Client Advisor - Preferential Transfer Claims, Adding Insult to Injury

Part Four of a Four-Part Series
Sept. 28, 2010

Years after a customer files bankruptcy, you may receive a letter from the estate trustee or counsel demanding return of so-called preference payments. Here are some things you should (and shouldn’t) do when you receive a pre-litigation preference demand letter:

Don’t panic, don’t procrastinate and don’t return the money. Possession, as they say, is nine-tenths of the law. But do get your attorney involved to ensure you are provided the best legal advice in the circumstances.

Understand your negotiating position
- From the payment defense analyses discussed below, you may be able assert valid defenses or negotiate a more favorable settlement.
- Get an understanding of the likely percentage recovery to the unsecured creditors. If a preferential payment must be returned, you will receive a replacement unsecured claim. This establishes a floor for settlement negotiations.
- How large is your claim and recovery in the bankruptcy relative to the preference claim? A creditor cannot receive a recovery under the bankruptcy plan until its preference claims are resolved. If the recovery under the plan is substantial relative to the preference claim, the debtor has significant leverage.
- The legal costs to estate mitigate its return. The firm prosecuting the claims may be working on a contingency basis and will need to weigh the costs of collection against the size of the claim. That is why these claims are almost always settled.
- How important a supplier are you? You may be able to reach a more favorable settlement if you are a critical supplier or can offer other enticements to settle the claim such as extended post-emergence trade terms or resolution of a contract cure amount.

Identify a contact person at the debtor to call to discuss the demand letter. Request support for the amount of the claim and point out any discrepancies in the debtor’s analysis. The debtor has the burden of proof to support the claim.

Determine whether the amount of the claim is worth the costs of retaining counsel and, possibly financial advisors, to assist in the defense.

Find out if the value of the transfers exceeds $5,000. A trustee otherwise cannot bring preference claims in commercial cases. If you are confident the claim, after payment defenses, is less than $5,000, advise the trustee and seek to have the claim eliminated.

Similarly, if you are confident the claim is less than $10,000, bring it to the trustee’s attention that litigation would need to be in a district in where you reside.

Payment Defenses

New value defense
The new value defense allows a creditor to deduct from preference payment exposure the value of any goods or services provided to the debtor following a payment.

The potential preference liability cannot be reduced below zero by a subsequent provision of new value.

If the creditor made regular and frequent shipments to the debtor during the preference period, this defense may quickly and easily reduce the creditor’s potential preference exposure.

Ordinary course defense
This defense requires a more complex analysis than the new value defense and provides two options for analysis of what constitutes “ordinary course.”

Ordinary course between the parties
- Statistical measures of payment days, typically including minimum, maximum, mean, standard deviation, and outliers are calculated for payments within the 90-day preference and compared with historical experience.
- Payments made within a reasonable number of days of historical experience, typically measured by number of days or standard deviation can be eliminated as being under the ordinary course of business between the parties.

Ordinary course in the industry
- This is a more difficult measure to apply and may require the creditor to obtain expert testimony or third-party evidence of the relevant industry norm.
- The code specifies that the transfers that can be excluded from preference claims are those “made according to ordinary business terms.” While the creditors industry is commonly viewed as the relevant industry for the test, in some instances, the terms of dealing in the debtor’s industry (e.g. auto or defense) may be regarded as appropriate measure.

Since ordinary course defense often requires bankruptcy counsel or financial advisor assistance, a creditor should consider whether it has a sufficient remaining preference exposure after applying the new value test to justify the expense.

Be proactive and begin preparation for the defense of potential preference claims while documents and data are still easily accessible. Whenever dealing with the complex legal issues surrounding a bankruptcy, consider the need to consult with legal counsel and financial professionals.

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For more information, contact Mark Bober, partner and practice leader for BMF's Transaction Advisory Group at 330.255.2425 or by email.

Part One - When It Comes to Troubled Customers, Knowledge is Power

Part Two - Risk Management in a Troubled Economy

Part Three - Response to a Bankruptcy Filing

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