Over the past few years, there has been a marked trend toward using chapter 11 to effectuate a quick sale of the debtor's assets under §363 of the Bankruptcy Code. Although these sales sometimes generate proceeds sufficient to fund a chapter 11 plan, the sales proceeds often are insufficient to satisfy the senior secured debt, and the estate is left with a motley array of business assets that generate negligible value, perhaps litigation against senior lenders or third parties that may generate a modest recovery, and last but not least the debtor's avoidance actions. It has become routine for the holder of the avoidance actions—which may be the debtor, a trustee, a party appointed pursuant to a plan or a secured lender—to send out demand letters and bring claims against dozens or hundreds of vendors who received payments in the 90 days before the filing.

Sometimes the prosecuting professionals make a detailed review in advance of commencing litigation, and bring claims only above a threshold amount and after assessing likely defenses. Often, however, complaints are filed on the eve of the running of the statute of limitations (and served months later) against anyone who shows up on the check register during the preference period, in whatever amount. Each defendant then must engage counsel, often in a foreign jurisdiction, and often with full knowledge that if the case does not settle quickly, the litigation costs will exceed the amount of the claim.

This article considers whether these claims make sense, particularly when the recoveries will have no material impact on the recovery to general unsecured creditors. Although some recent case law supports the ability to pursue these claims regardless of whether they generate any recovery for general unsecured creditors, a strong case can be made against these claims—in terms of expense to the estate, expense to the defendants and expense to the system.

Can Preference Claims Be Asserted Where There Is No Likelihood of Any Distribution to Unsecured Creditors?

A number of recent cases support the proposition that preference claims may be asserted even where the proceeds will not be distributed to general unsecured creditors, either because the claims have been assigned to a secured party or because the estate is administratively insolvent:

• In Mellon Bank N.A. v. Dick Corp.,¹ the Seventh Circuit upheld the secured lenders' right to pursue avoidance actions, the proceeds of which would be used solely to pay down their claims.
• In Gonzalez v. Nabisco Div. of Kraft Foods Inc. (In re Furrs),² a chapter 7 trustee was allowed to pursue avoidance actions pursuant to a settlement agreement that provided for a sharing of the proceeds between the secured lender and the estate. The estate's portion would be used to fund the trustee's fees, chapter 7 administrative expenses and a portion of the chapter 11 administrative expenses, but the trustee agreed that there would be no distribution to unsecured creditors.
• In Silverman Consulting Inc. v. Hitachi Power Tools U.S.A. Ltd. (In re Payless Cashways Inc.),³ the court ruled that a chapter 11 trustee had standing to pursue preference claims even though recoveries would go solely to satisfy administrative claims.
• In two related adversary proceedings,⁴ a district court in Delaware held that a purchaser of the debtors' assets had standing to assert avoidance claims, even though it would keep all recoveries.

Preference defendants have attacked these claims on two theories: first, that the plaintiff lacks standing under the Code to commence a preference action; and second, that the recovery of the avoided transfer is not "for the benefit of the estate." The courts sometimes have conflated these arguments (misleadingly) into a single argument that the plaintiff lacks standing.

Standing

Section 547 of the Code authorizes a "trustee" to avoid a preference. The Code confers similar power on a debtor-in-possession (DIP)(§1107(a)) and on a "representative of the estate" appointed pursuant to a confirmed plan of reorganization (§1123(b)(3)(B)). In attacking the standing of a lender or other third party to assert a claim, preference defendants have argued that a party who is not a trustee, DIP or authorized estate representatives lacks standing to bring a claim. They have relied on Hartford Underwriters,⁵ where the Supreme Court held that the plain language of the Bankruptcy Code permits only a trustee or DIP to move to surcharge collateral under §506(c) of the Bankruptcy Code, although the court reserved in a footnote whether a creditors' committee or other party could pursue claims derivatively on a debtor's behalf.⁶

Although a few courts had adopted this analysis (even before Hartford Underwriters) to dismiss avoidance actions brought by parties who were not estate representatives pursuant to a confirmed plan,⁷ the Seventh Circuit in Mellon Bank brushed this argument aside, permitting a secured lender to bring the claims and retain all recoveries. The court reasoned that "Mellon Bank has stepped into the shoes of the dissolved Qualitech, acquiring the debtor's claim.... The Supreme Court's decision in Hartford Underwriters did not disturb decisions allowing a lineal descent of statutory rights. Thus, we need not determine whether creditors ever may pursue avoidance actions while a DIP or trustee exists, and over their opposition, by a rationale along the lines of shareholders' derivative actions in corporate law."⁸

Interestingly, the Seventh Circuit court identified two undesirable consequences of a strict standing rule: first, that precluding sale of avoidance actions would undermine efforts to sell the business because abandoning preference claims would reduce the value of the estate's assets, and second, that it "would encourage the managers to make preferential transfers to favored vendors (who would not need to repay the firm)."⁹ The first point is illogical; if the avoidance actions are not sold, they nonetheless are retained by the estate, and their value is preserved. The second bears no relation to what happens in the real world in the weeks before a bankruptcy filing.

