Introduction

In the midst of the unprecedented global health challenge presented by the spread of the coronavirus (COVID-19), businesses will almost certainly face pervasive disruptions to operations as the economy experiences widespread financial distress. In light of the dramatic and continuing economic downturn, and with the certainty that almost every business sector has been or will be affected, it is imperative that each company have a plan for handling relationships with companies in financial distress. From taking steps to enhance credit protection prior to a counterparty faltering, to exercising state law rights and remedies upon default, to understanding the bankruptcy process, this article will discuss items for each business to consider.

Dealing With Delinquent Customers: Identifying the Warning Signs

Some of the typical early warning signs include (1) slow payment and/or a change in long-standing payment terms; (2) a change in the method or source of payment, or (3) a change in purchasing patterns.

Once a problem credit relationship arises, the credit professional must consider the possibility that the customer could file bankruptcy in the near future. Therefore, during this period, there must be two primary goals. The first and most obvious is the collection of the outstanding receivable or the recovery of the product sold. The second involves minimizing the risk of later having to give the money back as a result of preference or other litigation.

Pre-Bankruptcy Planning

Once a credit problem arises, the credit professional should determine whether the business is being conducted under a contract or on a purchase order basis. In addition, emails and other forms of communication should be reviewed to determine if the contractual terms had been altered or supplemented. One of the reasons for reviewing existing contracts is to determine whether there is any obligation to sell to the customer on credit. If there is no contract, a supplier can almost always require cash-on-delivery (COD) terms. Many contracts provide that credit remains in the sole discretion of the seller, in which case shifting to COD or payment in advance will likely be an option. But even if there is a contract and it provides for the sale on credit, a supplier may still be able to require COD. You should work with counsel to ensure the process for utilizing the Uniform Commercial Code (UCC) protections is correctly followed, including remedies to seek adequate assurance of future performance, stop goods in transit, reclaim delivered goods, or otherwise seek to protect yourself in selling to financially troubled customers. Moreover, in this current environment, contracts should be reviewed for force majeure provisions, and you will need to consult with legal counsel if your customer seeks to avail itself of such provisions. You should also be prepared to have a conversation with your customer about the health of its business.

Identify Alternative Payment Sources

When a credit problem arises, the credit professional should quickly determine what other payment sources exist or could become available upon demand, including letter of credit, third-party guaranty, surety, and security interest/mortgage.

Letter of Credit. A letter of credit (LOC) is a written undertaking, usually by a financial institution, to pay the creditor, upon satisfaction of conditions stated in the LOC. The LOC is an “absolute” guaranty and creates a primary obligation on the part of the issuer that is independent of the underlying debt owed by obligor. If the creditor is fortunate enough to have an LOC, it must comply strictly with the draw provisions within it and present all of the documents in the form required to ensure that the LOC will be honored. Also, the expiration date of the LOC must be identified to ensure a timely draw.

Third-Party Guaranty. Guarantees represent a promise by a third party to “stand in” for a counterparty in the event that the counterparty defaults on its obligations. Guarantees must be in writing — usually in a separate agreement. Guarantees substitute the creditworthiness of the guarantor for the lack of creditworthiness of its counterparty. If the guaranty is a guaranty of payment, the creditor can usually make immediate demand for payment from the guarantor. If the guaranty is one of collection, however, demand for payment may have to wait until collection efforts against the original obligor have been exhausted. Under both general contract and common law, the guarantor can assert the defenses held by the underlying obligor as well as any defenses that may exist with respect to the guaranty itself. Many of these defenses are directed at negating the underlying obligation of the primary obligor because if that obligation is void, the guaranty is unenforceable.

Surety. Closely related to the guaranty is the “surety,” which is a general term encompassing many different relationships among parties. A surety can be compensated, such as a bonding company, or uncompensated; primarily liable for the underlying obligation or secondarily liable; and related or unrelated to the primary or co-obligor. A guarantor is a type of surety.

Security Interest/Mortgage. A properly perfected security interest may get you to the head of the line with respect to payment from the proceeds of the collateral. The credit professional must ensure that all financing statements and mortgages have been properly executed and filed in the appropriate government offices. The execution process is different in every state and county, and strict adherence to the documents and local law is essential to success.

