California Creditor's Rights & Business Bankruptcy Lawyer & Attorney : Robert Eisenbach : Business Bankruptcy Blog

Companies in financial trouble are often forced to liquidate their assets to pay creditors. While a Chapter 11 bankruptcy sometimes makes the most sense, other times a Chapter 7 bankruptcy is required, and in still other situations a corporate dissolution may be best. This post examines another of the options, the assignment for the benefit of creditors, commonly known as an "ABC."

A Few Caveats. It's important to remember that determining which path an insolvent company should take depends on the specific facts and circumstances involved. As in many areas of the law, one size most definitely does not fit all for financially troubled companies. With those caveats in mind, let's consider one scenario sometimes seen when a venture-backed or other investor-funded company runs out of money.

One Scenario. After a number of rounds of investment, the investors of a privately held corporation have decided not to put in more money to fund the company's operations. The company will be out of cash within a few months and borrowing from the company's lender is no longer an option. The accounts payable list is growing (and aging) and some creditors have started to demand payment. A sale of the business may be possible, however, and a term sheet from a potential buyer is anticipated soon. The company's real property lease will expire in nine months, but it's possible that a buyer might want to take over the lease.

• A Chapter 11 bankruptcy filing is problematic because there is insufficient cash to fund operations going forward, no significant revenues are being generated, and debtor in possession financing seems highly unlikely unless the buyer itself would make a loan. 
• The board prefers to avoid a Chapter 7 bankruptcy because it's concerned that a bankruptcy trustee, unfamiliar with the company's technology, would not be able to generate the best recovery for creditors.

The ABC Option. In many states, another option that may be available to companies in financial trouble is an assignment for the benefit of creditors (or "general assignment for the benefit of creditors" as it is sometimes called). The ABC is an insolvency proceeding governed by state law rather than federal bankruptcy law.

California ABCs. In California, where ABCs have been done for years, the primary governing law is found in California Code of Civil Procedure sections 493.010 to 493.060 and sections 1800 to 1802, among other provisions of California law. California Code of Civil Procedure section 1802 sets forth, in remarkably brief terms, the main procedural requirements for a company (or individual) making, and an assignee accepting, a general assignment for the benefit of creditors:

1802.  (a) In any general assignment for the benefit of creditors, as defined in Section 493.010, the assignee shall, within 30 days after the assignment has been accepted in writing, give written notice of the assignment to the assignor's creditors, equityholders, and other parties in interest as set forth on the list provided by the assignor pursuant to subdivision (c).
   (b) In the notice given pursuant to subdivision (a), the assignee shall establish a date by which creditors must file their claims to be able to share in the distribution of proceeds of the liquidation of the assignor's assets.  That date shall be not less than 150 days and not greater than 180 days after the date of the first giving of the written notice to creditors and parties in interest.
   (c) The assignor shall provide to the assignee at the time of the making of the assignment a list of creditors, equityholders, and other parties in interest, signed under penalty of  perjury, which shall include the names, addresses, cities, states, and ZIP Codes for each person together with the amount of that person's anticipated claim in the assignment proceedings.

In California, the company and the assignee enter into a formal "Assignment Agreement." The company must also provide the assignee with a list of creditors, equityholders, and other interested parties (names, addresses, and claim amounts). The assignee is required to give notice to creditors of the assignment, setting a bar date for filing claims with the assignee that is between five to six months later.

ABCs In Other States. Many other states have ABC statutes although in practice they have been used to varying degrees. For example, ABCs have been more common in California than in states on the East Coast, but important exceptions exist. Delaware corporations can generally avail themselves of Delaware's voluntary assignment statutes, and its procedures have both similarities and important differences from the approach taken in California. Scott Riddle of the Georgia Bankruptcy Law Blog has an interesting post discussing ABC's under Georgia law. Florida is another state in which ABCs are done under specific statutory procedures. For an excellent book that has information on how ABCs are conducted in various states, see Geoffrey Berman's General Assignments for the Benefit of Creditors: The ABCs of ABCs, published by the American Bankruptcy Institute.