Regardless of whether the Seventh Circuit is right, an attack on standing is a limited weapon in the arsenal against abusive preference actions because parties usually can structure a case to avoid a standing problem. Most often in liquidating cases, a confirmed reorganization plan will vest a "representative of the estate," such as a plan administrator, with the power to pursue avoidance actions as permitted by §1123(b)(3)(B) of the Bankruptcy Code. Where a secured lender is the beneficiary of the claims, the trustee or estate representative can be given nominal authority to pursue the claims and a hypothetical upside in the recovery, with the lion's share of the proceeds going to the secured lender.¹⁰ Thus, the standing argument begs the question of whether even a trustee or DIP should bring avoidance actions where the unsecured creditors will receive no portion of the recovery.

For the Benefit of the Estate

Section 550(a) of the Bankruptcy Code provides that a trustee may recover an avoided transfer "for the benefit of the estate." But the more recent decisions do not equate benefit to the estate with recovery for unsecured creditors. For example, the court in In re Furrs said that "the estate benefits when the action increases the value or assets of the estate."¹¹ In that case, a DIP financing order granted the lenders a lien on the estate's avoidance actions and their proceeds. The case was converted to chapter 7, and the lender brought preference actions. According to the court, the estate benefited because proceeds of the avoidance actions not only would fund the secured lender's recovery, but also would pay the fees of the trustee and her counsel, the chapter 7 administrative expenses and a portion of the chapter 11 administrative expenses—although there would be nothing left for unsecured creditors. In Payless Cashways, the court similarly found that the estate would benefit from recoveries used to satisfy administrative expense claims.¹²

Finally, the Seventh Circuit in Mellon Bank posited that the general unsecured creditors had benefited from the assignment of avoidance actions to pre-petition lenders as adequate protection of their interests in other property, because the assignment was necessary to attract DIP financing. With the help of that financing, the debtor sold the business, and the secured lenders agreed to fund a distribution to general unsecured creditors. Judge Easterbrook explained: "Having put the prospect of preference recoveries to work for the benefit of all creditors (including the unsecured creditors) ex ante by effectively selling them to the secured creditors in exchange for forbearance—and in the process facilitating a swift sale that was beneficial all around—the bankruptcy judge did not need to use them ex post a second time, for still another benefit to the estate; there was no further benefit to be had."¹³

---

The proliferation of preference cases to fund deficiencies in professional fees requires commitment of judicial resources, further clogs heavy dockets and causes cases to remain open longer than they otherwise would.

---

In short, although defendants can muster arguments as to why preference actions fought for the benefit of administrative claimants or secured creditors fail to meet the "benefit of the estate" requirement of §550, the statute does not explicitly require that recoveries materially benefit general unsecured creditors, and many courts have been reluctant to find such a requirement.

Should Preference Claims Be Brought Where There Is No Likelihood of Any Distribution to Unsecured Creditors?

The fact that the trustee¹⁴ of an administratively insolvent estate may avoid and recover a preference under §547 does not mean that the trustee should bring a preference action. The preference statute incorporates the Bankruptcy Code's policy that similarly situated creditors should be treated equally by giving the trustee the power to avoid and redistribute a transfer that favors one creditor over another.¹⁵ If a debtor owes 10 creditors $100 each, but only has $200, the Bankruptcy Code suggests that each creditor should receive $20, rather than that two creditors should be paid in full and the other eight receive nothing. Of course, no one assumes that prosecution of preference claims will result in the distribution of $20 to all creditors; there will always be transaction costs and negotiated settlements that diminish the funds available for distribution. But can one really argue that the statutory purpose is advanced where the actions are successful and the other eight creditors still receive nothing? If not, there are strong policy grounds why a trustee should not pursue preference claims that will not materially enhance the distribution to general unsecured creditors.

