by Scott Schuster, Esq.

Many of you are familiar with preferences actions and the defenses to those actions. You may not be aware of fraudulent transfer actions. With the increasing rise in bankruptcy cases in which the main secured creditor is “under water,” bankrupt debtors and trustees are using preference actions as a primary means for collecting funds to distribute to unsecured creditors. However, since unsecured creditors are increasingly aware of preference defenses and how to properly deal with questionable debtors, preference actions are becoming less profitable for the bankruptcy estate. As a result, we’re seeing an increase in the use of fraudulent transfer actions to recover funds for the estate.

There are two types of fraudulent transfer actions: actual fraud (the Debtor deliberately defrauds creditors) an constructive fraud (discussed below). Since actual fraud is somewhat rare, this article is focused on constructively fraudulent transfers.

A transfer is constructively fraudulent if: (1) the debtor received less than reasonably equivalent value in exchange for the transfer and (2) the debtor was (a) insolvent on the date of the transfer or became insolvent as a result of the transfer, (b) the debtor was engaged or was about to engage in a business or transaction for which any property remaining with the debtor was an unreasonably small capital, or (c) the debtor intended to incur or believed that it would incur debts beyond the debtor’s ability to pay as such debts matured.

Most of the cases relating to fraudulent transfers focus on the “reasonably equivalent value” language of the statute. Generally speaking, the courts look to (1) whether the value transferred by the Debtor is approximately equal to the value of what was received by the Debtor in exchange for the transfer and (2) whether the transaction took place at an arm’s length.

In a typical scenario, a vendor provides goods or services having a certain value and the Debtor makes payment sometime thereafter. In this situation, no fraudulent transfer has occurred because the Debtor received “reasonably equivalent value” for its payment.

However, imagine the following scenario: A construction company is composed of three affiliates. Company A cuts timber and delivers it to Company B. Company B processes the timber and makes plywood and delivers it to Company C. Company C uses the plywood to make kitchen cabinets. While these three companies share some common owners, they conduct business at arms-length, do not have any parent-subsidiary relationships and are, for all intents and purposes, separate and distinct legal entities.

Now imagine the creditor that provides $100,000 worth of monthly shipping services for Company A. This creditor is “bankruptcy savvy” and, therefore, insists on 30 day payment terms and strict adherence to payments made in the “ordinary course of business.” All three companies file for chapter 11 bankruptcy protection. When the creditor receives notice of Company A’s bankruptcy, the creditor is secure in knowing that any potential preference action would top out at $300,000 (three months worth of payments) and knows that it has strong defenses to such an action.

Months later, the creditor receives a complaint from the Trustee in Company C’s Bankruptcy demanding the return of $2.4 million worth of “fraudulent transfers.” The complaint indicates that for many years all three companies were insolvent and had problems balancing cash flow. Due to these problems, Company C would pay some of Company A’s Accounts Payable. Pursuant to this arrangement, Company C paid all of the creditors invoices that were directed to Company A. The trustee claims that when Company C paid the monthly invoices for Company A, Company C received no value whatsoever, since the services were delivered to Company A. The trustee therefore demands the return of 2 years worth of monthly payments paid by Company C. Upon review of its file, the creditor is shocked to notice that the checks it received on its invoices were from Company C and not Company A.

Sounds ridiculous, right? Well, while there are certain fact intensive exceptions, such transactions are generally considered “fraudulent transfers” that are recoverable by a bankruptcy trustee.

A creditor that unknowingly receives such a fraudulent transfer is in a very unfortunate situation. While preferences only occur during the 90 days preceding the preference action, the bankruptcy code’s “look back” period for fraudulent transfers is 2 years (which can actually increase depending on which state’s laws apply). Consequently, creditors are at risk of much larger lawsuits being filed to recover fraudulent transfers than the typical preference actions, making it very hard to limit a creditors’ exposure.