Important Features Of ABCs. A full analysis of how ABCs function in a particular state and how one might affect a specific company requires legal advice from insolvency counsel. The following highlights some (but by no means all) of the key features of ABCs:

• Court Filing Issue. In California, making an ABC does not require a public court filing. Some other states, however, do require a court filing to initiate or complete an ABC.
• Select The Assignee. Unlike a Chapter 7 bankruptcy trustee, who is randomly appointed from those on an approved panel, a corporation making an assignment is generally able to choose the assignee.
• Shareholder Approval. Most corporations require both board and shareholder approval for an ABC because it involves the transfer to the assignee of substantially all of the corporation's assets. This makes ABCs impractical for most publicly held corporations.
• Liquidator As Fiduciary. The assignee is a fiduciary to the creditors and is typically a professional liquidator.
• Assignee Fees. The fees charged by assignees often involve an upfront payment and a percentage based on the assets liquidated.
• No Automatic Stay. In many states, including California, an ABC does not give rise to an automatic stay like bankruptcy, although an assignee can often block judgment creditors from attaching assets.
• Event Of Default. The making of a general assignment for the benefit of creditors is typically a default under most contracts. As a result, contracts may be terminated upon the assignment under an ipso facto clause.
• Proof Of Claim. For creditors, an ABC process generally involves the submission to the assignee of a proof of claim by a stated deadline or bar date, similar to bankruptcy. (Click on the link for an example of an ABC proof of claim form.)
• Employee Priority. Employee and other claim priorities are governed by state law and may involve different amounts than apply under the Bankruptcy Code. In California, for example, the employee wage and salary priority is $4,300, not the $10,950 amount currently in force under the Bankruptcy Code.
• 20 Day Goods. Generally, ABC statutes do not have a provision similar to that under Bankruptcy Code Section 503(b)(9), which gives an administrative claim priority to vendors who sold goods in the ordinary course of business to a debtor during the 20 days before a bankruptcy filing. As a result, these vendors may recover less in an ABC than in a bankruptcy case, subject to assertion of their reclamation rights.
• Landlord Claim. Unlike bankruptcy, there generally is no cap imposed on a landlord's claim for breach of a real property lease in an ABC.
• Sale Of Assets. In many states, including California, sales by the assignee of the company's assets are completed as a private transaction without approval of a court. However, unlike a bankruptcy Section 363 sale, there is usually no ability to sell assets "free and clear" of liens and security interests without the consent or full payoff of lienholders. Likewise, leases or executory contracts cannot be assigned without required consents from the other contracting party.
• Avoidance Actions. Most states allow assignees to pursue preferences and fraudulent transfers. However, the U.S. Court of Appeals for the Ninth Circuit has held that the Bankruptcy Code pre-empts California's preference statute, California Code of Civil Procedure section 1800. Nevertheless, to date the California state courts have refused to follow the Ninth Circuit's decision and still permit assignees to sue for preferences in California state court. In February 2008, a Delaware state court followed the California state court decisions, refusing either to follow the Ninth Circuit position or to hold that the California preference statute was pre-empted by the Bankruptcy Code. The Delaware court was required to apply California's ABC preference statute because the avoidance action arose out of an earlier California ABC.

The Scenario Revisited. With this overview in mind, let's return to our company in distress.

• The prospect of a term sheet from a potential buyer may influence whether our hypothetical company should choose an ABC or another approach. Some buyers will refuse to purchase assets outside of a Chapter 11 bankruptcy or a Chapter 7 case. Others are comfortable with the ABC process and believe it provides an added level of protection from fraudulent transfer claims compared to purchasing the assets directly from the insolvent company. Depending on the value to be generated by a sale, these considerations may lead the company to select one approach over the other available options.
• In states like California where no court approval is required for a sale, the ABC can also mean a much faster closing -- often within a day or two of the ABC itself provided that the assignee has had time to perform due diligence on the sale and any alternatives -- instead of the more typical 30-60 days required for bankruptcy court approval of a Section 363 sale. Given the speed at which they can be done, in the right situation an ABC can permit a "going concern" sale to be achieved.
• Secured creditors with liens against the assets to be sold will either need to be paid off through the sale or will have to consent to release their liens; forced "free and clear" sales generally are not possible in an ABC.
• If the buyer decides to take the real property lease, the landlord will need to consent to the lease assignment. Unlike bankruptcy, the ABC process generally cannot force a landlord or other third party to accept assignment of a lease or executory contract.
• If the buyer decides not to take the lease, or no sale occurs, the fact that only nine months remains on the lease means that this company would not benefit from bankruptcy's cap on landlord claims. If the company's lease had years remaining, and if the landlord were unwilling to agree to a lease termination approximating the result under bankruptcy's landlord claim cap, the company would need to consider whether a bankruptcy filing was necessary to avoid substantial dilution to other unsecured creditor claims that a large, uncapped landlord claim would produce in an ABC.
• If the potential buyer walks away, the assignee would be responsible for determining whether a sale of all or a part of the assets was still possible. In any event, assets would be liquidated by the assignee to the extent feasible and any proceeds would be distributed to creditors in order of their priority through the ABC's claims process.
• While other options are available and should be explored, an ABC may make sense for this company depending upon the buyer's views, the value to creditors and other constituencies that a sale would produce, and a clear-eyed assessment of alternative insolvency methods. 