Set-off and Recoupment

Most state laws recognize the right of a seller to set off an obligation owed to it by a customer against obligations owed by the seller to its customer. This is a simple way for a seller under certain circumstances to reduce its exposure in the event of a bankruptcy. However, set-off exercised within 90 days of a customer’s bankruptcy, except for specifically defined exceptions, may be recoverable by a debtor or trustee in bankruptcy.

Recoupment, which is similar to set-off, is also recognized in most states as an equitable right. It allows one party to offset and withhold something that is due to the other party when both obligations arise out of the same transaction.

Outside of bankruptcy, there will be little practical difference between setoff and recoupment. Once a bankruptcy occurs, however, the differences can be significant. Under section 553 of the Bankruptcy Code, setoff can only occur if both debts arose pre-bankruptcy and court approval is obtained. Except under certain limited circumstances, a post-bankruptcy setoff without court approval is a violation of the automatic stay and may cause sanctions to be imposed against the offending creditor. Recoupment on the other hand, if permitted under the state law in question, generally can involve both pre- and post-bankruptcy debts and usually does not require court approval.

A Creditor’s Rights of Stoppage in Transit and Reclamation

Stoppage in Transit

Under certain circumstances, the UCC allows a seller of goods on credit to stop delivery of product upon discovering the buyer’s insolvency. In summary, the seller loses the right of stoppage when (1) the buyer receives the goods; (2) a bailee, other than a carrier, acknowledges that it is holding the goods on the buyer’s account; (3) a carrier acknowledges to the buyer that it holds the goods for it; (4) a negotiable document of title, such as a bill of lading or a warehouse receipt, is negotiated to the buyer; or (5) the goods are received by a subpurchaser from the buyer. In other words, a seller loses the right to stoppage when the buyer obtains actual or constructive possession of the goods. It is important to note, however, that a seller does not lose the right to stoppage in transit solely because title to the goods has passed to the buyer.

The right of a seller to stop delivery of its goods in transit is the same in bankruptcy as before bankruptcy. Stoppage in transit does not violate the automatic stay provisions of Bankruptcy Code section 362(a). Therefore, if a seller is notified of a bankruptcy filing and the buyer has not yet “received” the goods, the seller may direct the carrier not to deliver the goods to the buyer.

Reclamation

If the product has already been delivered to the buyer, under certain circumstances, the UCC allows the seller of goods on credit to assert its right to reclaim the goods upon discovering the buyer’s insolvency. The right of reclamation is available to a seller of goods on credit while the buyer is insolvent. The buyer does not have to file bankruptcy in order for a seller to take steps to recover its product.

Once the notice of reclamation is served, the credit professional should immediately contact the buyer to determine its intentions with respect to the return of the goods. If the buyer refuses to release the goods (which it probably will) and if the customer has not filed bankruptcy, the seller should immediately proceed with an action in state court, seeking an order from the court directing the buyer to return the goods and/or a temporary injunction prohibiting the buyer from selling the goods.

Section 546(c) of the Bankruptcy Code creates a federal right of reclamation that allows a seller to reclaim goods delivered to the debtor within 45 days before the bankruptcy filing, so long as written demand is made no later than 45 days after receipt of the goods (or 20 days after the bankruptcy filing, if the 45-day period expires after the filing). However, the reclamation right is expressly subject to any prior rights that a secured creditor may have in the goods.

The federal right of reclamation has been supplemented by section 503(b)(9) of the Bankruptcy Code, which creates a right to administrative priority for the value of any goods sold to the debtor in the ordinary course of the debtor’s business that were received by the debtor within 20 days before the bankruptcy filing. As a result, vendors are more likely to receive payment for goods delivered in the 20-day period. Unlike the reclamation remedy, the 20-day administrative claim applies even if a bank has a lien on the inventory, and even if the goods have already been consumed by the time the bankruptcy petition is filed.

