1786 creditors received a total of $485 million in payments from Borders, Inc. or its co-debtors (“Borders” or the “Debtors”) in the 90 days before their bankruptcy. For these creditors, the Borders’ July 18, 2011 decision to liquidate means more than a write off of pre-petition unpaid invoices. Many of Borders’ vendors may be asked to repay as “preferential transfers” or “bankruptcy preferences” amounts received from Borders in the 90 days prior to the date of bankruptcy (the “Preference Period”). Section 547 of the Bankruptcy Code provides for such “clawbacks” of transfers found to be “avoidable” and not protected by one or more defenses.FN1
Much of the focus has been on the impact of the Borders bankruptcy on the publishing houses. Indeed, for some of these large creditors, the combination of the pre-petition unpaid claim amounts and the Preference Period payment amounts represents huge potential exposure by almost any measure. (See which creditors are on both Borders’ 30 Largest Unsecured Creditors and 50 largest payment recipients lists.)
While the dollar impact on the large creditors is impressive, the number of mid-market vendors affected by the Borders liquidation is staggering. In additional to smaller national vendors, the location of hundreds of stores though out the country meant that there were hundreds of regional and local vendors. This is reflected in the large number of vendors, more than 1200, who received between $5,850FN2 and $100,000 from Borders in the 90 days before the bankruptcy.
This article analyzes the pre-bankruptcy payment data, discusses the factors indicating preference claims will be brought and explains why mid-market trade creditors likely are targets despite their proportionately small percentage of the total Preference Period payments made by Borders.
Borders’ Payments in the Preference Period
The Borders, Inc. Amended Statement of Financial Affairs filed on April 13, 2011, included as Schedule 3b a list of each creditor who received more than $5,850 during the Preference Period together with the amount of each payment made. The distribution of creditors by size of the payments in the Preference Period is illustrated in Table 1. The crossover pattern shown on Table 1 is very common – the majority of preference period payments are usually made to a minority of creditors. However, in the case of Borders, the crossover occurs only when the payment range reaches the $500 thousand to $1 million bracket. This indicates an unusually large concentration of payments to a very few creditors.
Of the $485 Million paid out during the Preference Period, more than $318 million was paid to the Top 50 Preference Period Payment Recipients (see list in Table 2 below). In percentage terms, approximately 5% of the creditors received more than 72% of the dollars paid out in the Preference Period. For the remaining 1683 creditors potentially facing preference claims of less than $500 thousand, this high end concentration is not good news.
Seldom are preference recovery campaigns limited to the upper echelon of creditors. To the contrary, the success of mass preference recovery campaigns is usually heavily dependent on recoveries from trade creditors in the mid to lower range in terms of preference claim amounts. Creditors facing preference claims in excess of $500 thousand are much more likely to mount a vigorous, extended defense lasting months or even years. Creditors facing smaller preference claims generally are more concerned about the cost of preference claim defense. Additionally, preference claim defendants facing claims of less than $50 thousand are more likely to make an ill-informed decision to jump at the 50 percent discount frequently offered by preference plaintiffs without any consideration of possible defenses. Recoveries from these easy, early settlements provide financial support for the extended duration prosecution of larger preference claims.
|Rank||Name of Recipient||SOFA SCHEDULE 3b AMOUNT|
|02||INGRAM BOOK COMPANY||$40,083,742|
|04||DEPT OF TREASURY IRS||$19,366,159|
|05||INTERSTATE FREIGHT AUDITING||$17,105,290|
|06||SOURCE INTERLINK COMPANIES||$16,870,502|
|07||HARPERCOLLINS PUBLISHERS INC||$14,067,121|
|08||PENGUIN PUTNAM INC||$12,195,486|
|09||SIMON & SCHUSTER INC||$10,729,556|
|10||CASS INFORMATION SYSTEMS INC||$10,612,923|
|11||CAPITAL LOAN ADMINISTRATION||$10,290,590|
|12||AEC ONE STOP GROUP INC||$10,180,990|
|13||BAKER & TAYLOR ENT VOR||$10,069,178|
|15||SEATTLES BEST COFFEE INC||$6,451,001|
|16||HACHETTE BOOK GROUP||$4,895,524|
|18||PERSEUS DISTRIBUTION SERVICES||$3,743,373|
|19||SECURITY BANK OF UTAH||$3,326,915|
|20||GREAT AMERICAN GROUP||$3,206,464|
|21||TWENTIETH CENTURY FOX HOME ENT||$2,810,189|
|22||TOWER CLEANING SYSTEMS INC||$2,705,752|