Conclusion. When weighing all of the relevant issues, an insolvent company's management and board would be well-served to seek the advice of counsel and other insolvency professionals as early as possible in the process. The old song may say that ABC is as "easy as 1-2-3," but assessing whether an assignment for the benefit of creditors is best for an insolvent company involves the analysis of a myriad of complex factors.

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Tomorrow, October 17, 2007, marks the second anniversary of the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA.  BAPCPA was enacted primarily to make sweeping changes to the consumer provisions of the Bankruptcy Code. However, BAPCPA also made significant revisions in the business bankruptcy arena.  When it was passed, bankruptcy lawyers, creditors, and potential debtors had many questions about how these changes would play out as new cases made their way through the system. Two years out, we now have answers to some of those questions.

In this post I'll look at a few of BAPCPA's more substantial revisions and how courts have addressed them so far. These include new rules governing real estate leases, reclamation, the "20 day goods" administrative claim, key employee retention plans, cross-border bankruptcy cases, and an important preference defense. As we walk down memory lane, I'll also point you to earlier posts where you can find more details on these issues.

Commercial Real Estate Leases. Under BAPCPA, if the debtor is the tenant under an unexpired commercial lease, it must either assume or reject the lease within 120 days of the filing of bankruptcy. The court can extend this time period without the landlord’s consent for 90 additional days, making a total of 210 days, but any further extensions require the landlord’s prior written consent. If the lease is not assumed (or assumed and assigned) within this period, the lease automatically will be deemed rejected and the debtor will have to move out. 

• Before BAPCPA, debtors initially had only 60 days to assume or reject leases but there was no statutory limit on extensions of that period. Cumulative extensions of a year or more, over a landlord's objection, were not uncommon under the pre-BAPCPA version of the Bankruptcy Code. That is no longer possible under BAPCPA.
• Below market leases can represent a significant asset, particularly for retailers with many store leases, and BAPCPA has forced these debtors to move very quickly to assume and assign leases or to sell designation rights to make the most of the 210 day maximum period. In a number of cases, this 210 day limit has depressed the value of the debtor's leases and the recovery for its creditors.
• For more on real estate leases, you may want to read "Commercial Real Estate Leases: How Are They Treated In Bankruptcy?" previously posted on this blog.

Reclamation. When a debtor becomes insolvent or files bankruptcy, some vendors may be able to take advantage of a special, although limited, right to get back or "reclaim" certain of the goods. This reclamation right is part of both the Uniform Commercial Code and the Bankruptcy Code. BAPCPA made some changes in the reclamation area and post-BAPCPA cases have put some meat on the bones of those changes. A new, 45-day bankruptcy reclamation right was added to Section 546(c) of the Bankruptcy Code, expanding the Uniform Commercial Code's 10-day rule. Under BAPCPA, the goods must have been sold in the "ordinary course" of the vendor's business and the debtor must have received the goods while insolvent. The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the customer (now the debtor in bankruptcy).  If the 45-day period expires after the bankruptcy case is filed, the vendor must make the reclamation demand within 20 days after the bankruptcy filing.

Two decisions from earlier this year have helped clarify the impact, and highlight the limitations, of BAPCPA's reclamation changes.

• In January 2007, Judge Christopher S. Sontchi of the U.S. Bankruptcy Court for the District of Delaware refused to issue a temporary restraining order in favor of a reclamation claimant in the Advanced Marketing Services case who sought to prevent the sale of goods it was trying to reclaim. The Court cited the superior rights of the secured creditor, which had a lien on the goods. A discussion of the case and a copy of the Court's decision is available at this earlier post.
• Then, in April 2007, Judge Burton R. Lifland of the U.S. Bankruptcy Court for the Southern District of New York applied the "prior lien defense" in favor of a secured creditor by valuing all reclamation claims in the Dana Corporation case at zero. You can find a discussion of that case and a copy of the decision at this previous post.

The "20 Day Goods" Administrative Claim. Although the post-BAPCPA decisions have not been favorable to vendors in the reclamation area, recent developments have underscored the value of the new Section 503(b)(9) administrative claim. That new provision, added by BAPCPA, gives vendors an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor's business."  For an overview of the new provision, you may find the post entitled "20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy," of interest.

• We now have several decisions interpreting this new BAPCPA right for vendors. The first decisions held that a vendor generally must wait until confirmation of a plan to receive payment on this new administrative claim. (See "The New Section 503(b)(9) Administrative Claim: The Latest On What Courts And Debtors Have Been Doing" for more details.) 
• More recently, the Ninth Circuit Bankruptcy Appellate Panel held that even secured creditors can qualify for the benefits of the new provision. For more on these issues, as described in this post: "The Best Of Both Worlds: Can A Secured Creditor Get A Section 503(b)(9) '20 Day Goods' Administrative Claim Too?"