More importantly, preference defenses – i.e. ordinary course of business, new value, contemporaneous exchange – do not apply to fraudulent transfers. The fraudulent transfer defenses – typically that the payor received reasonably equivalent value and/or that the payor was insolvent at the time it made the payment – are heavily fact intensive. In other words, the litigation is time consuming and expensive.

For legal and tax purposes, most large companies are split into multiple affiliates, meaning the risks posted by fraudulent transfer actions to unknowing creditors are quite large. For those “bankruptcy savvy” creditors that I mentioned, the best way to protect against such an action is to demand payment from the debtor to which you supplied services. While accepting payment from an affiliate is often the easiest way to get paid timely, it may ultimately end up costing you substantially down the road.

by Scott Schuster, Esq.

It is now common to see individuals file 2, 3, even 4 personal bankruptcies. As the economy continues to stagnate, we are beginning to see multiple filers more often. Creditors should be on alert.

One of the primary reasons for the US bankruptcy system is to give debtors a “fresh start.” The theory is that a debtor weighed down by mountains of debt will have no rational motivation to work hard and contribute to society because any accumulated wealth will just be taken by his/her creditors. A bankruptcy discharge allows such a debtor the ability to avoid those debts and get on with his/her life. If such a discharge were not available, thousands of American citizens would have no reason to contribute to society and, therefore, become a burden to the rest of the country.

However, an individual debtor may file bankruptcy and receive a discharge of all of his/her debts once every seven years. In addition to being able to “burn” their creditors more than once, multiple filers pose even greater threats. Most first-time filers are unaware of how bankruptcy works (i.e. what can and cannot be discharged, how long the process takes, etc.). On the other hand, multiple filers know what debts can be readily discharged and are better able to “game” the system.

As a result, second (or third, or fourth . . .) time filers often prepare for bankruptcy years in advance by rebuilding their credit, obtaining credit and increasing their debts gradually, with no real intention to repay those debts. This is fraud, plain and simple. As a result, creditors should be on alert for second-time filers.

If you believe that one of your debtors has committee fraud, you should contact a bankruptcy attorney about the “nondischargeability” provisions in the bankruptcy code that may be available to you. The Bankruptcy Code sets forth an extensive list of debts that are nondischargeable. Unfortunately, nondischargeability is not automatic – a creditor that holds such a debt must file a complaint with the Bankruptcy Court seeking to have the debt declared nondischargeable. A nondischargeability complaint must usually be filed within about sixty (60) to ninety (90) days after the debtor files his or her bankruptcy petition. 

by Scott Schuster, Esq.

According to a recent article in the New York Times, individual and corporate bankruptcies are at a five-year high. As a creditor, here are three things to keep in mind during these difficult financial times:

1)      With the increase in “under water” secured creditors, unsecured creditors are receiving less and less on their claims through bankruptcy. It may be a good idea to have a backup if a customer fails to pay its bills. Letters of credit, lien rights, and partial payments on delivery are all ways to mitigate the damage that can be caused by a failing customer’s bankruptcy.

2)      Just because a customer has always paid its bills in the past does not mean it will do so in the future. Increasingly, even healthy companies are struggling financially. Keep an  eye on credit terms that you extend to all of your customers, both big and small. It never hurts to reevaluate the terms on which you extend credit to your largest customers. If you conduct a credit worthiness analysis and find something troubling, it may cause you to take additional action to protect yourself from unpaid bills. If the credit check reveals no problems, at least you can sleep soundly knowing that those customers are healthy enough to pay their bills in the future.

3)      Preference actions are on the rise. Debtors and trustees are looking to preference actions as a means to fund distributions to unsecured creditors. This means creditors should be aware of the defenses to those actions and should review their “danger” clients to make sure that payment times are not getting too high. Ideally, payments should be made within (or very close to) payment terms (“NET 30,” etc.). If customers are not doing so, it may be prudent to limit the amount of credit that you extend now to protect yourself from a preference action in the future.

by Scott Schuster, Esq.

