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.
Further, the large asset sizes of a number of bankruptcies over the past two years could boost the number of preference claims, thinks Jeff Morris, a professor at the University of Dayton School of Law who was named ABI’s resident scholar in January. Those filings included the bankruptcies of Mirant Corp. ($19 billion), NRG Energy Inc. ($10 billion), and US Airways Group ($8 billion), according to Bankruptcydata.com, a division of New Generation Research. Big bankruptcies mean “that there are more creditors involved, and many more transactions between debtors and creditors” that can be identified as subjects for preference claims, notes Morris.
Another reason for the rise in preference claims, says Morris, is that a cottage industry developed in the wake of much bigger bankruptcies in 2001 and 2002. Those blockbuster insolvencies included WorldCom Inc. ($104 billion), Enron Corp. ($63 billion), Conseco Inc. ($61 billion), and Global Crossing Ltd. ($30 billion). Those years saw a surge in the number of law firms and collection agencies focusing on representing debtors in preference-claim cases.
Previously, if an insolvent company didn’t pursue all of its preference-claim opportunities, it was probably because the trustee didn’t have the time or resources needed to identify all the potential targets and orchestrate a huge mass-mailing, tracking, and collection effort, says Morris.
But when trustees realized that collection agents were at their beck and call to identify and manage preference claims, the decision became easy. Now the trustee could continue to work on a bankruptcy or liquidation while collection agents chased preference payments.
Further, collection agents, who work on a commission basis, have an incentive to request preference payments — or help launch lawsuits if requests are challenged, as they usually are. That incentive is another factor likely to contribute to the rise in preference claims.
Although the looming onslaught of such claims seems formidable, creditors have several defenses they can use to shield themselves. For instance, to be considered preferential, a payment must be made outside of the ordinary course of business, explains Kelly, noting that a late payment could be such a situation.
But, he says, that while a late payment could be considered preferential, bankruptcy courts take into consideration the payment and the history of the collection relationship between the bankrupt company and creditor — as well as payment standards unique to the vendor’s industry — before deciding whether the transaction was out of the ordinary.
Requiring cash on delivery or payment in advance will also keep creditors from falling prey to preference claims; both payment types are exempt from the preferential-transfer provision. Creditors can also argue that the debtor company was still solvent when the payment was made.
Still, creditors might still want to allow risky payment terms even if they know the customer is in financial trouble. Consider Kmart’s $14.6 billion bankruptcy in 2002. Many creditors wanted to work with the mammoth retailer by extending credit, thereby taking a chance that payments deemed preferential would have to be returned.
“Some creditors looked at the pre- and post-bankruptcy Kmart as a continuous relationship,” says Ken Gruber, a former CFO and now a financial services partner with Tatum Partners.
“It’s a classic risk management call for CFOs,” adds Gruber. He reckons that finance chiefs must always weigh the business ramifications against the legal exposures when they decide to extend credit as a way of squeezing more value from the relationship.
To do that, Gruber says, CFOs need to know a lot about their major customers. That includes knowing the customer’s financial condition, whether the client is considered profitable to the company, and how much cash flow is at risk via extensions of credit to the customer. At the same time, extending credit to a distressed but high-margin customer may pay off in the long run if the company recapitalizes and becomes a profitable buyer again, reasons Gruber.
Still, whether a CFO extends credit to a distressed customer knowingly or not, the likelihood that a preference claim will wind up in your corporate mailbox has increased, at least for the next few years.
Marie Leone’s “Courts and Torts” column appears monthly. Contact her at MarieLeone@cfo.com.