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Putting Preference Claims on Hold in the Wonder Hostess Chapter 11

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Creditors in chapter 11 cases that have exposure to preference claims arising under Bankruptcy Code §5471 routinely confront the commencement of a lawsuit against them shortly before the two-year anniversary of the filing of a chapter 11 bankruptcy petition. The timing coincides with the expiration of the statute of limitations for the commencement of preference actions contained in §546(a) of the Code. Section 546(a) requires a trustee or debtor-in-possession (DIP) to file certain avoidance actions, such as preference actions, by the later of (a) the two-year anniversary after the debtor's bankruptcy case is commenced, or (b) on rare occasions, one year after the appointment or election of the first trustee under certain specified sections of the Code.2

In many chapter 11 cases, the two-year statute of limitations expires long after resolution of most of the issues that prompted the filing of the bankruptcy case. Often by the two-year anniversary of the chapter 11, a debtor has (1) successfully reorganized and emerged from chapter 11 protection, (2) sold all or substantially all of its assets, or (3) proposed, negotiated and obtained approval of a chapter 11 reorganization plan or liquidation encompassing some combination of asset sales and/or reorganizing around core businesses and/or assets. In such cases, the prosecution of preference claims generally follows the principal reorganization or liquidation efforts.

The general two-year statute of limitations can, however, create significant issues for large, complex chapter 11 reorganizations that are operational restructurings and where a chapter 11 plan has not yet been confirmed at the two-year anniversary of the case. For some debtors, prosecuting preference actions against hundreds (or thousands) of potential preference targets, while simultaneously attempting to develop an exit strategy for the bankruptcy case, can become an unmanageable distraction and a drain on estate resources. The debtor's management team and professionals most knowledgeable about the potential preference claims are likely to be devoting substantially all their efforts toward restructuring the debtor or ensuring that value is being maximized in a sale process.

Further complicating the issue, the entire exercise of prosecuting preference claims may ultimately result in a waste of resources for both the debtor and creditor/potential preference target if the debtor has not yet determined the recoveries for unsecured creditors. For instance, if a debtor's chapter 11 reorganization or liquidation plan (filed after the two-year anniversary of the petition date) provides for the full payment of all unsecured creditors' claims, no preference liability would exist because the debtor would be unable to prove one of the elements of a preference claim arising under §547(b)(5): The creditor's receipt of a greater recovery as a result of the alleged preferential transfer than the creditor would have received in a chapter 7 case. Moreover, even if the recovery to unsecured creditors is less than 100 percent, the distributions might nevertheless be substantial enough to warrant not spending the time and expense of pursuing preference claims. That was the set of facts confronting the debtor in the Interstate Bakeries Corp. chapter 11 case.

Background of the Interstate Bakeries Case

Interstate Bakeries Corp. and most of its subsidiaries and affiliates (IBC) filed chapter 11 voluntary petitions on Sept. 22, 2004, in the U.S. Bankruptcy Court for the Western District of Missouri.3 Kansas City-headquartered IBC is one of the largest bakers and distributors of fresh-baked bread and sweet goods in the United States. The company produces, markets and distributes a wide range of breads, rolls, snack cakes, doughnuts, sweet rolls and related products under such iconic brand names as Wonder® and Hostess®. IBC has more than 25,000 employees and operates 45 bakeries and approximately 800 distribution centers at various locations around the United States. IBC's sales force delivers fresh-baked goods to tens of thousands of food outlets. IBC also operates approximately 850 bakery thrift store outlets in markets throughout the country.

IBC'S Response to the Imminent Expiration of the Preference Statute of Limitations

IBC was recently faced with a situation where, at the two-year anniversary of the filing of IBC's chapter 11 petition, no reorganization plan had been filed and IBC's exclusive right to file a plan had been extended for an additional four months. IBC had identified approximately 350 parties (primarily trade vendors) as potential preference targets. Additionally, IBC had identified potential preference claims in excess of $250 million against its pre-petition secured lenders. IBC and its constituencies sought to preserve certain preference claims. However, they did not believe that it was in the estates' best interests to prosecute preference actions when the outcome of IBC's reorganization efforts remained uncertain.

IBC sought bankruptcy court approval of procedures that would protect the estates' preference claims without immediately prosecuting hundreds of preference lawsuits. The bankruptcy court approved an order establishing procedures (the procedures order) that allowed for a single complaint to be filed against all trade and other preference defendants in a single adversary proceeding, and the filing of a separate complaint against IBC's pre-petition lenders.

The procedures resulted in substantial cost savings by eliminating the need for IBC to file the hundreds of separate complaints against each defendant and pay the thousands of dollars in associated filing fees. The motion seeking entry of the procedures order, which included a copy of the draft complaint, was served upon all parties listed as potential preference defendants, as well as the U.S. Trustee and other key constituents in the IBC case.

The procedures order also extended the deadlines established under Federal Rule of Bankruptcy Procedure 7004 and Federal Rule of Civil Procedure 4, governing the time for service of complaints, to the earlier of (1) Dec. 31, 2007 (subject to further extensions), or (2) the 90th day after the effective date of any confirmed plan of reorganization in IBC's bankruptcy case. The pre-petition lenders have the option to reduce the deadline for serving the complaint to 30 days following a written demand by their agent anytime after Jan. 31, 2007. The time period to prosecute the preference claims, including filing an answer to the complaint, would not begin to run until the complaint is properly served on the defendants, following the filing of separate amended complaints against each preference defendant.