Unfortunately, the Code does not require that the administrative claim be paid in full immediately after the Court allows the claim. Instead, the Code only sets the relative priority of the claim.  In Chapter 11, a requirement for the confirmation of a Plan is that administrative expense claims be paid “in full and in cash.” If the case is ultimately declared “administratively insolvent” – i.e. the debtor does not generate sufficient cash to pay its administrative claims – then 503(b)(9) creditors will probably not receive the full amount of their claims.

While the court can order immediate payment of these claims, they often decline to do so. The courts have tended to be very debtor friendly on this issue. In two recent cases, In Re Bookbinders and In Re Global Home Products, LLC, creditors attempted to force immediate payment of 503(b)(9) claims. In both cases, creditors urged the court to order immediate payment of the claims, arguing that there may not be enough assets left at the end of the bankruptcy to pay the 503(b)(9) claims in full. In both cases, the courts’ reasoned that the Code did not explicitly provide for immediate payment. The courts in both cases denied the creditors’ request for immediate payment of their 503(b)(9) claims. Unfortunately, in the Global Home Products case, 503(b)(9) creditors ultimately received less than 50 percent of their claims under the debtor’s Plan.

While a 503(b)(9) creditor appears to face an uphill battle, it is not all bad news. In fact, section 503(b)(9) has greatly increased the potential for recovery for large numbers of unsecured creditors nationwide. Notwithstanding the difficulties of allowance and payment that 503(b)(9) creditors face, they stand in a better position than a general unsecured creditor. Section 503(b)(9) claims are given the same priority status as the debtors’ attorneys’ and other professionals’ fees. In the grand scheme of the bankruptcy system, this is about the best position in which a trade creditor can sit.

Since many 503(b)(9) motions are lightly contested, they can be handled by experienced creditors’ rights counsel at a modest price. In fact, a valid 503(b)(9) claim is often stipulated to by the debtor early in the case. Often the debtor will agree to allow the claim in full, if the creditor agrees to forego payment until a plan can be confirmed. This system benefits all parties because if all 503(b)(9) creditors demanded immediate payment in full, many debtors would not have sufficient cash flow to meet those demands, and would terminate operations shortly after entering bankruptcy. Since debtors rarely enter bankruptcy with significant cash reserves, such an outcome would likely result in 503(b)(9) creditors receiving far less than 100 percent of their claims.

If a creditor is willing to accept a reduced amount on its 503(b)(9) claim, then it should consider “claim traders” – companies that purchase bankruptcy claims from creditors. Claim traders are often very interested in 503(b)(9) claims and, depending on the circumstances of the particular debtor and its prospects for reorganizing, are often willing to pay a very large percentage of the claim.

by Scott Schuster, Esq.

Since clients ask about this all the time, I thought it would be a good time to give a quick refresher on 20-day claims and briefly discuss how creditors are faring in Bankruptcy cases when it comes to 20-day claims.

Under most state laws, a credit seller has the right to “reclaim” goods (get them back or get a lien for the value), from a defaulting buyer. Most state laws require a reclamation notice be given within 20 days of the delivery. Some require as few as 10 days. Recognizing the difficulty with these short timeframes, earlier changes to the Bankruptcy Code enabled creditors to give notice within 20 days after the bankruptcy filing. The right still only covered deliveries in the 10 days before the bankruptcy.

The 2005 amendments expanded the notice rights to provide that, when goods are sold to a debtor within 45 days of a bankruptcy filing, the seller has a right to reclaim those goods, so long as the seller gives notice within the first 20 days of the bankruptcy. Failure to provide this notice results in a waiver of the reclamation right. Sellers often miss this “notice deadline” and lose their right to reclaim their goods. Further, because the rights of a reclaiming seller are subject to the rights of a prior, properly perfected lienholder on the type of goods sold, this reclamation right is often illusory. Section 503(b)(9) was inserted into the Bankruptcy Code as a way of offering relief to sellers of goods whose reclamation right is rendered meaningless – either by failing to give the required notice or because of a prior lienholder’s rights.

