The Dark Side of the Bankruptcy Decline

Preference claims can sneak up on companies when they least expect it.

The numerical news from the corporate bankruptcy front has been relatively good. Since 2003, the number of businesses filing for bankruptcy has dropped by 36 percentage points, finishing at 23,887 for the year ending June 30, 2007. That’s 24 percentage points below last year’s total for the same time period. But the reported numbers don’t tell the whole story. What’s missing is the tally for preference claims, the lawsuits filed by trustees of bankrupt companies against the ailing company’s vendors — the suppliers that tend to be unsecured trade creditors.

Governed by the U.S. Bankruptcy Code, preference claims are meant to prevent an insolvent company from favoring one creditor at the expense of another. Basically, the bankrupt company has the right to sue vendors to force them to return payments that were made within 90 days of the bankruptcy filing. While the law’s rationale may not make immediate sense, its aim is clear. Its purpose is to stop failing companies from doling out payments to preferred vendors just before they go broke.

The number of preference claims on bankruptcy-court dockets, however, is hard to estimate because the courts don’t identify the suits per se. But attorney A. Dennis Terrell, a bankruptcy-practice partner at Drinker Biddle & Reath, reckons that preference suits can number as few as 30 for small-company bankruptcies or as many as 10,000 for the multi-billion-dollar insolvencies.

Unfortunately for creditors, preference claims represent a double whammy. First, vendors lose a customer to bankruptcy. Then, they must defend against a lawsuit that aims to grab back any recent payments the insolvent company may have made. More troubling, because of the protracted nature of most preference claims, the suit often takes a company by surprise. Preference claims are usually launched two years after the initial bankruptcy is filed—just before the preference claim statute of limitation expires.

Thus, the preference claims creditors will see this year are likely to be associated with Chapter 11 petitions and Chapter 7 liquidations filed in the second half of 2005, as well as 2006. That list includes some big cases, including Delta Airlines, Northwest Airlines, Tower Automotive, Meridian, and Delphi.

The vendors hit with the greatest number of claims tend to be in industries suffering through a downturn, such as perennials like the airline, auto, and subprime-mortgage sectors. Companies that do business across many sectors, such as telecoms and computer companies, are also likely to absorb many preference claims. “It’s not that they are in a lousy industry, it’s just that they do business in every industry,” says Hal Schaeffer, president of D&H Credit Services, a trade-credit-analysis firm that specializes in preference-claims research.

While both large and small companies have been besieged by trustees looking to collect preferential payments, Schaeffer predicts that smaller companies will be more of a target over the next few years. That’s because law firms that hired preference-claims specialists during the early part of the decade – when the Internet bubble burst and corporate scandals produced record-breaking bankruptcies – are now trolling for business because the number of filings are down. That means plaintiffs’ attorneys are searching for business—and are thus apt going after claims as low as $10,000, Schaeffer says.

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