The Bankruptcy Filing

Bankruptcy law is found in Title 11 of the United States Code, which is referred to as the Bankruptcy Code. To supplement and complement the provisions of the Bankruptcy Code, the U.S. Supreme Court (pursuant to the mandate of Congress) adopted rules of procedure relating to bankruptcy cases. These rules — called the Federal Rules of Bankruptcy Procedure, or “Bankruptcy Rules” for short — contain certain deadlines and other guidelines relating to bankruptcy cases.

The Bankruptcy Rules provide for the bankruptcy courts and the U.S. district courts to adopt specific local rules. Most courts have adopted local rules, which govern matters such as the format of pleadings, filing of pleadings with the bankruptcy court clerk’s office, and the motion practice of the particular court. Knowledge of the Bankruptcy Rules and local rules is essential to complying with all deadlines in a bankruptcy case.

Types of Bankruptcy

The most frequently filed bankruptcy petitions are filed under Chapter 7, 11 or 13 (which are discussed below). Chapter 9 is reserved exclusively for municipalities; Chapter 12 governs bankruptcy for family farmers, with regular annual income; and Chapter 15 governs cross-border insolvency cases.

Chapter 7

Chapter 7 is the most commonly filed type of bankruptcy in the United States. A Chapter 7 case permits individuals, corporations and most other entities, with some exceptions, to have their assets liquidated and the proceeds distributed to their creditors. Most Chapter 7 cases involve no distribution to unsecured creditors because either there are no nonexempt assets or the nonexempt assets are fully encumbered and there is nothing to be sold for the benefit of the estate or its creditors. To the extent there are nonexempt unencumbered assets, the Chapter 7 trustee will sell them and distribute the proceeds to creditors pursuant to the priorities outlined in the Bankruptcy Code.

Chapter 11

Chapter 11 cases are typically filed by corporate entities seeking to reorganize or sell their assets as a going concern. Unlike a Chapter 7 case, a trustee is not automatically appointed when the case is filed. Rather, the debtor continues to operate its business as a “debtor-in-possession,” with broad authority to conduct business in the ordinary course.

The debtor-in-possession is required to make periodic reports to the bankruptcy court, which are accessible to the public. The reports are generally standard and include a balance sheet, cash flow statement and a statement of unpaid liabilities for post-petition expenses, such as insurance, inventory, etc.

The goal of Chapter 11 is to confirm a plan that either salvages the debtor’s business or details the manner of liquidating the debtor’s business, or some combination of the two. The Bankruptcy Code provides a very broad framework as to what must be contained in a plan. Generally, a plan is required to (1) classify claims asserted against, and equity security interests in, the debtor; (2) provide a detailed description of how the debtor will be liquidated or reorganized; and (3) specify the treatment of the classes of claims and equity security interests. The plan is usually the culmination of negotiations between the debtor and the various constituencies in the case, including the committee.

Small Business Reorganization Act

The recently enacted Small Business Reorganization Act (SBRA) became effective on February 19, 2020. The SBRA creates a new Subchapter V to Chapter 11, which aims to make small business bankruptcy proceedings more expeditious and efficient for the debtor company. The SBRA provides a middle ground for small business debtors between the high costs and complexities of existing Chapter 11 bankruptcy or liquidation through Chapter 7. The SBRA seeks to lower costs and streamline the bankruptcy plan confirmation process, while allow existing ownership to retain control of the company.

To be eligible for relief under the SBRA, the debtor must be engaged in business and have a limited amount of debt (not exceeding $2,725,625, subject to periodic adjustment).¹ A trustee will be appointed to each debtor case under the SBRA. The trustee will not have the broad powers of a Chapter 7 trustee, but rather will perform duties similar to a Chapter 13 trustee in helping ensure the debtor’s reorganization stays on track, including the power to object to proofs of claim filed by creditors.

The SBRA includes multiple provisions to streamline and lower costs, such as requiring a committee of creditors only when ordered by the bankruptcy court for cause and eliminating the requirement to file a disclosure statement in connection with the plan confirmation process. The SBRA also eases some of the requirements for plan confirmation and allows existing ownership to retain control even if all creditors are not paid in full.