Creditors have had mixed results in the first three years following the addition of section 503(b)(9) to the Code. For starters, obtaining an allowed administrative claim requires an upfront investment. The creditor must do one of two things: 1) get the debtor to agree to allow the 503(b)(9) claim; or, 2) if the debtor refuses to agree, file a motion with the court. This means that the creditor often has to hire an attorney and expend resources upfront.

More importantly, debtors will often challenge the 503(b)(9) claim in an attempt to get the creditor to negotiate the amount. Debtors will often claim that they received the goods outside of the required 20-day window. This forces the creditor to show evidence, through supporting documentation and testimony. Debtors sometimes take this position solely as a negotiation tactic. Debtors know that it will cost the creditor valuable time and money to litigate the case and that the creditor may be willing to settle for less in order to avoid litigation.

Be sure to check back for A Refresher on 503 (b)(9) “20-Day Claims” Part 2

By Scott E. Schuster, Esq.

I read this article in the Pittsburgh Tribune Review:(http://www.pittsburghlive.com/x/pittsburghtrib/news/s_672744.html) and it got me thinking about state oversight of financially distressed municipalities. Under Pennsylvania state law (commonly referred to as Act 47), municipalities in the Commonwealth are not eligible to file for federal bankruptcy protection without first implementing a financial recovery plan overseen by a state appointed board.

This approach to municipal reorganization stands in stark contrast to the federal bankruptcy code. Under the state law, a distressed municipality attempts to cut expenses and increase revenue in an effort to pay off its debts. The result is often a myriad of political “quick-fixes,” such as new taxes, elimination of social programs, and the sale or lease of municipal assets, such as parking garages.

The state system lacks two significant components that the bankruptcy code provides to distressed companies or municipalities to assist in reorganization. First, Act 47 does not allow for the discharge of debts. Instead, Act 47 requires that the municipality attempt to restructure certain debts or pay them off with a lump sum. Of course, financially distressed municipalities usually lack the cash flow to make lump sum payments on large debts. Similarly, Act 47 does not allow municipalities to cancel unfavorable contracts. The inability to discharge debts and cancel unprofitable contracts would have proven fatal to several big companies that have emerged from Chapter 11 Bankruptcy over the past two decades; GM, US Airways, and the Pittsburgh Penguins, just to name a few.

Second, the Bankruptcy Code gives corporate debtors the ability to “cram down” union contracts for the best interest of all creditors. In other words, the Bankruptcy Code allows union contracts to be reasonably restructured so that the company’s employees do not sap all of the company’s future revenue, leaving nothing for creditors. Act 47 system has no such provision and, in fact, relies exclusively on the political leaders of the municipality – often unions’ closest allies – to enact changes in applicable collective bargaining agreements. Such a system is destined to fail and has done so, repeatedly.

The Tribune Review reports that 25 municipalities have entered Act 47 oversight but only 6 have escaped. Proof of Act 47′s shortcomings can be seen right here in Pittsburgh, which was forced into this state form of receivership in 2004 and has spent nearly 6 years attempting to right its financial ship, but to no avail. As of this writing, Pittsburgh’s employee pensions have only 30% of the money necessary to fund future payouts. Unions have refused to agree to reduce their benefits and the politicians responsible for forcing such concessions lack the political backbone to press for change. In short, politics has taken over and, 6 years later, the City is still on the verge of bankruptcy. How has Act 47 helped the City of Pittsburgh? It hasn’t.

With the economic downturn and lack of revenue, more and more municipalities in Pennsylvania are at risk of falling into Act 47 protection. Those municipalities are staring at five to ten years of financial purgatory, during which no meaningful changes take place and bankruptcy continues to loom on the horizon. I say let Pennsylvania municipalities file bankruptcy.

by Scott E. Schuster, Esq.

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.

by Scott Schuster, Esq.

There is nothing more frustrating that having one of your biggest customers file for bankruptcy, leaving your company holding a large unpaid debt, and then to be sued later for a “preference.” Clients often ask us: “I was not getting preferential treatment by the debtor, why am I being sued for a preference?” The answer to that question lies at the root of the supposed purposes of preference statutes in the bankruptcy code.