Pursuing preference claims, of course, entails a cost to the estate. I'm not aware of any data comparing the costs of litigation to the resulting impact on distributions. Indeed, in many cases there is little or no review of the fees expended by the estate's professionals. Often, a plan will provide that professional fees are paid on a monthly basis, with little oversight, and in my experience it is unheard of that fees would be reviewed retroactively to determine whether they are proportionate to the amount recovered.¹⁶ Indeed, the information necessary to make that inquiry often is not publicly available; sometimes the amounts of the settlements themselves are kept confidential.

The decision of whether to pursue preference claims also should take into account the costs that the action will impose upon the putative defendants. The preference statute is as close to a stacked deck as any plaintiff could hope for:The trustee can simply introduce evidence of an invoice and a check paid within 90 days of the petition date, rely on the (well-founded) presumption of insolvency, and the case is made. The burden then shifts to the creditor to prove an ordinary-course-of-business defense, a new-value defense, or some other defense or more creative reason why the trustee is not entitled to recover. The ordinary course of business, as any trustee's counsel will assure you, is fact-intensive, and the creditor should be prepared to show a course of dealing over a year or more and to offer expert testimony on industry practice; any failure of proof will be fatal to the defense.

The balance of power is further distorted when the claims are in the tens of thousands or even thousands of dollars, and require the defendant to engage counsel to fight in a jurisdiction far from home. In those circumstances, the process affords the plaintiff enormous negotiating leverage regardless of the merits of the claim. In one recent case, the chapter 7 trustee of a defunct journal brought two dozen preference claims against freelancers and graphic artists who had been paid as little as $1,000, and some of whom resided far from New York, where the case was filed.¹⁷

Finally, there is a cost to the system. The proliferation of preference cases to fund deficiencies in professional fees requires commitment of judicial resources, further clogs heavy dockets and causes cases to remain open longer than they otherwise would. More importantly, abusive cases undermine the very credibility of the bankruptcy process. Bankruptcy practitioners know how difficult it is to advise a client who has lost money dealing with a debtor that not only will the client not recover on its claim, but it also will have to pay back amounts that it was paid before the petition was filed, and will have to pay counsel to defend or settle the claim. It is all the more difficult to explain that the returned funds will not be distributed to unsecured creditors, but rather will fund unpaid chapter 11 professional fees.

What Can Be Done to Curb Clearly Abusive Preference Actions?

Here are several thoughts. A starting point is for professionals to exercise discretion in whether to pursue these claims, as many already do. When a liquidating plan is negotiated, the debtor's and creditors' committee professionals should evaluate preference claims and determine whether claims should be pursued and, if so, the criteria for pursuing such claims. If preference claims will simply offer the prospect of enhancing a two-cent plan into a three-cent plan, they should simply be abandoned. In any event, claims under a certain amount (say $25,000, though the number could be higher) should not be pursued. Nor should claims be asserted unless an initial determination has been made that the recipient does not appear to have meritorious defenses. Whatever criteria are agreed to should be described in the disclosure statement. Where preference claims will not materially benefit unsecured creditors, they should not be brought unless there is a compelling purpose—e.g., to penalize an insider who is paid a large amount during the preference period, where the debtor deliberately channeled funds to favored creditors on the eve of bankruptcy; or where a creditor has enhanced its position through a lien or attachment during the preference period. Indeed, there are ethical reasons why a practitioner should not commence a preference action where he or she has reason to believe there are meritorious affirmative defenses or the litigation costs are disproportionate to the benefit to the estate.¹⁸

Next, courts can refuse to grant a secured creditor or DIP lender a lien on avoidance actions. In the rare and compelling case where the court concludes that a particular preference claim or class of claims is an essential component of the collateral package, the court might grant the lender a lien on or interest in the proceeds of a preference action, but the claim itself should be asserted by a trustee or other estate representative under the purview of the bankruptcy court, who can exercise discretion not to bring claims where the costs to the parties are disproportionate to the merits.

Finally, interested parties and the court should require greater disclosure of the fees and expenses related to each action, and should hold the professionals accountable—through fee reductions—where the fees are a high percentage of the recovery. This oversight should include ex post review of contingent fee awards, because the system has an interest in discouraging trustee's counsel from inducing vendors to return payments solely because the cost of retaining counsel to defend the claim will be more than the amount of the demand. The best way to deter needless preference actions is to assure that a trustee and the trustee's professional will make money only where the actions provide a material benefit to unsecured creditors.