Under Chapter 11, all post-petition claims must be paid in full on the effective date of a bankruptcy plan as a condition to confirmation. This requirement is eliminated by the SBRA, which allows administrative claims to be paid out over time. This provision is of particular importance to creditors that continue to do business with a debtor under the SBRA post-petition because, rather than payment in the ordinary course or at the latest upon plan confirmation like under standard Chapter 11, the SBRA will allow payments on post-petition claims to be stretched out over time. In light of the numerous changes, such as the treatment of post-petition claims and the ability of the SBRA trustee to object to claims, creditors must be aware of this new act and closely monitor cases filed under the SBRA.

Chapter 13

In order to file a Chapter 13 case, the debtor must be an individual with regular income and with debts under a certain dollar amount cap. At the time the case is filed, a Chapter 13 trustee is appointed. The Chapter 13 trustee is a “standing trustee,” which means the same person acts as the trustee in every Chapter 13 case filed in that particular jurisdiction.

As in a Chapter 11 case, the goal of the Chapter 13 case is the confirmation of a plan. However, unlike the Chapter 11 case, where the plan is usually filed after negotiation with the various constituencies, a Chapter 13 plan is usually filed when the case is commenced. The Chapter 13 plan is typically much less complicated than a Chapter 11 plan. A Chapter 13 plan is required to pay creditors at least as much as they would receive in a Chapter 7 liquidation.

In a Chapter 13 case, the debtor retains all of his or her assets and makes monthly payments to the Chapter 13 trustee. Once the plan is approved by the bankruptcy court, the Chapter 13 trustee makes payments to creditors, pursuant to the terms of the plan. A Chapter 13 plan will generally require monthly payments to creditors over the life of the plan.

The Bankruptcy Process

After the filing of a bankruptcy petition, a Notice of Commencement is filed and served, which provides the following: (1) the debtor’s name and address; (2) the date of the commencement of the bankruptcy case; (3) the type of bankruptcy case that was filed (e.g., Chapter 7, 11, etc.); (4) the date, time and place of the first meeting of creditors; (5) in some cases, the date by which proofs of claim must be filed; and (6) the imposition of the automatic stay.

The Automatic Stay

As a result of the commencement of a bankruptcy case, an “automatic stay” goes into effect pursuant to section 362(a) of the Bankruptcy Code that, among other things, prohibits (1) any act, including the commencement or continuation of judicial, administrative or other actions or proceedings, to collect a prepetition claim against the debtors; (2) any act to create or enforce any lien against any property of the debtors; (3) any act to obtain possession or control of any property of the debtors; and (4) any attempt to terminate any contract or lease with the debtors, in each case other than via the proper procedure in the bankruptcy case. The automatic stay provides the debtor a breathing spell and prevents piecemeal litigation by individual creditors that would frustrate the goals of maximizing the going-concern value of the bankruptcy estate and assuring equality of distribution among similarly situated creditors.

The Schedules and Statement of Financial Affairs

Within 14 days from the commencement of a bankruptcy case (unless the bankruptcy court grants an extension of time), the debtor must file with the court schedules and a statement of financial affairs (the Schedules). The Schedules list all of the debtor’s assets and liabilities and include a list of all of the debtor’s creditors and the amount the debtor believes was due and owing to each such creditor as of the date of the petition date.

The First Meeting of Creditors

Bankruptcy Code section 341(a) provides that “[w]ithin a reasonable time after the order for relief in a case under this title, the United States trustee shall convene and preside at a meeting of creditors.” This meeting, sometimes called the “341 meeting,” is generally held shortly after the debtor files its Schedules. The debtor (if an individual) or a representative of the debtor (for corporate entities) is required to appear at the meeting and testify under oath. Any creditor or party in interest may appear at the 341 meeting and ask questions of the debtor.

First Day Orders/Cash Collateral/DIP Financing

In Chapter 11 cases, the debtor will often file various “First Day Motions” to allow it to continue to operate and minimize the disruption in the business that would ordinarily be caused by the commencement of the case. “First Day Orders” are orders entered by the bankruptcy court approving those various initial motions, which are designed to ensure a smooth transition into Chapter 11.

