Courts and Torts: Bankruptcy’s Perks

Even though the number of bankruptcies has declined, preference claims based on those filings are mounting. That poses a risk to creditors paid shortly before Chapter 11 filings.

In early 2003, a small temporary-staffing firm located near the World Trade Center site in New York was making a slow recovery after suffering heavy financial losses tied to the September 11 attacks. Its revenue stream was sporadic.

Still, the $10 million, family-owned business was making steady progress on the basics, showing improved cash flow while holding down its expenses, says the CEO, who asked not to be identified.

Then came a “shocking setback,” he said. The firm was sued by a customer that had fallen into bankruptcy. The preference-claim suit requested the return of a $30,000 payment made to the staffing firm a few months before the company went bankrupt.

“I guess large corporations are familiar with the law, but we just never encountered it,” noted the CEO. The executive found it mind-boggling that a customer who still owed his company $60,000 was allowed to sue to recover a prior payment.

While the law’s rationale may not make immediate sense, its aim is clear, says attorney Michael Kelly, head of the bankruptcy practice at Cooley Goodward LLP. It’s there to stop failing companies from doling out payments to preferred creditors just before a company goes broke. The U.S. bankruptcy code identifies a preferred payment as one that is made within 90 days before the bankruptcy filing and outside of the normal course of business.

Perhaps more troubling than being caught off guard by a preference suit is the notion that over the next few years, experts predict, the number of such claims will rise despite a decline in the national bankruptcy rate. That trend should give CFOs pause because it suggests that the odds have risen that their companies will be the target of a preference suit.

To understand the causes of the hike in preference claims, it’s necessary to look at the last few years of bankruptcy filings. A decline appears to have tracked the overall economic upturn of the period. In 2001, there were 40,099 business bankruptcies filed, according to the American Bankruptcy Institute (ABI), which compiles statistics collected by the U.S. courts. By 2003, that total had dropped by 13 percent, to 35,037. (The first three quarters of 2004 show another small decline in bankruptcies, to 26,389 last year from 26,591 for the same period a year earlier.)

If the number of bankruptcy claims are falling, however, why are preference claims on the rise? The statue of limitations of the law governing preference claims is a big reason.

A company that voluntarily files for bankruptcy is allowed two years from the time it files its petition to launch a preference claim, explains Bill Creim, a bankruptcy attorney with Creim, Macias & Koenig. For much of that time, the trustee of the bankrupt company is usually working hard with creditors to negotiate the most favorable terms possible and isn’t inclined to sue creditors for preference payments.

As a result, many preference claims are filed toward the end of the statute of limitations, as negotiations with creditors are winding down. Thus, the preference claims creditors will see this year are likely associated with Chapter 11 petitions filed in 2003 and early in 2004. Thus, in spite of a lower bankruptcy rate projected for this year, preference claims are likely to rise, posits Creim.

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