The 2008 Ply-Marts’ bankruptcy case (ND Ga. Case #08-72687) provides a poster-child picture of how trade creditors can lose when an involuntary bankruptcy petition is filed against a financially-strapped customer. In addition to the recovery of pre-petition preferential transfers under Section 547 of the Bankruptcy Code, many of the 45 adversary proceedings filed by the Chapter 7 trustee between August 16 and August 30, 2010, are introducing the defendants to the rights of a trustee to seek recovery under Section 549 on account of payments made to a creditor after an involuntary petition is filed and before the bankruptcy judge orders the commencement of the bankruptcy.
We begin by highlighting the distinctions between voluntary cases and involuntary ones.
The Push/Pull Distinction between Voluntary and Involuntary Petitions
Voluntary cases, by far the more common, begin when debtors affirmatively seek bankruptcy court protection from their creditors. The debtor, in effect, “pulls” its creditors into the realm of bankruptcy. There, the debtor expects to have some “breathing room” to allow it to reorganize and obtain a better outcome than it could expect to obtain on the “outside.”
An “involuntary” case starts when there are stakeholders who themselves believe that their debt collections would improve if conducted under the watchful eye of a bankruptcy judge, as distinguished from the status quo, “outside” of bankruptcy. Typically, an involuntary case is commenced when creditors are so unhappy with the way things are going that they “push” the debtor into the bankruptcy court.
The Gap Period
When a debtor files a voluntary petition, the bankruptcy case automatically begins, and bankruptcy laws immediately take effect on the debtor and its creditors.
In an involuntary case, the creditors’ petition does not automatically start all aspects of the bankruptcy process. An involuntary petition must first be approved by a bankruptcy judge. Approval takes the form of an “order for relief.” The time between the date of filing an involuntary petition and the date an order for relief is entered is called the “gap period.” Entry of the order for relief starts the bankruptcy case on a going forward basis. In addition, entry of an order for relief has a retroactive effect, with bankruptcy law governing events that occurred during the gap period.
The “Not-Good:” – Preference Liability under Section 547
The not-good side is straightforward and goes by the name of “preference.” If a creditor, through pressure, leverage or luck, has reduced its credit exposure while other creditors have gone unpaid, the intervention of an involuntary bankruptcy case – like intervention of a voluntary case — is likely to be followed by a bankruptcy preference action against the once-lucky creditor.
As in the case of a voluntary petition, the commencement of an involuntary case triggers potential preference liability. In Ply-Marts, the trustee has brought preference actions against 45 creditors seeking recovery on account of transfers that occurred on or within 90 days before the date of filing the involuntary petition, and for these creditors, the Ply-Marts involuntary case can be summed up in two words — “not good.”
The Bad: Gap-Period Payment Liability under Section 549
Although involuntary bankruptcy cases frequently make the local news, many trade creditors don’t learn that their customer is the subject of an involuntary petition until a bankruptcy judge “blesses” it by entering an order for relief. The gap period is frequently consumed by controversy on whether or not an order for relief should be entered. The controversy can last for months. In the Ply-Marts case, the gap period was about three months.
Payments received by creditors during the gap period can trigger additional liability. Although the liability is in many ways like that triggered by “preferential payments,” creditor liability triggered by gap period payments is governed by a separate bankruptcy code section, Section 549. (See table below for a comparison of selected aspects of the two operative statutes.)
In general, payments to creditors during the gap period will trigger liability under Section 549 unless the creditor can point to specific bankruptcy law or an order of the bankruptcy judge authorizing the payments or, failing that, show that two conditions were met: it gave value during the gap period and the gap period payment was made in exchange for the additional value given in the gap period.
For creditors who, with or without knowledge of the involuntary petition, applied gap period payments to reduce debt that existed when the involuntary petition was filed, gap period payments spell trouble. Soon after the Ply-Marts involuntary petition was filed, the bankruptcy judge entered two consent orders that arguably “authorized” gap period payments. Nevertheless, the Ply-Marts trustee is suing to recover sums allegedly due on account of gap period payments. For the affected creditors who must show the payments were “authorized” or that they gave “value” in exchange for the payments, news of the trustee’s gap period avoidance actions can be summed up in one word – “bad.”
The Ugly: a Hopeless Debtor in Liquidation
Creditors typically want to avoid bankruptcy like the plague. If, as was the case in Ply-Marts, there are three creditors who saw bankruptcy as an improvement, it’s fair to assume that the situation was disastrous.
Indeed, in Ply-Marts, a secured but undercollateralized creditor had been successful in having a federal receiver appointed to liquidate the debtor. In liquidation, the receiver could be expected to do only three things: (1) sell assets; (2) pay the net proceeds to the secured creditor; and (3) pay only the ongoing expenses of the liquidation. The receiver would not be expected to run the debtor as a going concern; it would not be buying goods or services from trade creditors. Three creditors decided that bankruptcy was a better option.
One of a trade creditor’s best defenses to a trustee’s avoidance actions is based on a premise that the debtor was continuing its relationships with trade creditors “in the ordinary course” when making payments to creditor in the 90 days before the bankruptcy filing. The filing of an involuntary petition is provoked when the petitioning creditors feel very strongly that creditors are not being paid in the ordinary course of the customer’s business. It follows from the foregoing that unsecured creditors being sued on account of preference period payments and gap period payments are not likely to have one of the principle defenses ordinarily available.
The Ply-Marts situation was dire; the day after U.S. Bankruptcy Judge Mary Grace Diehl entered the order for relief, she converted Ply-Marts’ Chapter 11 reorganization case to a Chapter 7 liquidation. She replaced the receiver with a bankruptcy trustee. One of the petitioning creditors is now a defendant against whom the trustee has filed a $300,000 preference action. And that is downright ugly.
COMPARISON OF SELECTED ASPECTS OF CLAIMS BASED ON ALLEGED SECTION 547 PREFERENCE PAYMENTS AND SECTION 549 GAP PERIOD PAYMENTS
|Distinctive Elements/Defenses||Preference – 11 U.S.C. 547||Gap Period Payment – 11 U.S.C. 549|
|Subject Matter of Transfer||Interest of the debtor in property prior to the filing of the voluntary or involuntary petition [11 U.S.C. 547(b)]||Property of the estate in bankruptcy as determined upon the filing of the involuntary petition [11 U.S.C. 549(a); 11 U.S.C. 541]|
|Time of Transfer||On or within 90 days before the date of filing the voluntary or involuntary petition [11 U.S.C. 547(b)(4)(A)]||After the date of filing the involuntary petition [11 U.S.C. 549(a)]|
|Statutory Defenses||All of the 547(c) defenses, the most commonly applicable of which are:
||Gap period payment was “authorized” by specific bankruptcy statute or by the bankruptcy judge [11 U.S.C. 549(a)(2)(A) and (B)]
Value given by the creditor during the gap period [i.e., between the date of filing of the involuntary petition and date of entry of the order for relief] in exchange for the gap period payment [11 U.S.C. 549(c)]