When a major customer files for bankruptcy, you may think that the receivables you have already collected are safe in the bank. That is, until you are confronted by a demand letter and ensuing litigation from counsel for a trustee, debtor in
possession or unsecured creditors’ committee seeking repayment of all transfers
received from your customer within the 90
days prior to the bankruptcy petition date
known as the “preference period.” Your business is then faced with the prospect of not
only having to disgorge what was received
but also with the costs of defending the
claim.
“While it is important for CEOs to act decisively once such a claim is made, because of
prior inattention to the receivable, many
times it is simply too late to significantly alter
the outcome,” says Jeffrey Isaacs, a partner
within the Finance, Restructuring &
Bankruptcy practice at Procopio, Cory,
Hargreaves & Savitch LLP.
Smart Business spoke with Isaacs about
how CEOs should handle adversary proceedings in bankruptcy court and some of
the proactive measures that are helpful in
defending bankruptcy-related litigation.
What are bankruptcy avoidance powers?
As a CEO, you may not be aware that some
of the companies you are dealing with are on
the verge of bankruptcy and, should they file,
you may be subject to litigation based on
what are known as ‘the trustee’s avoiding
powers.’ Avoiding powers are statutory rights
provided to a bankruptcy trustee or debtor in
possession in a Chapter 11 case to recover
certain transfers of property such as preferences, transfers in fraud of creditors or avoidance of certain liens created before the commencement of a bankruptcy case.
Even if your debt is secured by a lien, it may
be divided into a secured claim, to the extent
of the value of the collateral, and an unse-cured claim equal to the remainder of the
total pre-petition debt. Generally, a secured
claim must be perfected under applicable
state law to be treated as a secured claim. In
this regard, a perfection problem that is corrected at the eleventh hour is often treated as
an avoidable preference.
What are adversary proceedings in bankruptcy court?
Bankruptcy litigation, known as ‘adversary
proceedings,’ is litigation conducted pursuant to the specific Federal Rules of
Bankruptcy Procedure. One unique feature
of the litigation is that personal jurisdiction
may be easily acquired through service by
mail. Usually, bankruptcy adversary proceedings will be commenced in the district where
the underlying bankruptcy case is pending,
which may have no relationship to where the
facts giving rise to the claim occurred and is
therefore convenient only to the trustee or
debtor in possession and its counsel.
Because of this, from a pure tactical standpoint, the deck is decidedly stacked in favor
of the trustee or debtor in possession. Also,
fees for prosecuting the preference action
are normally borne by the bankruptcy estate,
whereas fees in defending a preference action are borne solely by the creditor alleged
to have received the avoidable transfer.
What immediate steps should CEOs take if
their company is sued?
Because there is normally only 30 days to
respond to an avoidance action once it is filed, it is important for the CEO to act decisively and receive advice as to whatever
options are available in defending the action,
such as abstention or change of venue.
Do CEOs need local or specialized representation?
If you end up defending the action in a distant jurisdiction, it’s often important to hire
local counsel because the judges and attorneys who work bankruptcy cases in a given
judicial district tend to have very collegial
relationships, so this will level the playing
field to some extent. However, the creditor’s
general counsel may also participate on a pro
hac vice basis to avoid duplication of effort
and reduce defense costs.
How can CEOs evaluate the costs of defense
in determining their options?
Since your company will be responsible for
the costs of defense in any event, it is important to weigh the projected expenses of
defense and the potential outcome. CEOs do
not want to find themselves in a position
where the already incurred cost of defense
becomes the primary factor in whether the
litigation should go forward. Experienced
bankruptcy counsel can provide realistic estimates that can help with this risk/benefit
analysis at an early stage in the case.
What proactive steps can be taken to ensure
success in bankruptcy-related litigation?
It is important to monitor how your customers are performing in regard to payment
of your accounts receivable and how much
credit you are extending to them. If it appears
that a customer is having financial difficulty
and is falling behind in payment, decisions as
to how any monies received against those
receivables is applied may be vital to the ability to defend a subsequent preference claim.
Since we may be headed toward an economic downturn, it’s likely that these issues
will arise in greater frequency.
JEFFREY ISAACS is a partner with the Finance, Restructuring &
Bankruptcy practice at Procopio, Cory, Hargreaves & Savitch LLP.
Reach him at (619) 515-3213 or [email protected].