Key Employee Retention Plans. One of BAPCPA's most notable changes was the significant restrictions imposed on key employee retention plans, known as KERPs. Prior to BAPCPA, KERPs were a very popular way of making sure that a company could retain its most important officers and employees to guide it through bankruptcy. Citing perceived abuses, however, Congress added language in BAPCPA that requires debtors to satisfy nearly impossible standards before courts would be permitted to approve payment of retention bonuses (or severance payments) as administrative claims to officers and other insiders of a bankrupt company. In short, a debtor would have to show that the individual was essential the the survival of the business and that he or she had a bona fide job offer from another business at the same or greater rate of compensation.

Debtors looking to compensate key officers have moved away from retention plans entirely and instead have turned to incentive plans. 

• Several courts have approved incentive plans covering insiders but have applied certain factors to judge the reasonableness of the plan, including an assessment of the relationship between the plan and the results to be obtained, the cost of the plan, and whether the plan's overall scope is fair and reasonable.
• In May 2007, the Delaware Bankruptcy Court even approved a downward adjustment to an incentive plan's targets, permitting a bonus to be paid to insiders, when the original plan's targets turned out to be unrealistic. 
• For more on this topic, including copies of three significant decisions in the Dana Corporation, Global Home Products, and Nellson Nutraceuticals cases, follow the link to this earlier post on key employee incentive plans.

Chapter 15 On Cross-Border Bankruptcies. BAPCPA added a new chapter to the Bankruptcy Code to adopt an internationally drafted Model Law on Cross-Border Insolvency.  Chapter 15 is used principally by representatives of, or creditors in, foreign insolvency proceedings to obtain assistance in the United States, by a debtor or others seeking to obtain assistance in a foreign country regarding a bankruptcy case in the United States, or when both a foreign proceeding and a bankruptcy case in the United States are pending with respect to the same debtor. Follow the link in this sentence for a detailed overview of Chapter 15.

• In a recent case involving two Bear Stearns hedge funds, the Bankruptcy Court in the Southern District of New York refused to recognize proceedings pending in the Cayman Islands as either a foreign main or foreign nonmain proceeding, denying those entities Chapter 15 protection in the United States.
• You can find the details on this case (and a copy of the original and amended decisions) here and here.

Preferences. Before it took effect, one of BAPCPA's most talked about changes was a revision to the "ordinary course of business" defense to preference claims. BAPCPA dropped the requirement that a preference defendant establish that a transfer was both (i) made in the ordinary course of business or financial affairs between the debtor and the defendant and (ii) made according to ordinary business terms.

• BAPCPA's main change was to replace the "and" with an "or", meaning that a preference defendant now has to establish only one of the two prongs (instead of both) to prevail on the defense. When it was enacted, many bankruptcy lawyers believed this change would favor preference defendants. 
• In something of a surprise, however, the first case interpreting the revised statute applied a brand new standard to the "ordinary business terms" provision. Unlike the prior analysis of that prong, the new standard examined the question from the perspective of both the creditor (as had been done pre-BAPCPA) and the debtor (the new BAPCPA twist). As a result, in that decision the preference defendant lost. For more on the decision, in the In re National Gas Distributors, LLC case, check out this post on David Rosendorf's BAPCPA Blog.
• There have been surprisingly few cases interpreting this section, so it remains to be seen whether other courts will follow the National Gas Distributors interpretation.

Another Great BAPCPA Resource. In addition to the BAPCPA Blog, which has posts on many decisions from BAPCPA's first year, don't miss Steve Jakubowski's Bankruptcy Litigation Blog, in particular his BAPCPA and BAPCPA Outline topics. Steve has posted on a range of BAPCPA issues, including major consumer decisions and many business bankruptcy decisions.

Acting Like A Two Year Old? As we begin the third year under BAPCPA, the law is beginning to take early steps toward greater clarity in some areas but much remains to be decided. In particular, few appellate decisions have been issued on BAPCPA's key changes, giving us little guidance on how the Courts of Appeals will interpret the new law.  As always, stay tuned for more developments and feel free to subscribe to the blog by email or by RSS to your feedreader.

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Preference lawsuits are filed all the time in bankruptcy cases and the ordinary course of business defense is frequently asserted. Still, it's the rare case that ends up with a federal court of appeals decision addressing jury trial rights and invalidating a bankruptcy court's local rule. This post is about just such a case.

