On September 13, 2010, Eugene I. Davis, as Litigation Trustee for the Quebecor World Litigation Trust, filed affidavits and requests for entry of defaults in 269 bankruptcy preference actions.  According to the affidavits, the defendants in these adversary proceedings simply failed to answer.  This note briefly discusses the number of defaulting defendants, the size of  the defaulted claim amounts and the impact of Section 502(d), which will preclude distributions on the prepetition unsecured claims of each of the defaulting defendant until the  judgment is paid.

The Percentage of Defaulting Defendants and the Size of the Defaulted Claims

The 269 defaulting preference actions represent over 15% of the total of the 1732 preference actions brought by the litigation trustee.  A higher percentage of defaults was to be expected because the supply base, in terms of numbers (versus dollar amounts) was heavily in the service sector.  Additionally, a large number of the defaulting defendants are logistics or transport providers and the transportation sector has undergone is own trials in recent years.

Defaults are also more common when the claim amount is less than $20,000.  This is borne out in Quebecor where 112 of the defaults involve claims of less than $20,000.

With respect to claims between $20,000 and $100,000,there are an additional 118 defaulted claims – 79 claims with claim amounts $20,000 or more and less than $50,000 and another 39 where there claim amounts are between $50,000 and $100,000.

The final 39 claims are above $100,000 with 29 of the defaulting claims being between $100,000 and $200,000.  There are 6 defaulting claims above $300,000 (one above $800,000) and 4 of these defendants are transportation providers.

Default judgments are not a good thing for a bankruptcy preference recovery effort.  The failure of a defendant to answer usually is a pretty good indication that the defendant has determined itself to be judgment proof.  The Quebecor default numbers would be a big blow in most mass preference recovery actions.  In Quebecor these losses are spit wads against the battleship.  The 269 proceedings represented only $14.5 million of the total $382.5 million originally sought.

The Lesson and Why a Defendant who Does Answer Should Care

The lesson should be clear – bankruptcy preference actions that concentrate heavily in a distressed industry sector and that are against service providers are more likely to yield a significantly higher percentage of defaults.  (In this respect, it would be interesting to compare the results in TOUSA, where a similar situation exists with respect to approximately 1,400 preference actions brought in the construction sector.)

If you are a defendant in a mass preference action, why should you care about the success or failure of recovery efforts against other defendants?  Every mass bankruptcy preference recovery effort starts with a target/budget of what will be recovered in the preference actions.  If the recovery effort is going well and to budget, the preference protagonist may feel that it has more flexibility to compromise on your claim.  If the preference recovery actions are not going well, the plaintiff may dig in its heals and become inflexible in the settlement process.  Simply, sometimes it is a very bad idea to be among those settling last.

There Goes that Pre-Petition Claim and it Does the Defendant no Good

In Quebecor, the distribution to the unsecured creditors will be of promissory notes in a face amount of approximately 50 cents on the dollar (subject to certain possible downward adjustments).  The first and foremost remedy available to the litigation trust is that afforded by Section 502(d) of the Bankruptcy Code – no distributions will be made on the prepetition claims of the defaulting defendants until the judgment is paid.

Many defendants have a mistaken belief that the amount of a default judgment will be reduced by the amount of the pre-petition claim.  This belief is disastrously incorrect.  No distributions will be made until the pre-petition claim is paid and the debtor is not required to reduce any preference judgment by the amount so withheld.

For Claim Transferees – A Bad Day

Five of the defaulting defendants previously sold their pre-petition, unsecured claims.  For the transferees the situation appears bleak.  While a well drafted transfer agreement will give the transferee recourse against the transferor in this situation, the value of the recourse is worthless when the transferor is judgment proof.

This situation leads to a rash of interesting questions:

• Does the transferee have a right to intervene in the adversary proceeding?
• Does the transferee have standing to attempt to open the default?
• Does the bankruptcy preference plaintiff have any obligation to notify the transferee of the default?
• Where a Section 502(d) remedy is asserted, should the claim transferee be named as a party?

Defaults are Bad Bankruptcy Preference Defense Strategy

Bankruptcy preference claims might just seem like the last straw for an already distressed business.  While the temptation might be to throw in the towel, burying one’s head in the sand is not the right answer.  Most experienced preference protagonists will consider collectability in the settlement process and will discount event the most solid preference claim if the defendant is financially distressed.  Something is better than nothing and this reality is staring everyone in the face – after all this is all happening because of a bankruptcy.