Almost every Chapter 11 debtor will file a First Day Motion to use cash collateral and/or for the approval of debtor-in-possession financing (DIP financing). Most corporate debtors have at least one lender with a “blanket” security interest in all of their assets. This means that a lender will have a security interest in all of the debtor’s machinery, equipment, inventory, accounts receivable, etc. That lender, or another lender, may also have mortgages against any real property owned by the debtor. Before the debtor can use its cash, which is collateral subject to the lender’s liens, it must have a bankruptcy court order authorizing this use. The bankruptcy court may enter a cash collateral order only if the secured creditor is afforded “adequate protection” for the use of its collateral. Although there are several ways to adequately protect a secured creditor, it is usually granted a security interest in the replacement collateral purchased with its cash collateral.

In many instances, a debtor cannot survive in Chapter 11 with only the use of its cash collateral. In these instances, the debtor will seek to obtain post-petition DIP financing, either from its current lender or a new lender. It is not unusual in a Chapter 11 case for a pre-petition secured lender to give the debtor post-petition credit to keep it afloat and to preserve the value of inventory and receivables. However, the secured lender will usually request additional security or some other protection as part of the post-petition loan. Thus, the lender may obtain a lien on some remaining unencumbered assets of the debtor or collateralize the post-petition obligations of the debtor by post-petition assets, to the detriment of the unsecured creditors.

Creditor’s Involvement in the Bankruptcy Process

Formation of the Creditor’s Committee and the Committee’s Role

In a Chapter 11 case, the office of the United States trustee (UST) is required to attempt to appoint a creditors’ committee of creditors willing to serve. The committee has a fiduciary duty to represent the interests of all creditors — not the specific interests of the individual members. The committee, once appointed, helps shape the direction of the case.

If an unsecured creditor is interested in serving on the committee, it should immediately contact the UST or the attorney for the debtor and determine whether it is listed among the 20 largest. If it is not listed but believes that it should be, and is interested in serving on the committee, it should immediately contact the trial attorney for the UST assigned to supervise the case.

Shortly after the Chapter 11 case is filed, the UST will set a time, date and place for the meeting to select and organize the committee (the Organizational Meeting). At the Organizational Meeting, the UST will appoint the committee and then file a formal pleading with the court stating the names and addresses of the particular creditors appointed to the committee. Neither the Bankruptcy Code nor the Bankruptcy Rules mandate or regulate the “internal workings” of the committee. The committee itself will determine how and when it calls meetings, how the meetings will be conducted and the governance of the committee. Some committees adopt bylaws, while others do not.

The Bankruptcy Code specifically allows the committee to retain counsel, accountants and other professionals. The professionals retained by the committee will be paid by the bankruptcy estate; their fees and expenses are administrative expense claims, which will paid before any distribution is paid to unsecured creditors. In addition, the Bankruptcy Code specifically authorizes the reimbursement of the expenses of committee members if the expenses are incurred by the committee members in performing their duties as committee members.

Doing Business With the Debtor-in-Possession

The Bankruptcy Code expressly authorizes a debtor-in-possession to continue to remain in possession of its assets and to operate its business. It may not, however, use, lease or sell property of the estate outside its ordinary course of business, without court approval. For example, if the debtor is a manufacturer of widgets and, in the ordinary course of its business, sells the widgets, it does not need court permission to sell the widgets (although it will need court authority to use cash collateral, and, if the widgets are subject to a validly perfected security interest, the proceeds from the sale of the widgets will constitute cash collateral). However, if the same widget manufacturing debtor wanted to sell a piece of its real property, it would need court permission to do so.

The Bankruptcy Code also grants administrative expense priority to all claims representing the “actual, necessary costs and expenses of preserving the estate.” Thus, the debtor is authorized to continue to operate its business and, in the ordinary course of business, is authorized and required to pay for post-petition goods and services. The amount owed for goods sold and/or services rendered after the commencement of the bankruptcy case is elevated to a higher priority than the unsecured amount owed for goods sold and/or services rendered before the commencement of the bankruptcy case (excepting claims for goods sold within 20 days before the bankruptcy, which are in effect treated as post-petition claims). If the debtor fails to timely pay invoices for post-petition services rendered and/or goods sold, the creditor may file a motion with the bankruptcy court requesting that the court enter an order requiring immediate payment.