The Bankruptcy Preference. As a quick refresher, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

Jury Trials In Bankruptcy Cases? Preference defendants who do not file proofs of claim in the main bankruptcy case have the option to demand a trial by jury in the preference lawsuit. This is a right protected by the Seventh Amendment to the Constitution. The parties in the lawsuit can consent to having the bankruptcy court conduct the jury trial but this doesn't happen very often. Why would a preference defendant make a jury demand? Here are three common reasons:

• The defendant believes a jury would be more inclined to find in its favor than a bankruptcy judge;
• The defendant wants the case moved to federal district court from the bankruptcy court, which some defendants perceive as more debtor-friendly; and
• Jury trials are more expensive and complex, a fact the preference defendant may hope will translate into settlement leverage.

The HealthCentral.com Case. In a recent case, Sigma Micro Corporation, a company sued for an alleged preference by debtor HealthCentral.com, made just such a jury trial demand. It then filed a motion for certification before the bankruptcy court seeking to have its case moved to the district court, in accordance with Local Rule 9015-2(b) of the United States Bankruptcy Court for the Northern District of California. That Local Rule, entitled "Certification to District Court," provides:

If the Bankruptcy Judge determines that [a] demand was timely made and the party has a right to a jury trial, and if all parties have not filed written consent to a jury trial before the Bankruptcy Judge, the Bankruptcy Judge shall certify to the District Court that the proceeding is to be tried by a jury and that the parties have not consented to a jury trial in the Bankruptcy Court. Upon such certification, [the jurisdictional] reference of the proceeding shall be automatically withdrawn, and the proceeding assigned to a Judge of the District . . . .

The Bankruptcy Court held that Sigma had a right to a jury trial but then stayed its order to retain jurisdiction for pre-trial matters. It later granted the debtor's motion for summary judgment in the preference case, finding no genuine issue of material fact and rejecting Sigma's ordinary course of business defense. On appeal, Sigma argued that the Bankruptcy Court did not have jurisdiction to enter summary judgment because it should have transferred the case to the District Court upon finding that Sigma was entitled to a jury trial. It also argued that it had raised genuine issues of material fact on its ordinary course of business defense, precluding summary judgment.

The Ninth Circuit's Decision. On September 21, 2007, the Ninth Circuit issued its opinion in the case (available here).  In addressing the jurisdiction question, the Ninth Circuit confronted "an issue of first impression in this circuit, that is, the validity of Local Rule 9015-2(b)." After reviewing the right of courts to promulgate local rules, it came to the core of the issue:

Considering these rules we hold Local Rule 9015-2(b) to be invalid as it establishes a procedure for withdrawing the district court’s jurisdictional reference inconsistent with the Acts of  Congress and Federal Rules of Bankruptcy Procedure. Cf. Coffey v. Marina Management Servs. (In re Kool, Mann, Coffee), 23 F.3d 66, 67-69 (3rd Cir. 1994) (finding local rule invalid because of inconsistency with Bankruptcy Code); In re Morrissey, 717 F.2d 100, 104-05 (3rd Cir. 1983) (same).

The Ninth Circuit noted that 28 U.S.C. § 157(d) provides that a "district court" may withdraw the reference of all or a part of a case or proceeding and that Federal Rule of Bankruptcy Procedure 5011(a) expressly states that a "motion for withdrawal of a case or proceeding shall be heard by a district judge." Putting these two provisions together, the Court of Appeals held:

After careful review we find the procedure established by Local Rule 9105-2(b) cannot be squared with the procedure established by 28 U.S.C. § 157(d), an “Act of Congress,” and Rule 5011(a), a “Federal Rule of Bankruptcy Procedure.” Fed. R. Bankr. Proc. 9029. At least two inconsistencies bear mentioning. First, Local Rule 9015-2(b) allows for the bankruptcy court to “withdraw[ ]” the jurisdictional reference, whereas 28 U.S.C. § 157(d) and Rule 5011(a) make it explicit that only a district court may “withdraw” the jurisdictional reference. See FTC v. First Alliance Mortg. Co. (In re First Alliance Mortg. Co.), 282 B.R. 894, 901 (C.D. Cal. 2001) (holding that “a motion [to withdrawal] is heard by the district court”) (emphasis added). Second, Local Rule 9015-2(b) permits a party to obtain a withdrawal of the reference upon a “Motion for Certification,” while 28 U.S.C. § 157(d) and Rule 5011(a) make it clear that a party may only obtain a withdrawal of the reference upon a “Motion for Withdrawal.” See Hawaiian Airlines, Inc. v. Mesa Air Group, Inc., 355 B.R. 214, 218 (D. Hi. 2006) (holding that “a litigant who believes that a certain [action] or portion of a [action] pending in the bankruptcy court should be litigated in the district court may make a motion to withdraw the reference”) (emphasis added).

Having invalidated the Local Rule, the Ninth Circuit found no error in the Bankruptcy Court's decision not to adhere to it or to withdraw the reference. The Court of Appeal then considered whether the Seventh Amendment jury trial right itself required immediate transfer to the District Court, even for pre-trial proceedings. The Ninth Circuit agreed with courts outside the circuit that, it stated, had universally agreed that a jury trial right "does not mean that the bankruptcy court must instantly give up jurisdiction and that the case must be transferred to the district court."

