Preference Actions Lessons Taught by Experience

Preference Actions Lessons Taught by Experience

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The old saying, "There is no teacher like experience," is absolutely true. Trust me, I speak from first-hand experience.

A few years ago, I was asked to manage the bankruptcy administration and wind-down for a global, multi-billion dollar corporation, and was appointed its general counsel and managing director of bankruptcy administration. Having been assistant general counsel for the company for eight previous years and knowing the company intimately, I felt that I was properly educated and well qualified to handle the job with relative ease. Also, I had previously been general counsel of a privately held multi-million dollar national conglomerate during its chapter 11 bankruptcy case. While I did not have a hands-on role in that prior case per se, I did work closely with bankruptcy counsel. Certainly, I believed I knew more than enough to manage the bankruptcy and the ultimate liquidation of my current company. How wrong I was!

Bankruptcy, like many other legal specialties, is a niche unto itself. While many in the corporate law world can talk the lingo, my experience is that most general, corporate and outside counsel, who are not bankruptcy experts, seldom really understand what it takes to be a "bankruptcy attorney."

In my personal bankruptcy adventure, I was incredibly fortunate to be surrounded by talented, experienced professionals, most of whom dealt with bankruptcy on a daily basis. I have learned bankruptcy the hard way, from hands-on experience and by realizing how much I didn't know. My recommendation for any corporate or general counsel who is not intimately familiar with bankruptcy is simple: Learn as much as you can while deferring to the experts!

Asserting All the Defenses

Without a doubt, preferences are among the most glaring examples of an area where significant knowledge must be acquired by any attorney dealing with bankruptcy. My team was asked to take on the task of managing, settling, negotiating and analyzing preferences for our company. Simple enough, it seemed, at least in the beginning. However, we soon began to understand that "ordinary course" does not necessarily mean what is "typical" in the industry. We learned that "new value" is not the same as "contemporaneous exchange" and that progress and installment payments may or may not be deemed preferential, depending on a number of circumstances surrounding those payments.

It has been an amazing and eye-opening experience for me and my team (only one of whom, in addition to myself, is an attorney) to learn to analyze preferences and to determine what is truly recoverable, as opposed to thinking we can easily recover the entire gross transfer made during the 90 days prior to the filing. Also, we now understand how to analyze preference defenses.

What has been even more startling is the discovery that many attorneys (in-house counsel, general counsel and even outside counsel) virtually "give away" money because they do not properly analyze the available defenses, nor do they assert those defenses correctly.

Countless times, a preference defendant's counsel will vigorously argue that his client does not owe the entire gross transfer amount that was initially asserted. Yet that same counsel will end up making us a settlement offer (or accepting our counter-offer), without properly taking into account new value and/or ordinary course defenses, or without doing the appropriate analysis to determine if our numbers are correct. If counsel did perform these tasks, they would often discover defenses that could and should have been asserted.

Record-keeping and Documentation

It is also clear from our experience that the books and records of both debtors and creditors are often inadequate and confusing. It would certainly benefit all vendors against whom preferences are regularly asserted to go back and verify their records to determine if the information the debtor conveys to them regarding payments is accurate. In our case, we have been as efficient and thorough as possible in providing the most accurate information available. However, we are aware of instances where our records were less than complete, or in some cases, where they were proven inaccurate. Counsel often did not have the information or attempt to verify the correct information, which would have raised potential arguments to refute at least part of the preference claim.

Without a doubt, preferences are among the most glaring examples of an area where significant knowledge must be acquired by any attorneys dealing with bankruptcy.

Also to be considered is verification by counsel to determine if the entity pursuing the preference was, in fact, insolvent at the time of the filing. In our case, we clearly had financials—10Ks and 10Qs—which evidenced that fact (notwithstanding the fact that some counsel could not read these and understand that the company was clearly insolvent). Therefore, the ability to read and understand this type of documentation is essential in order to know when insolvency should be a real issue rather than an expensive diversion. The debtor should be asked to supply appropriate documentation, or at least verify that appropriate documentation exists to which counsel can refer to substantiate insolvency.

