Bankruptcy Preference Claims Timing – Other Factors

Last updated March 20, 2012.   The timing of preference claims is affected by 3 major factors: the statute of limitations; the desire of the debtor to re-establish goodwill (and trade credit) with the supply base; and the discontinuation of the debtor’s business operations.   The statute of limitations is addressed in a separate article that can be read by clicking this link.  This article addresses the second and third factors.  These two factors most frequently influence the decision on timing of bringing bankruptcy preference actions where the debtor is a debtor-in-possession.

The Debtor’s Desire to Re-Establish Goodwill of the Supply Base

Where a debtor is seeking to reorganize or where the debtor is seeking to sell all or a substantial portion of its business through the bankruptcy process, a critical objective of the debtor is to maintain its supply lines under the most favorable commercial terms possible.  In other words, the debtor-in-possession needs to maintain supplier relationships in the months following bankruptcy in order to continue business.  Needless to say, these relationships would be strained if the suppliers knew that they would be receiving a demand for return of payments.

One of the best articles describing this phenomenon in real- life terms is a Today in Finance article in “Delphi Files Secret Preference Claims” dated October 2, 2007. In this article, the customer’s bankruptcy representative’s motivations are summarized as follows:

Under the law, a trustee must file a preference claim within two years of the company’s Chapter 11 filing, in most cases. But trustees usually wait until the last possible moment to file a preference suit so as not to ruin the company’s relationship with vendors while negotiating bankruptcy settlements with them. Indeed, if the company emerges from Chapter 11, it will need strong vendor relationships to keep the operation viable.

This failure to mention the prospect of preference claims is not seen as an effort to “hide the ball” from the creditor. The creditor is presumed to be sophisticated and to know that the prospect of preference claims exists. As one Bankruptcy Court noted when talking about the separation of preference claims from the resolution of other matters with a creditor:

“[I]n large chapter 11 cases sophisticated creditors typically are well aware of prospects and risks of preference litigation. In this chapter 11 case when the petition was filed creditors knew that it was a liquidation case that would very likely result in preference actions. Thus, it seems unlikely that creditors could be surprised or caught off guard when such preference complaints are finally filed.

TWA Inc. Post Confirmation Estate v. City and County of San Francisco Airports Commission, 305 B.R. 221 (Bankr. D. Del. 2004).

In representing clients who are concerned about exposure to bankruptcy preference claims, we continually try to determine the status of the bankruptcy preference claims process. We are sometimes told by the bankrupt customer’s counsel that the answer is in the plan of reorganization. But the plan of reorganization frequently will only contain language “reserving” the right to pursue preference actions. For example, in a recent case the plan of reorganization, in addressing preference actions said:

Avoidance Actions shall be prosecuted, settled, or compromised as deemed appropriate by the board of directors of Reorganized Debtor in an exercise of its business judgment under applicable corporate law.

The Discontinuation of Debtor’s Business Operations

The discontinuation of the debtor’s business operations is the third factor affecting the timing of bankruptcy preference claims. Discontinuation of business operations puts an end to a debtor’s efforts to reorganize. The most common instances where a debtor ceases operations are:

  • conversion of the Chapter 11 case to a Chapter 7; and
  • completion of a Section 363 sale in which all or substantially all of the operating assets are sold.

In either of these scenarios, any concerns for maintaining the debtor’s ongoing business operations disappears.  Where a Chapter 11 case is converted to Chapter 7A Chapter 7 trustee is appointed and its desire is to liquidate the debtor’s assets as soon as possible.  Following the completion of a Section 363 sale, there usually only dog and cat assets remaining.  Worries for keeping a supply base supplying are gone.

The need to fund operations will usually determine how quickly bankruptcy preference claims are brought after discontinuation of business operations. If there is cash available to pay for the continued wind up of operations, then there may be a further delay in bringing of preference claims. If there is no cash available, then it is common for bankruptcy preference claims to be brought quickly.

Lessons for Bankruptcy Preference Negotiation

From a negotiation perspective, only the bankrupt customer and the customer’s bankruptcy representative are benefited by the separation of bankruptcy preference claims from the process of negotiating the terms of a continued supply of goods and services. From the supplier’s perspective, giving up the leverage of negotiating terms of a continued relationship before resolving a preference claim puts the supplier at a big disadvantage.

For this reason, it is critical that supplier’s counsel: (1) look for and evaluate any opportunity to include the resolution of preference claims as part of negotiations on other matters; and (2) include a release of preference claims, where appropriate, in any settlement documentation resolving matters with the customer’s bankruptcy representative.