Footnotes

¹ 351 F.3d 290 (7th Cir. 2003), pet. for cert. filed, 72 U.S.L.W. 3580 (U.S. Mar. 2, 2004) (No. 03-1252). Return to article

² 294 B.R. 763 (Bankr. D. N.M. 2003). Return to article

³ 290 B.R. 689, 696-97 (Bankr. W.D. Mo. 2003). Return to article

⁴ All Star Int'l. Trucks Inc. v. Burlington Motor Carriers Inc. (In re Burlington Motor Holdings Inc.), 2002 U.S. Dist. LEXIS 718 (D. Del. Jan. 17, 2002), and Burlington Motor Carriers Inc. v. Comdata Network Inc. (In re Burlington Motor Holdings Inc.), 2002 U.S. Dist. LEXIS 805 (D. Del. Jan. 18, 2002). Return to article

⁵ Hartford Underwriters Ins. Co. v. Union Planters Bank N.A., 530 U.S. 1 (2000). Return to article

⁶ Id. at 13 n.5. Return to article

⁷ See Harstad v. First Am. Bank (In re Harstad), 39 F.3d 898 (8th Cir. 1994) (post-confirmation debtors); Southtrust Bank N.A. v. WCI Outdoor Prods. (In re Huntsville Small Engines Inc.), 228 B.R. 9, 13 (Bankr. N.D. Ala. 1998) (secured creditor); Met-Al Inc. v. Gabor (In re Metal Brokers Int'l. Inc.), 225 B.R. 920 (Bankr. E.D. Wis. 1998) (assignee); Fleet Nat'l. Bank v. Doorcrafters (In re North Atl. Millwork Corp.), 155 B.R. 271 (Bankr. D. Mass. 1993) (DIP lender). See, also, Congress Credit Corp. v. AJC Int'l., 186 B.R. 555, 559-60 (D. P.R. 1995) (chapter 7 trustee's action dismissed because proceeds would only benefit the secured lender and thus are not "for the benefit of the estate"). Return to article

⁸ 351 F.3d at 292. The defendants have argued in their cert. petition that the Seventh Circuit's decision either contravenes Hartford Underwriters or requires resolution of the derivative standing issue left open in the Supreme Court's footnote. Petition for writ of certiorari, Dick Corp. v. Mellon Bank N.A., No. 03-1252, 2004 WL 424083, at **13-14 (U.S. March 2, 2004). Return to article

⁹ 351 F.3d at 294. Return to article

¹⁰ See, e.g., In re Furrs, 294 B.R. at 767-68, 770. Return to article

¹¹ Id. at 772. Return to article

¹² 290 B.R. at 696-97. Return to article

¹³ 351 F.3d at 293 (emphasis in original). Return to article

¹⁴ For convenience, I refer generically to the party pursuing the preference actions as a "trustee," regardless of whether the claims are brought by a trustee, DIP, estate representative or other party. Return to article

¹⁵ The other purpose of preference statute—to deter a race to the courthouse to dismember the debtor's assets—is seldom implicated where trustees file wholesale preference actions to recover payments made to trade creditors. Return to article

¹⁶ Contingent-fee arrangements are becoming increasingly popular. Although such arrangements impose some check on proportionality, professionals paid on a contingent fee have an incentive to target the weakest recipients, who will be most apt to pay because they cannot afford litigation costs. In addition, there also appears to be a trend toward lead bankruptcy counsel rewarding itself by taking the larger preference cases on a straight contingent-fee basis, even though the potential reward to counsel is disproportionate to the litigation costs and risks. Return to article

¹⁷ See Geltzer v. Givens (In re University Business LLC), Adv. No. 03-93441 (Bankr. S.D.N.Y.) (claim to avoid $1,000 payment made to individual residing in Indianapolis). These cases were brought to my attention in "Letter from Delaware" (Mar. 24, 2004), available at www.thedeal.com. See, also, Cotts, Cynthia, "Adieu, Tiny Lawsuits, Lingua Franca Freelancers Fight Back," The Village Voice, Feb. 4, 2004 (www.villagevoice.com). Return to article

¹⁸ See Fenning, L. and Watts, W., "Ethics for the Business Practitioner: Evaluation of Potential Preference Actions," presented at ABI's Winter Leadership Conference (Dec. 6, 2003). The authors cite (1) the attorney's obligation under Fed. R. Bankr. P. 9011 to file only well-founded complaints, (2) the attorney's ethical obligation to the client not to generate fees disproportionate to the probable benefit and (3) the attorney's obligation as an officer of the court not to bring the bankruptcy system into disrespect by filing meritless preference actions for the purpose of extracting settlements. Return to article