If a creditor decides to do business with a debtor-in-possession, it has several options. It may attempt to require the debtor to pay for goods on a cash in advance (CIA) or COD basis. However, if the creditor has an executory contract for services that provides for the extension of credit, there is a risk that the debtor will attempt to enforce the credit provisions in the contract and could even move to hold the creditor in contempt for attempting to revoke credit. Moreover, there have been several recent Chapter 11 cases where debtors have attempted to force suppliers to sell to them on credit when an existing supply contract contains credit terms. Thus, such a creditor should consult with bankruptcy counsel before taking any action.

If the creditor is willing to continue to extend credit to the debtor-in-possession, it should closely monitor the payment of the post-petition invoices as well as the Chapter 11 proceedings and, if appropriate, contact counsel to the committee to obtain information relating to the status of the case.

Proofs of Claim

• must be filed in Chapter 7 and Chapter 13 cases
• must also be filed in order to obtain a distribution in a Chapter 11 case if the claim is not properly listed in the Schedules of Assets and Liabilities or is listed as contingent, disputed or unliquidated
• must be filed by the proof of claim bar date
• filing proof of claim will submit creditor to bankruptcy court jurisdiction.

When Must a Proof of Claim Be Filed?

The Bankruptcy Code and the Bankruptcy Rules establish the time frames in which proofs of claim must be filed. In Chapter 7 and Chapter 13 cases, proofs of claim must be filed within 70 days after the petition filing date. In Chapter 11 cases, there is no time prescribed in the Bankruptcy Code or the Bankruptcy Rules by which proofs of claim must be filed, and the debtor will file a motion with the court for entry of an order setting the date by which claims must be filed (the Claims Bar Date). However, in some jurisdictions, local rule establishes the date by which proofs of claim must be filed (e.g., within 90 days of the date set for the first meeting of creditors). A creditor should review the local rules of the court where the case is pending to ensure that the local rules do not set a Claims Bar Date. This information is typically included in the Notice of Commencement sent to all creditors at the time that the case is filed. Therefore, even in a Chapter 11 case, always carefully review the Notice of Commencement.

It is imperative that a creditor comply with the Claims Bar Date. Failure to timely file a proof of claim will almost always result in the disallowance of the claim. If for some reason the time in which to file a claim has expired (either through operation or law or the expiration of the Claims Bar Date), you may still file a proof of claim, with the bankruptcy court’s permission, if you can establish “excusable neglect.”

How Do I File a Proof of Claim?

To avoid any dispute as to whether a proof of claim is properly filed and recognizable by the court and the debtor, a creditor should submit a proof of claim that conforms substantially to the official bankruptcy form, Proof of Claim (Form 410).

The proof of claim must be fully completed, executed and sent to the clerk or, in certain cases, the designated claims agent. The creditor should always make sure that the proof of claim form is transmitted so that the signed proof of claim form is received by the court or the designated claims agent as required before the Claims Bar Date; mailing the proof of claim form on or before the Claims Bar Date will not suffice if it not also received by that date.

If the form is not adequate to reflect all of the information relating to the claim, an addendum may be attached to the proof of claim form. It is also always prudent to attach to the proof of claim form all of the documents substantiating the basis for the claim. For example, if the claim is based on purchase orders and invoices, attach copies of all of the pertinent documents.

What Are the Risks of Filing a Proof of Claim?

The “hazard” of filing a proof of claim is that it submits the creditor to the jurisdiction of the bankruptcy court. This may become an issue if the creditor is not otherwise subject to jurisdiction in that court. If the creditor is sued by the debtor or trustee in a preference or fraudulent conveyance action or in a collection action, its filing of the proof of claim will be held to constitute a waiver of jurisdictional objections. The filing of the proof of claim may also constitute a waiver of a right to a jury trial. However, if the debtor’s Schedules do not state the correct amount of the debt owed to the creditor, do not list the creditor’s claim at all, or list the creditor’s claim as unliquidated, contingent or disputed, the creditor must balance the benefit of pursuing the claim against the debtor in the bankruptcy court against the risk of submitting to the jurisdiction of the bankruptcy court.

What Happens After a Proof of Claim Is Filed?