Concluding that the Bankruptcy Court properly retained the case for pre-trial matters, the Ninth Circuit did ultimately reverse its grant of summary judgment. It found that Sigma had raised genuine issues of material fact on its ordinary course of business defense under the version of Section 547(c)(2) of the Bankruptcy Code in force prior to the amendments made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

What About Local Rules In Other Courts? It appears that the Northern District of California's local bankruptcy rule on certification of a jury trial right and transfer to the District Court is unusual. Some bankruptcy courts, including the District of Delaware and the Southern District of New York, have no specific rule addressing withdrawal of the reference based on a jury demand. Others require a prompt motion for withdrawal of the reference to be filed with the District Court, as provided in Central District of California Local Bankruptcy Rule 9015-2(g). 

Conclusion. Although it appears that the decision's direct impact is limited to the Northern District of California and its jury demand procedures, this case proves that even well-established local rules will be struck down if inconsistent with governing statutes. That's a pretty extraordinary outcome for an ordinary course of business preference case. 

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On June 4, 2007, the U.S. Court of Appeals for the Ninth Circuit brought some additional clarity to the earmarking defense to preference claims in its decision in Metcalf v. Golden, an adversary proceeding within the In re Adbox, Inc. Chapter 7 case. In this post, I'll give a little background on preferences and the earmarking defense and then discuss how the defense works in the Ninth Circuit.

Preferences And Earmarking. Before reaching its decision on the earmarking issues, the Court set the legal context by discussing what preferences are and how earmarking can sometimes be a defense to a preference claim.

Under 11 U.S.C. § 547 the bankruptcy trustee may recover certain transfers made by the debtor within 90 days before filing for bankruptcy, if the trustee proves:

(1) a transfer of an interest of the debtor in property;

(2) to or for the benefit of a creditor;

(3) for or on account of an antecedent debt;

(4) made while the debtor was insolvent;

(5) made on or within 90 days before the date of the filing of the petition; and

(6) one that enables the creditor to receive more than such creditor would receive in a Chapter 7 liquidation of the estate.

In re Superior Stamp & Coin Co., Inc., 223 F.3d 1004, 1007 (9th Cir. 2000) (citing 11 U.S.C. § 547(b)). Such a transfer is known as an 'avoidable preference' or a 'preferential transfer.' Id. at 1007-09. The 'earmarking doctrine' is a courtmade exception to this rule that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor. Id.; In re Sierra Steel, Inc., 96 B.R. 271, 274 (B.A.P. 9th Cir. 1989). In such circumstances, the funds are deemed 'earmarked' and are not considered part the debtor’s estate. Sierra Steel, 96 B.R. at 274.

For more information on preferences, and some tips on how creditors can protect themselves when dealing with a financially troubled customer, you may find this post of interest.

Is Earmarking An Affirmative Defense? One previously unresolved issue involving the earmarking defense was whether it is a true "affirmative defense," which would mean that to assert it a preference defendant would have to include it in its answer to the preference complaint. In Metcalf, the Ninth Circuit said no:

Earmarking is not one of the affirmative defenses enumerated in Rule 8, and we decline to construe it as such under Rule 8’s residuary clause for 'any other matter constituting an avoidance or affirmative defense.' Properly understood, the earmarking doctrine is not an affirmative defense under Rule 8, but rather a challenge to the trustee’s claim that particular funds are part of the bankruptcy estate under 11 U.S.C. § 547. See Libby Int’l., 247 B.R. at 467 [In re Libby Int’l., Inc., 247 B.R. 463 (B.A.P. 8th Cir. 2000)]. Thus, the Metcalfs did not waive their earmarking defense by failing to plead it in their answer in the preference action.

Who Has The Burden Of Proof? With the affirmative defense issue out of the way, the Ninth Circuit then tackled the even more important question of whether the trustee or the defendant has the burden of proof on the earmarking defense. The Court held that although the trustee has the burden to prove that the funds at issue came from the debtor's account, the real burden of proof to establish the actual earmarking defense shifts back to the defendant:

As the district court noted, there is 'substantial confusion' over who bears the burden of proof on an earmarking defense. The Ninth Circuit Bankruptcy Appellate Panel addressed this question in Sierra Steel, where it denied an earmarking defense because the defendant 'ha[d] not traced the funds to money received by the debtor from [the lender].' 96 B.R. at 275. While the Sierra Steel court started from the general principal that the trustee has the burden of establishing that property is part of the bankruptcy estate, it also noted that the funds in question were disbursed from the defendant’s general account. Id. at 274 n.5. The source of the funds raised the presumption that the funds were property of the bankruptcy estate and the burden of proof accordingly shifted from the trustee—to establish that the funds were part of the estate —to the defendant—to show that they were not. Id. (citing In re Bullion Reserve of N. Am., 836 F.2d 1214, 1217 n.3 (9^th Cir. 1988)).

