party is just entitled to money and is a creditor.  If there is still something to be performed by both sides, then the contract is “executory.”  Unfulfilled orders and unexpired real estate leases are examples of executory contracts.  If the contract is an executory contract, then the Debtor often gets to decide if it wants to keep the contract or not.  This is known as “assuming” or “rejecting” a contract.  Generally, the Debtor gets to make this choice, subject to Court approval.  If the debtor’s decision unreasonably burdens the company (harming other creditors), the Court may not approve the decision.

Assuming or Rejecting a Contract.  If the debtor decides to assume the executory contract, it is usually required to cure any defaults and show that it can perform in the future.  The debtor then gets the benefits and burdens of that contract after the bankruptcy.  If the Debtor chooses to reject a contract, the other party may be entitled to damages, just as if the company had breached a contract outside of bankruptcy.  The damages are usually treated as pre-bankruptcy, unsecured debts and are added to the other debts of the Debtor.  Collective Bargaining Agreements (Union contracts) have additional protections, but can eventually be modified or rejected by the Debtor.

Sales of Assets.  Although unclear in the current stories about Chrysler, we are expecting a sale of some of the operating assets of the Debtor.  Section 363 of the Code allows the sale of assets free of liens of the secured creditors.  These sales are often referred to as a “363 Sale.”

Plan of Reorganization.  This is the Debtor’s proposed restructuring.  Everyone (and in this case that includes the government) gets to weigh in on the Plan and try to improve its respective position.  This is the document that says who gets what and what the company looks like when it comes out the other end of the bankruptcy.  Sometimes the Plan is negotiated before the bankruptcy case is filed and then the Plan is filed at or near the time when the bankruptcy petition is filed, along with the required approvals of creditors.  When that works, the case can be called a Pre-Pack or pre-packaged bankruptcy.  When it doesn’t work, the Court still considers the proposal of the creditors and decides if it meets the tests of the Code and can be approved.

Why couldn’t this be done outside of bankruptcy?  Outside of bankruptcy, all parties must agree to the change of contracts and debts.  In bankruptcy, the Court can bind reluctant arties under certain circumstances.  It is often hard to get unanimous consent in a class of creditors (like bondholders or trade vendors).  Chapter 11 allows the Court to force a treatment on a class when more than half the creditors voting and more than  2/3 of the amount of money voting, approves the treatment.  Sometimes the Court can approve a plan when even these tests aren’t met, but it requires a much more difficult burden n the Plan proponent.

Why is Chapter 11 so expensive?  Some say Enron will cost more than $1 billion in professional fees.  Lehman Brothers estimates run over $700 million.  The Debtor’s professional have to handle everything and fight with everyone.  Every official party (committee, Examiner, Trustee) has professionals that get paid by the Debtor and have to participate in every aspect of the case to make sure their constituency is represented.  So every time the Judge hears anything in the case, there are several (or dozens) of lawyers in the court getting paid by the Debtor. 

Why does it take so long?  They can be very complicated.  A company like Chrysler didn’t get created overnight and didn’t get into this mess overnight.  It can take month or years to figure out how to fix it or to unwind it if it can’t fixed.  The Code has reasonable time limits built in, but things can get messy.  If everyone agrees in a Pre-Pack, it can move through in 60 days or so.  Some large cases have.  Here, it is likely to take much longer.  Who knows?

What to expect?  Expect stories about how Chrysler can jettison dealer agreements (which it can), pay some suppliers and not others (which it can), close plants and end supplier relationships (which it can).  If there is a good restructuring plan which just needed the power of the Court to bind reluctant creditors, it might move pretty smoothly.  With Lenders being asked to write off billions of dollars, expect there to be some significant relocation.

This outline of the basic terms and concepts should help people to better follow the twists and turns.