A properly filed proof of claim supersedes any claim scheduled by the debtor and is assumed to be the amount of the creditor’s claim, until and unless an objection is filed to the claim. This means that, once a proof of claim is properly filed, a creditor need not take any action with respect to that claim until an objection is filed. Until an objection is filed, the claim will be deemed allowed for purposes of voting on any plan of reorganization and distribution.

What Are Objections to Proofs of Claim?

In most jurisdictions, any party in interest may object to a proof of claim. The debtor, the committee or a post-confirmation entity created through the bankruptcy plan, however, is usually the party to review the claims and determine whether they are properly filed against the estate. To the extent that the claims were not properly filed, an objection to the proof of claim and a notice of hearing is filed with the court and served on the creditor, the debtor and any appointed trustee, at least 30 days before the hearing date. The address on the proof of claim is the address to which the objection will be sent. The actual procedure for resolving the objection to the claim varies from jurisdiction to jurisdiction. Some courts require an evidentiary hearing on the objection whether or not the claimant responds to the objection or appears at the hearing. Other courts will dismiss the hearing and enter an order granting the relief requested in the objection if a creditor does not respond within a specifically designated time period. These procedures are generally governed by the local rules of the court in which the case is pending. Therefore, the creditor should become familiar with the local rules and carefully review the notice sent with the objection.

When responding to and litigating claims objections, it is always important for a creditor to consider the amount of the expected distribution in the case. If the debtor is seeking to reduce the creditor’s claim by $10,000, and expects a distribution to unsecured creditors of 10 percent, the creditor is, in essence, litigating over $1,000. On the other hand, if the debtor expects a distribution to unsecured creditors of 50 percent, the creditor is litigating over $5,000. This analysis is of practical importance in determining the extent to which a creditor should continue to pursue its claim.

Preferential Transfers in Bankruptcy

Introduction

Preferences are a statutorily created cause of action in bankruptcy. As a general proposition, there is no cause of action for a preference outside of bankruptcy except under certain limited, and rarely used, state insolvency laws. When Congress drafted the preference provisions in the Bankruptcy Code, it was most concerned about the large, isolated transfer on the eve of bankruptcy or transfers to insiders of a debtor. The purpose and policy of 11 U.S.C. § 547, therefore, is to (1) stop the race to the courthouse, (2) prevent the dismemberment of the debtor, (3) provide for the equitable distribution to all creditors, and (4) recover all isolated transactions and insider dealing. However, that has not proved to be the practical effect of preference actions. In many cases, a preference analysis requires professionals to conduct a detailed review of business transactions, causing significant fees and expenses, which may only result in the redistribution of a small amount of money. In other words, the policy and intent of the section makes sense, but, in many cases, the application does not.

Elements of a Preference

Preferences are defined in 11 U.S.C. § 547(b) as:

• any transfer of an interest of the debtor in property
• made to or for the benefit of a creditor
• for or on account of a debt that was owed by the debtor before the transfer was made
• made while the debtor is insolvent — this is a net-worth insolvency
• within 90 days before the date the bankruptcy case is filed or within one year for “insiders,” as that term is defined in 11 U.S.C. § 101
• that enables the creditor to receive more than it would have received in a Chapter 7 liquidation.

The trustee or debtor has the burden of proving each and every element of a preference.

If a transfer is found to be a preference under section 547, the Bankruptcy Code requires the creditor to return the transfer, and, in exchange, the creditor may file an unsecured claim against the debtor for the amount returned. In this way, the creditor receiving a preference is in the same position as if its debt had not been paid.

Preferences Defenses/Exceptions

Even if preferential transfers have been made, section 547(c) of the Bankruptcy Code creates several defenses/exceptions to preferences; there are certain transfers for which all of the elements apply, but that will not be treated as a preference for purposes of recovery. The four most common defenses used by trade creditors are:

• contemporaneous exchange
• transfers in the ordinary course of business
• subsequent new value
• improvement in position.

The preference defendant (e.g., the trade creditor) has the burden of proving any defense asserted to the preference.

