Bankruptcy Reform Act Aids Creditors in Claims

By René Lastreto, II
Lang, Richert and Patch

In April 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“Reform Act”). Most of the provisions go into effect on October 17, 2005. While the Reform Act contains many changes to consumer bankruptcy law, it also contains significant provisions applicable to business bankruptcy issues.

In particular, the law has been changed for “preference claims,” litigation filed by bankruptcy trustees or plan agents seeking to have the creditor return hard-earned money received from the bankruptcy debtor within 90 days of the filing of the bankruptcy petition.

The policies underlying preference claims include “equality of distribution” among similarly situated creditors, which includes the theory that creditors paid by a beleaguered debtor as he “slides” into bankruptcy should not benefit at the expense of the other creditors.

To address this “inequality,” bankruptcy law allows estate representatives to sue non-insider creditors to recover payments they received within 90 days of the bankruptcy filing. Insider creditors are subject to a one year “reach back.”

However, not all payments are recoverable as preferences. Only those payments made on antecedent (older) debts are recoverable to the extent the creditor received more than it would have received were the debtor liquidated under Chapter 7 and each creditor received a pro rata distribution.

It should be noted that the law also requires that the debtor was “insolvent” during the 90 day preference period, however, the law presumes insolvency, and it is up to the creditor to prove otherwise.

Creditors, however, do have certain defenses, including that the payment was in “the ordinary course of business” and under ordinary business terms; that the payment was made contemporaneously with the creditor giving “new value” to the debtor; or that after the payment was made the creditor gave the debtor additional “new value.”

Under current law, a creditor defending against a preference claim must prove that an otherwise preferential payment was: (1) made by the debtor in the ordinary course of the debtor and creditor’s business (the “subjective element”); and (2) according to ordinary business terms (the “objective element”). Thus a creditor must prove that the payment was typical both as between the creditor and its customer(the debtor) and according to industry standards.

The objective element is problematic for several reasons. First, while most companies have employees who can testify to industry standards, their knowledge may have been gained from sources that would be inadmissible in court such as trade journals, conversations with peers, etc. This requires a defendant to hire an expert with its attendant costs and other concerns.

The Reform Act makes this defense more tenable since creditors will now need to prove either that the payment was in the ordinary course of business between the creditor and the debtor or was made under ordinary business terms. This should make the defense easier to establish as an expert will not be needed to establish the creditor’s history with the debtor.

In addition, two very irritating aspects of preference practice have also been addressed under the Reform Act: the small case and far away venue.

First, creditors with valid defenses to preference claims have been coerced into unfavorable settlements of small cases due to the economics of litigation. The Reform Act addresses this issue by requiring that a preference claim in a business case must exceed $5,000 to be recoverable.

While still perhaps too low, this threshold should discourage litigation over very small claims. Interestingly, this is a new defense to the preference claim, meaning the creditor must raise and prove the defense. Still, if the facts exist to support the defense, estate representative and their lawyers may face sanctions for pursuing a frivolous case.

Second, because of the bankruptcy law’s venue provisions, creditors would often be required to litigate small cases in far away venues such as Delaware or New York, where the “mega-case” was pending.

Under the Reform Act, any case seeking less than $10,000 from a non-insider must litigate the preference claim in the district where the creditor-defendant resides. Prior law allowed litigation where the main bankruptcy case was pending so long as the claim was over $1,000. This led to virtually all cases being brought in the venue of the main bankruptcy case, forcing creditors to hire counsel in far away places to litigate small cases.

The Reform Act contains many provisions that affect consumers and businesses. While many changes will not affect the daily business of many of the clients of Lang, Richert & Patch, the Reform Act contains some benefits for those who occasionally are involuntarily brought into the bankruptcy process.

Rene Lastreto, II heads the firm’s bankruptcy practice and is certified in Creditor Rights Law. Lastreto has more than 20 years experience dealing with business litigation issues, with a strong focus on complex bankruptcy, collection and insolvency cases. Individuals and businesses facing such problems are encouraged to contact him for a consultation.