Bankruptcy Preferences - An Introduction

Today I spoke to a credit manager with an interesting problem. He called to discuss a letter he received demanding the payment of almost $400,000 from a customer that is in bankruptcy. Adding insult to injury, the customer still owes over $75,000 on its account. What a paradox! What my credit manager friend just received is called a Preference Demand Letter.  Dealing with preferences is one of the most common encounters with the bankruptcy process for today’s Credit Professional, and preference litigation is the most common type of adversarial proceeding in bankruptcy court.

Certain payments within 90 days (1 year if the payee was an insider) of the date of the filing of a bankruptcy petition may be considered preferential and are potentially recoverable by the bankruptcy estate.

The whole notion of the return of preferential payments under the Bankruptcy Code is the “fair and equal” treatment of all unsecured creditors. This is accomplished in a “Water Leveling” process in which property (money) is recovered from the recipients of preferential payments for the benefit of the estate. It does not seem very fair when you’re the one asked to pay back money from a company that still owes money.

I am going to discuss this subject on a regular basis here, so continue to check back if it is of interest. We will be discussing the elements of a preference as well as how they are prosecuted and defended.

If you’ve received a demand, don’t ignore it, be proactive and seek the advise of counsel experienced in these matters.  If you like, please call my office.  We are experienced in the analysis of these matters and can possibly refer you to experienced legal counsel.

How Is Bankruptcy Under Chapter 11 Different From A Case Filed Under Chapter 7 Or Chapter 13?

    Chapter 11 is the known at the Reorganization Chapter; Chapter 7 is called the Liquidation     Chapter; and Chapter 13’s title is Adjustment of Debts Of An Individual With Regular Income.

    As I wrote earlier the goal of a Chapter 11 Case is more often than not the rehabilitation of a troubled business entity, although individual filers are not uncommon.

    Chapter 7. In a chapter 7 case a trustee is appointed, who gathers and sells the debtor’s nonexempt assets for the benefit of the creditors. The notion of chapter 7 is that creditors of the same class will be treated equally; and the debtor, who will retain limited exempt assets, will get a fresh start.

    Chapter 13. Chapter 13 is similar to chapter 11, as the goal is for an individual debtor to confirm a plan that repays all or a portion of the debtor’s obligations. Chapter 13 is available only to individuals (no corporations, LLCs, or partnerships). An individual that operates a business as a sole proprietor (a dba is OK) may be eligible to file for bankruptcy under chapter 13.
    To be eligible to file under chapter 13 the individuals unsecured debts must not exceed $307,675 and the debtor’s secured debts may not exceed $922,975. These thresholds are periodically adjusted for inflation.

    Chapter 11. The goal of a chapter 11 cases is for a rehabilitated debtor to emerge from bankruptcy through the confirmation and implementation of a plan of reorganization. The plan is basically a contract between the various interested parties (creditors, debtor, secured lenders) that controls how the debtor’s affairs are to be conducted.

    An advantage of chapter 11 is that by allowing an enterprise to continue in business, value will be maximized for the benefit of the debtor’s unsecured creditors. Generally a going concern is worth more than a business that is in a state of forced liquidation. Often chapter 11 will be used as a platform to sell an operating business. The proceeds are then used to repay creditors according to priority.

What is Chapter 11 Bankruptcy?

    Chapter 11 of the United States Bankruptcy Code is titled “REORGANIZATION”.

     The goal of a Chapter 11 case is to have the Court enter an order confirming a Chapter 11 Plan. It can be a plan of liquidation or a plan of reorganization. In either case it is a contract between the various parties in a chapter 11 case setting forth how the bankruptcy pie is going to be split up.

    A unique aspect of Chapter 11 is that usually there is not an appointed Bankruptcy Trustee. In most cases filed under Chapter 11 the Debtor plays the roll of Trustee. Many creditors that I get calls from are surprised. “Richard, the same management that got the Debtor into trouble in the first place is acting as the Trustee!” I’ll often hear. 

    The notion of Chapter 11 is the rehabilitation of the Debtor. To provide balance to the fact that the Debtor is acting as Trustee, the Bankruptcy Code provides for the appointment of an Official Committee of Creditors (“Creditors Committee”). I’ll write more about Creditors Committees latter, but suffice it to say that a Creditors Committee can play the roll of a very powerful watchdog.

Do I Need To File A Proof Of Claim? (Chapter 11 Cases Only)

A a creditor from New York called and asked me if he needed to file a Proof of Claim.

First some background. The debtor in a Chapter 11 Bankruptcy case is required to file a list of its unsecured creditors on an official form called “Schedule F”. In addition to the amount owed the debtor may further classify a claim as disputed, contingent, or unliquidated.

According to the Bankruptcy Code, in a Chapter 11 bankruptcy case creditor whose claim is not scheduled; scheduled in the wrong amount; or scheduled as disputed, contingent, or unliquidated shall file a proof of claim before the deadline that will be set by the Court. Please note that requirements for the allowance of a claim under the Bankruptcy Code is not the same for cases under the other Bankruptcy Chapters.

In other words, if a creditor’s claim is listed in the correct amount and not classified as disputed, contingent, or unliquidated then the listing in the schedules by itself is evidence enough for the claim to be allowed. Also your lawyer may have a reason for you to file or not file a Proof of Claim.

Now please don’t throw out your vendor files, as at a latter date a party in the case may object to the claim and evidence of the validity of the claim may need to be provided. Also see me post How To File A Proof Of Claim.

How To File A Proof Of Claim (Chapter 11 Cases Only)

I frequently get calls from creditors asking how to file a Proof of Claim in a Chapter 11 Case. Beware; the rules and requirements are different in the other types of cases (cases filed under Bankruptcy Chapters 7, 9, and 13).

Your attorney may or may not recommend the filing of a Proof of Claim.

A Proof of Claim form will usually be sent out, but a copy of the form can be downloaded here.

Attach any necessary copies (not originals) of documents to support the validity and amount of the claim to the Clerk of the Court where the case is being heard.