Contemporaneous Exchange Exception

This exception applies when the parties intend that the performance by both parties occur at virtually the same time. In order for this exception to apply, the creditor must establish both that the parties intended that the exchange be substantially contemporaneous, and that it was, in fact, substantially contemporaneous. The defense is only effective to the extent of the value given. The most common forms of contemporaneous exchange are COD, CIA or wire transfer payments.

A creditor intending to structure a pre-petition transaction under this defense should (1) keep a paper record proving the parties intended the exchange to be contemporaneous and (2) do everything possible to ensure that it is paid quickly after the goods or services are provided to the debtor (preferably within a week).

Ordinary Course of Business Defense

The ordinary course of business defense applies when the following three criteria are met: (1) the transaction occurred in the ordinary course of business or financial affairs of the debtor, (2) the payment was in the ordinary terms established by the creditor and the debtor, and (3) the transaction occurred with the ordinary business terms within the industry. The first prong is easy and not usually an issue in the case. The debt must be incurred in the ordinary course of the debtor’s business. In most cases, the debt is a normal trade debt.

The second prong, that the payment was made in the ordinary terms established by the creditor and the debtor, is the most confusing and hotly litigated issue in preference law. In part, the case will turn on which judge hears the case and his and her interpretation of what the ordinary course of business between the parties was historically. The test to be employed is a subjective one and very fact-specific. Courts generally look at several factors, including the timing, the amount, the method of payment and the circumstances under which the transfer was made. The court then compares this to how the parties historically conducted business.

The alternative objective test, that payment has to be made “according to ordinary business terms,” can also be confusing. The majority of courts considering the issue have held that the payment must be ordinary in relation to the industry as a whole, and that “ordinary business terms” refers to the broad range of terms used in that creditor’s industry, and that those dealings that are so unusual as to fall outside of that broad range should be deemed outside the scope of “ordinary business terms.”

Subsequent Value Defense

The subsequent value rule allows the creditor to insulate a payment from a preferential transfer attack to the extent that the creditor subsequently replenishes the estate by giving new value. The creditor, however, is not permitted to net out all of the new shipments against the preferential transfers. Rather, a creditor may only net the new credit extended subsequent to the preferential payment. Any payments received after the giving of new credit are not taken into consideration because a creditor is prohibited from carrying forward an extension of credit to offset a subsequent payment. This means that, if the last transaction is a payment, this defense is not available as to that payment.

Setoffs Within the Preference Period – Improvement in Position Test

Similar to the preference recovery provisions of Title 11, Bankruptcy Code section 553(b) provides a remedy whereby a trustee or debtor-in-possession may recover otherwise valid pre-petition setoffs. This section allows recovery of those setoffs during the 90 days before the filing that results in an improvement in the creditor’s position. Not only must the incremental increase (the improvement) be disgorged, but the creditor is left with an unsecured claim.

The improvement in position test is a mechanical application of the Bankruptcy Code. The first measuring point under the test is the 90th day before the filing of the bankruptcy petition or the first day during the 90-day period in which the creditor’s debt is less than the creditor’s claim. This amount (claim minus debt owed) is the insufficiency. This insufficiency is then compared to the picture at the time the setoff is taken (again, claim minus debt). If the first insufficiency is greater than the insufficiency at the time of the setoff, then the trustee may recover the improvement in position, up to the amount actually set off.

The Critical Vendor Doctrine

A bankruptcy court may be persuaded to permit the debtor to pay the pre-petition unsecured claims of certain key vendors and suppliers in the first few days of a bankruptcy case. In large cases, these critical vendor motions have become a standard part of the debtor’s “First-Day Motions.” Critical vendor treatment protects the debtor from losing sole-source and other hard-to-replace suppliers of goods and services by allowing a continuation of the relationship with minimal interruption. Critical vendor treatment can also be used to protect suppliers that are dependent on the debtor, on the justification that the vendor would go out of business without immediate payment and the debtor would lose a valuable source of supply. In addition to preserving these critical business relationships, the special treatment afforded to critical vendors may allow a debtor to negotiate favorable post-petition terms, reinstitute important sources of trade credit, or lock creditors into a commitment to continue credit for an extended period. However, the doctrine is not universally allowed and not applied uniformly across jurisdictions that do permit critical vendor payments.

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