The procedures order also authorized IBC not to pursue preference claims against certain persons that IBC considered "critical" to its business by not naming them as defendants in the filed complaint. IBC did not name as preference defendants those trade creditors that were providing important unsecured post-petition credit to IBC, sole source providers of certain goods and/or services, and providers of unique goods and/or services that would have been difficult or impossible for IBC to replace. The creditors' committee and other constituencies were given the opportunity to review and discuss with IBC the claims that IBC had decided to exclude from the complaint. The procedures order also grants IBC authority, upon written notice to the official committees and the pre-petition lenders, to drop additional named defendants from the lawsuit.

Simultaneously with serving the motion for entry of the procedures order, IBC, in consultation with its creditors' committee, sent a memorandum to each of the named nonlender defendants. The memorandum explained the purpose of the procedures order, as well as contact information for IBC's counsel and counsel to IBC's creditors' committee, in the event any of these defendants had questions about the procedures order. IBC and the creditors' committee received very few inquiries concerning the proposed procedures. Objections to the procedures order were filed by three trade creditors that were listed as potential defendants on the draft complaint. All three of these objections were resolved prior to the hearing, and the procedures order was entered on Sept. 19, 2006, without opposition, three days before the two-year statute of limitations was set to expire.

Prior to the entry of the procedures order, certain potential defendants entered into a "tolling agreement" with IBC to have the preference target's name removed from the list of defendants on the filed complaint. A tolling agreement is typically a contract between the debtor (or other estate representative) and the preference target. The target agrees that any statute of limitations that may be applicable to the claim (for instance, the two-year limitation applicable to preference actions) would be tolled and the target would not raise statute of limitations as an affirmative defense in the event a lawsuit is eventually filed against the target. In the IBC case, the procedures order had the same practical effect as a tolling agreement. However, the preference targets in IBC were actually named in a complaint on record with the bankruptcy court. Those defendants that entered into tolling agreements with IBC were not named in the preference complaint.

Prior Cases Where Preference Claims Were Put on Hold

In two prior cases, the Delaware bankruptcy court had approved somewhat similar procedures extending the time for the service of process of preference complaints. In In re Safety-Kleen Corp.,4 the court had approved procedures that allowed the debtor to file separate adversary actions under seal and extended the time for serving preference complaints to 180 days following the filing of a complaint. These deadlines were subsequently extended on several occasions. Similarly, in In re USG Corp.,5 the court approved a stipulation between the debtor and the creditors' committee authorizing the creditors' committee, nunc pro tunc, to pursue potential preference claims via a single complaint naming all defendants, similar to the procedures approved in the IBC case. The process for seeking entry of the procedures order in the IBC case was much more transparent than that utilized in Safety-Kleen and USG Corp. because IBC, unlike Safety-Kleen and USG Corp., served the proposed procedures order, and draft preference complaint, on all the potential defendants and afforded them an opportunity to object to the relief requested.

Issues Raised by the Procedures Order

While the procedures order provides a creative way for placing the preference complaints "on hold" until the resolution of the central issues in IBC's reorganization, it might have negative consequences for the named preference defendants. The preference defendants will not have the opportunity to prove any of the affirmative defenses (e.g., ordinary course of business, new value, contemporaneous exchange) to obtain dismissal or settlement of the lawsuit. The defendants cannot file a motion to dismiss or for summary judgment because the complaint has not yet been served, and therefore, the Bankruptcy Rules and Federal Rules of Civil Procedure governing motion practice have not yet become operative. Nor can the defendants seek to have the complaint dismissed for failure to serve and prosecute the complaint, because suspension of IBC's obligation to serve the complaint was expressly authorized by the procedures order. Finally, quick settlements of preference claims would seem unlikely, because the entire purpose of the procedures order was to eliminate or greatly reduce the need for IBC to devote resources towards investigating and resolving those claims at a time when the more central issues of IBC's reorganization need to be addressed.

Conclusion

The procedures order was a novel way of attempting to balance the competing interests of preserving valuable estate avoidance rights, against ensuring that estate resources were not diverted from IBC's reorganization efforts. IBC's chapter 11 case was filed prior to BAPCPA, which applies to bankruptcy cases filed on and after Oct. 17, 2005. As a result of BAPCPA, Code §1121(d)(2) now contains absolute deadlines of 18 and 20 months, respectively, after the chapter 11 filing for the debtor's exclusive right to file and solicit acceptances of a chapter 11 plan. These new plan exclusivity deadlines might seriously curtail the number of chapter 11 cases, like IBC, in which a debtor would be continuing major restructuring initiatives by the two-year anniversary of the case. Even if major restructuring efforts are unlikely at the two-year anniversary of BAPCPA chapter 11 cases, a creditors' committe or trustee responsible for pursuing preference claims might seek bankruptcy court approval of a process similar to the Procedures Order to allow more time to fully investigate claims. Only time will tell how Procedures Orders will be used, and who will seek them, in future cases.

 

Footnotes

1 Bankruptcy Code §547(b) requires that the following elements be proven to recover a transfer as a preference: (1) a transfer of property of the debtor, (2) to or for the benefit of a creditor, (3) made on account of an antecedent debt owed by the debtor to the creditor before the transfer, (4) made when the debtor was insolvent, (5) made within the 90 days of the bankruptcy filing (and between 90 days and one year of the filing if the transferee was an insider) and (6) that enabled the creditor to receive more than another creditor of the same class.

2 Additionally, Code §108(a) tolls certain statute of limitations for, among other things, state law and other applicable nonbankruptcy law claims (such as fraudulent transfer) a debtor may assert.

3 Case. No. 04-45814 (Bankr. W.D. Mo.).

4 Case No. 00-2303 (Bankr. D. Del. May 17, 2002).

5 Case No. 01-2094 (Bankr. D. Del. July 29, 2003).

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Friday, December 1, 2006

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