1. Firearms Trust, Gun Trusts and NFA Weapons Trusts
  2. Avoiding Extortionate "Preferential Transfer" Claims following Commercial Bankruptcies
  3. Problems Passing an "Instant Check"
  4. Firearms Law and Inheritance
  5. Financing your Litigation
  6. Fairness in Marcellus Shale Dealings

Avoiding Extortionate "Preferential Transfer" Claims following Commercial Bankruptcies

The spate of bankruptcies by large steel producers in the late 1990’s gave smaller suppliers fits. Owners of smaller businesses helplessly watched important accounts receivable suddenly disappear. Plans for expansion and hopes for an annual bonus gave way to a scramble for survival. For a good number of suppliers it was the end of the line, but many struggled on. Then, a year later, a second blow falls.

Compounding the injury, letters began to arrive from law firms and collection agencies representing bankrupt companies, demanding that suppliers – who already lost the money they were owed – actually give back what little money they had been paid prior to the bankruptcy. If they did not, they would be sued. These demands were invariably accompanied by an offer to settle the claim for a greatly reduced amount, if the supplier would pay right away.

Demands for the return of payments previously made by a bankrupt company are certainly not limited to the steel industry, and they are generally legitimate. But we have often seen claims for hundreds of thousands of dollars which were little more than veiled extortion.

Business people of every description, often still cash-strapped from the losses they incurred when their customer went bankrupt, are vulnerable. Facing a large claim, they are inclined to seize what appears to be an “opportunity” to negotiate down claims themselves, not realizing the claims they are paying are actually worthless.

The white-collared shakedown artists who work this angle are good at it. They speak with great authority, have had a lot of practice, and know that business people loathe litigation. They count upon fear, and despair of any alternatives to collect.

But there are practical alternatives. The first and best defense is to be able to distinguish between a legitimate preferential transfer and a bluff.

Preferential Transfers

A primary objective of the bankruptcy law is to collect all of a debtor’s assets, and then equally distribute such as there is among all creditors, on a pro-rata basis. To that end, the law empowers the estate of a bankrupt company to recover any funds the bankrupt company paid to any creditor in contemplation of bankruptcy, because the effect of such payments would be to prefer some creditors over others. In principal, this is fair enough.

The legal mechanism to recover preferential payments is to allow a debtor to “avoid” (take back) any transfer of money or property made to a supplier within 90 days of the filing of a bankruptcy petition (within a year if the transfer was to an “insider”). This “avoidance” power can be exercised, however, only if the following conditions are met:

  1. The transfer was to, or for the benefit of, a particular creditor;
  2. The transfer was for or on account of a debt the creditor was owed by the debtor before the challenged transfer was made;
  3. The debtor was actually insolvent at the time the transfer was made; and
  4. As a result of the transfer, the creditor was able to receive more than the creditor would have received if the debtor were liquidated and the transfer had never been made.

Those who regularly supply goods or services to major industrial producers are typically paid 30, 60 or 90 days after invoice. When a major player in any industry goes bankrupt, it is inevitable that thousands of such payments will have been made within 90 days of the date of the filing of the bankruptcy petition. All of those payments, on their face, meet the conditions stated above.

BUT routine payments pursuant to routine business transactions are not what the bankruptcy law is designed to prevent. Further, if suppliers of goods and services to a financially troubled customer know they might have to give back anything they are paid by that customer, they will be reluctant to continue to deliver goods and services to that customer. This would have the effect of forcing troubled companies that would otherwise solve their financial problems into bankruptcy prematurely.

To avoid this adverse result, Congress explicitly exempted certain transfers from the debtor’s power to “avoid.”

Among the exempted transfers are those which:

  1. Are in payment of a debt incurred in the ordinary course of the business of the debtor and the supplier;
  2. Which were made in the ordinary course of the business of the debtor and the supplier; and
  3. Were made according to ordinary business terms.

The key to the avoidance power is in the definition of “ordinary course of business.” A debtor who pays a supplier according to the ordinary terms of an established business relationship is not seeking to prefer one creditor over another. Therefore, a bankrupt or its representative cannot legitimately demand the return of such payments.