Congress enacted preference statutes for two reasons: 1) to prevent creditors from “dismembering” a struggling debtor during the debtor’s slide into insolvency; 2) to promote equality of distribution (of debtor’s assets) amongst debtor’s creditors.

The former is based on the premise that creditors typically realize when a debtor is struggling financially. Concerned that they debts may not be paid if the debtor enters bankruptcy, those creditors threaten the debtor (with lawsuits) until the debtor agrees to pay the debt. The debtor, at a time when cash flow is already a major problem, pays the debt in hopes of staying afloat by avoiding legal expenses.

If multiple creditors take the same action, the debtor’s limited assets are haphazardly distributed amongst a few select creditors to the detriment of debtor’s other creditors. In the meantime, debtor is stripped of its operating capital and forced into bankruptcy, leaving most of its creditors with unpaid debts.

In theory, the threat of bankruptcy preference actions may prevent creditors from demanding payment once a debtor is in financial turmoil. In reality, the creditor takes whatever action it would normally take and then hopes that more than ninety days pass before the bankruptcy is filed.

The second foundation for preference statutes is equally dubious. More often than not, preference payments are made to unsecured creditors. When money is recovered through preference actions during the preference case, significantly less than 100% of that money is paid to unsecured creditors. Usually, a substantial portion of the recovered assets are paid to administrative creditors (i.e. those that provided goods and services after the bankruptcy was filed) and priority creditors (like taxing authorities and employees).

In fairness, preference actions usually benefit more creditors than they hurt. Again, more often than not, those receiving payments during the 90-days preceding the bankruptcy filing are less in number than creditors that did not receive such payments. Consequently, the end result of preference actions is usually some benefit to unsecured creditors as a whole, but often very little.

In any event, the dual aims of preference statutes described above are rarely achieved.

by Scott Schuster, Esq.

A recent article in the Pittsburgh Post-Gazette indicates that bankruptcies are once again on the rise. With the economy in a deep recession and unemployment hovering at over 10% with no end in sight, this comes as no surprise. As an attorney that practices almost exclusively in bankruptcy, here are some of my observations about bankruptcies in the past year.

1) Increasingly, secured creditors find themselves “under water,” leaving little to nothing for unsecured creditors through traditional bankruptcy reorganization. In these trying times, 503(b)(9) “20-day” claims are extremely valuable and should always be analyzed before closing a collection file after a customers’ bankruptcy. Don’t assume that you’ll get paid through a plan of reorganization.

2) Many chapter 11 debtors are failing to reorganize due to the lack of “exit” financing in the financial market. This means that creditors doing business with chapter 11 debtors should keep credit terms tight and may want to consider having legal counsel keep an eye on the bankruptcy proceedings. Often times, legal counsel can spot a failure months in advance, allowing creditors to get paid before the debtor is forced to liquidate.

3) More and more, debtors and trustees are looking to preference actions as a means to fund distributions to unsecured creditors. This means creditors should be aware of the defenses to those actions and should review their “danger” clients to make sure that payment times are not getting too high.

4) Fraud seems to have become more prevalent than ever before. In the past, debtors relied on easy credit to fund cash flow shortages and business operations. As debtors face tight credit markets, the pressure to “cut corners” increases. As a result, we’re seeing an increase in falsified financial reports, falsified credit applications, and fraudulent billings. Creditors should be on the look-out for this behavior. Since debts obtained by fraud are not dischargeable through bankruptcy, if a creditor discovers that a debtor has committed fraud in obtaining a debt, the creditor should consider a “nondischargeability action” as a way of maintaining their ability to pursue those debts after bankruptcy.

5) More “good” companies are in bankruptcy than ever before. Previously, with some exceptions, a corporate debtor was in bankruptcy due to one of three things: poor management, a poor business model, or a failing industry. Now, we’re increasingly seeing well run companies in struggling industries (construction, steel, auto) falling victim to difficult economic times. It’s important to keep an eye on the credit terms you extend to even your best customers, as no one seems to be immune from this economy.