|23||EX POINT INC||$2,382,957|
|25||BANK OF AMERICA NATIONAL ASSOC||$2,185,888|
|27||JOHN WILEY & SONS INC||$2,121,193|
|28||PETERS IMPORTS CANDY||$1,874,021|
|29||CAPITAL CLEANING CONTRACTORS||$1,832,782|
|30||BAKER & TAYLOR INC. VOR||$1,798,431|
|32||GE CORPORATE FINANCIAL SVCS INC||$1,750,000|
|33||EXPERIAN MARKETING SOLUTIONS||$1,680,220|
|34||INGRAM PUBLISHER SERVICES||$1,535,444|
|35||MELISSA & DOUG LLC||$1,378,425|
|36||BAKER & TAYLOR INC||$1,301,911|
|37||EMI MUSIC MARKETING||$1,298,698|
|38||AGREE LIMITED PARTNERSHIP||$1,256,100|
|39||JEFFERSON SMURFIT CORPORATION||$1,209,638|
|40||PUBLICATIONS INTERNATIONAL LTD||$1,183,387|
|41||QUALITY SOLUTIONS INC||$1,182,388|
|42||THE BOSTON CONSULTING GROUP INC||$1,168,250|
|43||IMAGINE PRINT SOLUTIONS INC||$1,166,361|
|44||MERRILL LYNCH RETIREMENT & BENEFITS||$1,165,994|
|45||BAKER & TAYLOR ENTERTAINMENT||$1,162,095|
|46||PERFECT TIMING INC||$1,119,512|
|47||GACAPITAL LOAN ADMINISTRATION||$1,074,246|
|48||GRAPHIC COMMUNICATIONS HOLDINGS INC||$1,068,106|
|49||SD RETAIL CONSULTING, LLC||$1,048,372|
Factors Indicating that Borders Preference Claims are Probable
An analysis of several key factors leads to the conclusion that it is probable mass preference claims will be pursued in the Borders bankruptcy.
First, Borders will need the money generated by preference claims. Because preference claims arise at the time of the bankruptcy filing, they are not subject to the security interests of pre-petition secured creditors. Lenders providing debtor-in-possession (“DIP”) financing may try to obtain a lien on the preference claim recoveries. Such was the situation in Borders, but the Creditors Committee objected and the DIP lender’s request for a lien on preference recoveries was dropped. The Borders’ preference recoveries remain one of the Debtors’ few unencumbered assets available to fund the Debtors’ liquidation and provide recovery to the general unsecured creditors.
Second, firms that regularly prosecute mass preference campaigns will find the Borders preference claims profile very attractive. The large number of preference claims means ideal economies of scale for plaintiff’s counsel. Equally important, the high crossover range discussed above means that many of the Borders preference claims are in the “easy, early settlement sweet spot.” Most mass preference plaintiff law firms are paid on a contingency basis. For the firm representing the plaintiff in the Borders’ preference recoveries, the preferential transfer litigation stands to be quickly self funding, if not profitable.
Third, there are indications that, at least for the largest unsecured creditors, one of the three primary preference claim defenses may be unavailable. This means that there is a potential for higher percentage recovery on the Borders’ preference claims.
Is the Ordinary Course of Business Defense to Preference Claims Available to Borders’ Creditors?
The ordinary course of business defense affords protection for payments made during the preference period that are paid consistently with the historical payment patterns and dealings between the creditor and the debtor. The Declaration of Scott Henry Pursuant to Local Bankruptcy Rule 1007-2 in Support of First Day Motions (the “First Day Motion Declaration”) puts in doubt that the largest unsecured creditors will be able to prove this consistency in dealings. The First Day Motion Declaration provides the following description of “Vendor Financing”:
19. Vendor Financing. Prior to December 2010, the Debtors relied on unsecured vendor credit to finance approximately 44% of the Debtors’ inventory. As of the Commencement Date, the Debtors owed approximately $303.2 million to vendors for inventory, net of vendors’ debit balances. In January 2011, the Debtors generally paid cash on delivery for inventory.
* * *
36. Also, in December 2010, the Debtors announced that due to liquidity issues they would withhold payments to certain vendors and seek to restructure those obligations on a consensual basis. In January 2011, the Debtors increased their holdback of vendor payments and began to withhold payments to landlords as well. Prior to the Commencement Date, approximately $178.8 million was past due to vendors, and approximately $18.6 million was past due to landlords.
For the very large vendors, the loss of a potential ordinary course of business defense caused by going to “cash on delivery” may be offset by the possible qualification of C.O.D. payments under the contemporaneous exchange defense. The contemporaneous exchange defense is notoriously fraught with difficulties and is inherently fact intensive. Its potential availability is an improbable factor in any decision to pursue preference claims.