We follow well-established law in holding that the trustee bears the initial burden of establishing that a transfer is an avoidable preference under § 547. See Sierra Steel, 96 B.R. at 274. If, however, the trustee establishes that the transfer of the disputed funds was from one of the debtor’s accounts over which the debtor ordinarily exercised total control, we follow the approach of Sierra Steel and find that the trustee makes a preliminary showing of an avoidable transfer “of an interest of the debtor” under § 547(b). The burden then shifts to the defendant in the preference action to show that the funds were earmarked.

In the Metcalf case, the Court ultimately held that the defense was not established. The defendants could not prove the existence of an agreement between the debtor and the lender that had advanced the funds requiring them to be paid to the defendants. Since the debtor could have used those funds for another purpose, the payment to the defendants was a preferential transfer from the debtor's estate.

Where Does This Leave The Earmarking Defense? The Ninth Circuit's decision reaffirmed the existence of the earmarking defense and resolved two important procedural questions about how the defense may be asserted. The decision also highlighted the level of proof needed to make a successful earmarking defense. If a creditor is getting paid with loaned funds and hopes to use the defense, it should make sure that there is an actual agreement requiring the debtor to use the newly loaned funds to pay that creditor. Without proof of such an actual agreement, the earmarking defense will fail. 

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In a decision issued on April 3, 2007 in the In re: Ahaza Systems, Inc. case, the Ninth Circuit held that even first time transactions can qualify for the "ordinary course of business" defense to preferences. A copy of the Court of Appeal's decision is available here.

The Bankruptcy Preference. As a quick refresher, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

Pre-BAPCPA Statute. The ordinary course of business defense, designed to protect parties who engage in normal transactions with a financially troubled business, is one of the most common defenses available to preference recipients. The Ninth Circuit examined it under the version of the preference statute, Section 547 of the Bankruptcy Code, as it existed before the 2005 amendments made in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA). This pre-BAPCPA statute, specifically Section 547(c)(2), provided that a trustee could not avoid a transfer as a preference

to the extent that such transfer was —

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and

(C) made according to ordinary business terms.

The Court's focus was on subsection (A), the "debt" issue. Usually, parties have a series of contracts or purchase orders, as well as a payment history, that gives context to the ordinary course of business between them. In this case, however, the transaction that led to the allegedly preferential payments was their first one. The Court faced the question of whether a debt can be considered as having been incurred in the ordinary course of business of the debtor and the preference defendant when there had been no other past transactions to which it could be compared.

Court Looks To Past Practices With Other Similar Parties. The Court's answer was yes, holding that a preference defendant can indeed assert the ordinary course of business defense involving a debt created by the first contract or transaction between the parties. However, the Ninth Circuit articulated a special rule when a "first time" debt is involved:

[W]hen we have no past debt between the parties with which to compare the challenged one, the instant debt should be compared to the debt agreements into which we would expect the debtor and creditor to enter as part of their ordinary business operations. Consistent with Food Catering [971 F.2d 396 (9th Cir. 1982)], however, this analysis should be as specific to the actual parties as possible. Thus, we hold that to fulfill § 547(c)(2)(A), a first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties. Only if a party has never engaged in similar transactions would we consider more generally whether the debt is similar to what we would expect of similarly situated parties, where the debtor is not sliding into bankruptcy.

Both Original And Restructured Agreements Are Relevant. On a related point, since the first transaction here was an agreement that was later restructured to give the debtor more time to pay, the Ninth Circuit also held that both the original and revised agreement should be evaluated for ordinariness.

Ruling Still Important Under BAPCPA. BAPCPA revised the ordinary course of business defense so that Section 547(c)(2) now provides that a payment or other transfer cannot be avoided

to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

Although different, the current statute still makes the issue decided in the In re: Ahaza Systems case, whether the debt was incurred in the ordinary course of business, a requirement. The major change is that the statute now allows the defense to be established by additionally showing that payments were made either (A) in the ordinary course of business of the parties or (B) according to ordinary business terms, rather than both as under the pre-BAPCPA version.

How Hard To Meet? Having established the new test, the Court then reversed the granting of summary judgment to the defendant because it found the proof presented was inadequate. This suggests that although the Ninth Circuit will permit preference defendants to assert the ordinary course of business defense on first time transactions, some defendants may face a challenge in meeting that standard.