For payments to be regarded as having been made in the ordinary course of business, the debt and payment of the debt must be both “ordinary” when viewed in relation to the overall course of business dealings between the bankrupt and the supplier, and “ordinary” in relation to standards prevailing in the industry generally. This means the manner, amount and timing of the payments made and received prior to the filing of the bankruptcy must have been typical of those received throughout the history of the business relationship between the two companies.

Any payments during the “preference period” must also have been typical of the way such payments are made within some significant segment of the industry. In most industries, monthly payments net 60 or 90 days of invoice would likely satisfy these requirements.

If, however, the payments were in fact prompted by unusual collection activity, they would not be typical, and would not, therefore, qualify as being “in the ordinary course of business.” Unusual collection activity includes such things as threats to sue or to cut off supply, putting the customer under special payment terms, turning an account over to a collection agent or making telephone calls to officials or principals within the debtor company to secure payment.

Abuse of the System

Obviously, demanding payment on a claim one knows to be specious on pain of litigation is unethical and, in many states, illegal. A more common abuse, however, is the assertion of claims the merit of which is unknown.

Every state has laws that prohibit the bringing of a lawsuit against any person without first conducting a reasonable investigation of the facts and, based upon that investigation, having a good faith belief the claim is valid. The rules governing federal litigation (including all bankruptcies) specifically require that one filing suit must certify he has made “an inquiry reasonable under the circumstances,” and that following such inquiry he has a good faith belief factual allegations upon which the claims are based will be supported by admissible evidence.

Collection agents for bankrupt companies sometimes examine the accounts payable records of a bankrupt entity, and indiscriminately claim all payments made within 90 days of the filing of the bankruptcy are “preferential.” They perform no meaningful investigation into whether payments made within the statutory preference period were made within the “ordinary course of business,” and simply write demand letters en masse. If the demand results in payment, they made out. If the supplier protests, they negotiate, undoubtedly assisted by the looming threat of litigation.

In the case of the steel industry bankruptcies, thousands of such letters went out. Many of them, perhaps even most, either overstated the amounts subject of avoidance or were completely without substance. Tens of millions of dollars were paid over, much of it by people who expressed doubts about the fairness or legitimacy of the claims.

Protecting your Business

Unless one is familiar with the legal definition of “ordinary course of business” and knows the payments they received do not fit that bill, it seems foolish to pay claims without consulting an attorney for a review of one’s specific circumstances. If your company was a supplier who got nothing more than routine payment for previously supplied goods or services, and absent any unusual collection activity, the chances are your firm does not owe a thing.

Of course, any experienced business person knows that being right does not mean one will not be sued. Many collection agents count upon people’s awareness of that fact. But victims of these practices are not as helpless as they may think.

Whether the potentially preferential payments were typical should be apparent from the bankrupt company’s own records of the history of its transactions with your company. The debtor would also surely know whether the payment terms were typical of those in any significant segment of the same industry (including, of course, the bankrupt’s other suppliers), and whether the payments were prompted by any unusual collection activity. It would seem any “reasonable inquiry” by the debtor would have to include a review of at least these readily available sources.

Where a suit is based upon naked allegations unsupported by any investigation, and that investigation would have disclosed a claim is not supportable, the litigant, the attorneys for the litigant, and any person who directed, advised or assisted in the filing of the suit can be held responsible for resulting damages. This means not only the estate of the bankrupt company, but also its officials and attorneys, may be subject to liability to your company for attorney fees, court costs, loss of executive and staff time, and other expenses incurred in defending the suit.

Even if you ultimately elect to negotiate rather than fight, appearing through experienced counsel and making it known you are prepared to resist doubtful or spurious claims will greatly strengthen your negotiating position. If the claims are substantial, investment in investigation and representation will save much more than it costs.

At Greystone Legal Associates we have experience resisting preferential transfer claims. If you are confronting this problem, we would be pleased to discuss your situation with you, free of charge.

back to top