Fortunately, for the vast majority of Borders’ vendors, the ordinary course of business defense is likely to remain intact. The cash-management technique of stretching out invoice aging is oftentimes not directed to mid market vendors. The administrative burden of delaying small vendor payments can not be justified by the relatively inconsequential cash flow benefits. Also, few mid market vendors have the leverage to demand and obtain the preference-claim safe harbor offered through properly implemented “cash on delivery” arrangements.
Was Borders Insolvent throughout the Preference Period?
In order for any of the Preference Period transfers to be avoidable, Borders must have been “insolvent” at the time the payment was made.FN3 “Insolvency” in the Bankruptcy Code is based on a comparison of the “fair valuation” of the debtor’s assets against the amount of its liabilities. If the value of the assets is less than the amount of its debts, the debtor is “insolvent”.
In the case of Borders, the Borders Group, Inc. unaudited Condensed Consolidated Balance Sheets (emphasis added) for the period ending October 30, 2010 show total assets of $1,356,600,000 and total liabilities of $1,397,400,000. However, consolidated balance sheets may not provide an accurate picture as to the of solvency of any one debtor of a consolidated group. The Schedule of Assets and Liabilities of Borders Inc. filed on March 30, 2011 states that on the petition date, Borders Inc. had assets of $1,190,492,893 and liabilities of $644,669,368.
Despite the encouraging indication provided by the Borders, Inc. bankruptcy schedule, the possibility of a challenge to Borders’ solvency during the preference period is unlikely to deter a mass bankruptcy preference campaign. First, preference claimants, even when debtors in possession, seem to have little difficulty repudiating debtor bankruptcy schedules. Second, although in theory the fair value of assets should be determined based on pre-petition conditions and without considering the value devastation caused by the bankruptcy filing itself, bankruptcy courts have looked to post petition valuations in determining pre-petition solvency. In the case of Borders, it will be difficult to overcome the reality of a post petition liquidation that produces pennies on a pre-petition balance sheet asset valuation. Finally, the complexity and expense of an insolvency dispute make it the province of the few creditors who have substantial amounts at stake, substantial financial resources and the willingness to expend those resources in pursuit of a issue whose resolution is in doubt.
The Debtors’ and the Creditors Committee’s evaluation of the Borders’ preference claims will start in earnest soon. The “who and when” questions regarding the prosecution of preference claims will not be answered until the Debtors unveil a plan of liquidation or move to convert the cases to Chapter 7. In all events, the most important task for a potential defendant is assembling and preserving records regarding the business and financial dealings with Borders’ – invoices, payment records, delivery documentation, contracts, and other communications. Both figuratively and literally, its not time to close the books on Borders.
FN1 The Bankruptcy Code in Section 547 authorizes the trustee, if one has been appointed, or the debtor in possession, or any other bankruptcy court approved representative of a debtor’s estate to seek recovery of “avoidable” transfers.
The five requirements for a transfer to be found an “avoidable” preference are in Section 547(b), and simplified, require that the debtor have transferred, (1) in the 90 days preceding the debtor’s bankruptcy filing (2) while the debtor was insolvent, (2) something belonging to the debtor (3) to a creditor (4) against a pre-existing obligation (5) thereby allowing the creditor to receive more than it would have in a Chapter 7 liquidation where the payment was not made.
One a transfer is show to be avoidable, the burden shifts to the defendant to establish that the transfer is protected by one or more defenses. The three most common defenses are the ordinary course of business defense, the subsequent new value defense and the contemporaneous exchange defense. However, there are at least 32 defenses to preference claims found both inside and outside of the Bankruptcy Code.
FN2 A debtor is not required to disclose payments to creditors who received less than $5,850 during the 90 days before the bankruptcy. See Discussion of Bankruptcy Preference Jurisdiction Limit.
FN3 Insolvency is the only requirement of a preference claim that looks to the condition of the debtor and for that reason can preclude any preference claims as to all transfers made to all creditors during the same period. Insolvency is also the only element of a preference claim that is presumed to exist. Although an element of the plaintiff’s claim, a defendant must first rebut the presumption of insolvency before the preference claimant has the burden of proving the debtor’s insolvency during the Preference Period. For a discussion of the insolvency issue in the Delphi Corporation bankruptcy see DPH Holdings Corp. (fka Delphi Corporation) Moves to Amend 130 Bankruptcy Preference Actions – Does the Presumption of Insolvency Trump Ashcroft v. Iqbal’s Mandate for Pleading Facts from which Insolvency Can be Found? Does Delphi Have the Insolvency Facts to Plead?