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Scott Riddle over at the Georgia Bankruptcy Law Blog has an informative post on the decision by the U.S. Court of Appeals for the Third Circuit last week in the American Pad & Paper Company case. The case involved Section 546(a) of the Bankruptcy Code, which extends the standard two-year statute of limitations for bringing preference and other avoidance actions by up to one additional year if, before the two-year period expires, a trustee is appointed or elected.

The Third Circuit's Holding. In short, the Third Circuit decided that the appointment during this two year window of an interim trustee under Section 701 of the Bankruptcy Code does not trigger the additional one year extension. Instead, the Third Circuit held that Section 546(a)(1)(B) specifically refers to Section 702 of the Bankruptcy Code and not Section 701. As a result, in a Chapter 7 case, a permanent trustee must be appointed or elected under Section 702, before the two-year period expires, for the one year extension to kick in. 

When Does This Come Up? Although not an everyday occurrence, this situation can arise when a case originally filed under Chapter 11 is converted to Chapter 7 after almost two years. In the American Pad & Paper Company case, the selection of a permanent trustee under Section 702 was delayed (the creditors decided to elect a permanent trustee instead of letting the interim trustee become the permanent trustee), resulting in the expiration of the two-year statute of limitations before it could be extended for one additional year. The impact? The court held that the permanent trustee's preference actions were all time-barred.

What Creditors Should Watch For. Defendants in preference or other avoidance actions in cases that were converted to Chapter 7 after a couple of years in Chapter 11 should carefully review the sequence of events surrounding the trustee's appointment to see if the statute of limitations expired. Likewise, if a Chapter 11 case converts to Chapter 7 more than two years after the case was originally filed (technically, after the "order for relief" was entered), and no preference actions were brought in the Chapter 11 case, the trustee will be barred by the statute of limitations from bringing any avoidance actions. 

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Many businesses not only sell products or services to another company, they also buy products and services from that company.  If you do business with a customer or vendor and you each end up owing the other money, you may have the right to "set off" the amount the other company owes you against the amount you owe it.  

Setoff. When a complete setoff is made, no cash changes hands but each side's debt to the other is canceled. In some business relationships, including in the telecommunications industry, these kinds of cross-debts occur frequently and setoffs can be an important part of the payment structure. In others, setoffs only come up if one side fails to pay what it owes.  The term is also used to describe a bank's right to sweep or set off the amounts owed on a loan against amounts the borrower has on deposit at the bank. 

Recoupment. A related concept called "recoupment" is similar to a setoff but it applies only when the offsetting amount or other defense to payment arises from the same contract or transaction that gives rise to your debt to the other company.

Impact of bankruptcy. The U.S. Bankruptcy Code does not create any setoff rights, but with certain limitations it does recognize the rights that exist under other applicable law.  However, with a bankruptcy filing comes a new risk that is similar to the preference risk that arises when you receive a direct payment before a bankruptcy.

• If you made a setoff within 90 days before the bankruptcy filing, the debtor company (or its bankruptcy trustee, if one has been appointed) may have a right to sue you to recover the amount of that pre-bankruptcy setoff.  
• Be sure to maintain detailed records of any setoffs made, along with the amounts each side owed the other during the business relationship. These records can be very helpful to your defense if such a claim is ever brought.

Setoff after bankruptcy. Making a setoff after a bankruptcy is filed -- also known as a "post-petition" setoff -- is allowed only in narrow circumstances.  Among other technical requirements, the debts have to be mutual between you and the actual debtor (not with one of its subsidiaries, for example) and they have to have arisen before the bankruptcy was filed.  Another very important point to remember is that you cannot make a setoff unless the bankruptcy court first grants you relief from the automatic stay that arises as soon as a company files for bankruptcy.

Get legal advice. This is a complex area of bankruptcy law and neither setoffs nor recoupments should be attempted after a bankruptcy has been filed without the advice of a bankruptcy attorney.  The old adage “Don’t try this at home” definitely applies. 

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It's bad enough when you can't collect everything you are owed because of a customer's financial problems.  We've all faced that situation at one time or another.  Unfortunately, the U.S. Bankruptcy Code can add an entirely different wrinkle to the problem called a "preference."  (The word comes from the idea that your successful collection efforts enabled you to get preferred treatment over your customer's other creditors that didn't get paid.)  

Without some planning, an unhappy scenario can develop even if you aggressively move to collect the account.  If the customer files for bankruptcy, the customer's bankruptcy trustee -- or even the customer itself -- may sue you to recover those payments you were lucky enough to collect, calling them preferences. 

There are defenses and, with some careful planning, you can act to protect yourself.  These range from waiting to ship new goods or provide new services until after you've received a payment to putting the customer on C.O.D. or other payment in advance arrangement.  Here are some pointers on minimizing the bankruptcy preference risk. 

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