Where court approval of the settlement is required, counsel should confirm whether the individual settling the preference, if not a trustee or plan administrator, has the requisite authority to settle cases in his/her absolute discretion. Assuming such is the case, appropriate orders will have been entered by the bankruptcy court. Counsel should either request, or have access to, the relevant orders to verify the ability of the company or its representatives to settle the preference without further court involvement.

Successor Entities and Subsidiaries

Another potential pitfall involves identifying the correct party to sue for the preference. We have seen a number of cases where a company was sold and, as part of the sale transaction, liabilities were either assumed by the purchaser or were expressly retained by the seller. If liabilities are assumed, then the purchaser will most likely be liable for the preference. Typically, unless such liabilities are expressly assumed, the selling company has retained the liabilities. Again, interaction between bankruptcy counsel, outside counsel and corporate counsel is essential. All parties must understand the relationship that exists between seller and buyer, so that the parties can quickly assess the correct party to sue to recover the preference. In several cases, we asserted preference claims against companies as indicated by our records. Further information surfaced that indicated that the party we initially pursued was not necessarily liable for the claim. One test in this regard determines if the successor company ultimately benefited from the proceeds of the preference payment. If the successor company did not benefit, in many instances it would have no preference liability. However, in several instances, successor companies, which seemingly had no liability on asserted preferences, offered and paid a settlement for the case.

When companies have subsidiaries or operating divisions, counsel defending the preference understand the relationship of those entities to the filing debtor entity. Divisions are most likely to be considered part of the same legal entity. Therefore, a preference asserted by ABC Inc. is the same as a preference asserted by XYZ Co., a division of ABC Co. We had significant and protracted debates with counsel who did not want to pay because one of our divisions made payments to their clients. However, this was merely our parent company asserting the preference. That was, of course, correct corporate governance. Similar issues are presented when dealing with debtor subsidiaries. Again, counsel should understand the relationship between the parent and its divisions or subsidiaries.

"Nuisance" Settlements

Any of these issues can lead to what is ultimately a cost-of-defense, or "nuisance," settlement. Often there is a debate over whether the defendant has been well served by its counsel in these circumstances. Certainly, any debtor will take those payments, especially in situations where they may not ultimately be otherwise entitled to collect. There is, of course, the very real practicality of the cost of defense. If an adversary complaint is filed on a preference, there is an inherent cost in both retaining local counsel and defending that action. However, it is clear from our experience that we were often paid in situations that should have been defended (or better defended), and we also have not been paid (through a reasonable settlement) in circumstances where a poorly conceived defense is being maintained by an ill-informed counsel. Counsel representing defendants in preference actions must perform a cost benefit analysis to compare the cost of pursuing a defense to a reasonable settlement payment. Based on the facts and circumstances, counsel should consider offering a cost of defense settlement to save the client from incurring additional fees and expenses merely to defend a case that will ultimately be lost. Often times, even if counsel wins, the client pays more than the cost of defense settlement.

We have heard the word "extortion" more times than we care to remember in discussions with individuals representing preference defendants, and we take severe offense at that insinuation. As we all are aware, the Bankruptcy Code allows a debtor to pursue those matters that, in good faith, it believes have a recoverable value for the estate. To the extent that a settlement is warranted, even if such is merely to eliminate defense costs, the best interests of the client and the process requires that settlement as timely as possible to avoid additional time, costs and fees. Further, rather than unnecessarily involving both bankruptcy counsel, and to the extent necessary, local counsel, attorneys for preference defendants should first attempt to settle these matters. In a majority of cases, settlement is warranted and will ultimately happen. Preference defendants can save costs by at least having their primary counsel attempt a good-faith settlement early in the process.

Journal Date: 
Monday, April 1, 2002