The economy continues to struggle to mount a real recovery. Economists and banking experts argue about how to maintain the little bit of momentum we’ve seen over the last six months. From our view as Virginia creditors rights lawyers, we think there is a coming wave of preference claims that will surprise a lot of companies that were thanking their lucky stars that they had collected their accounts due before customer X, Y and Z had filed for bankruptcy.

Probably the hardest thing for a bankruptcy attorney to explain to his or her corporate client is the concept of a bankruptcy preference claim. The common refrains are: “You have to be kidding me!” “I received a payment and now I have to give it back!!?” “They owed us this money, so why do we have to give it back?”

With the wave of bankruptcy filings in the past couple of years, and a two year statute of limitations for bankruptcy preference actions, corporations, or individuals, may unfortunately find themselves faced with this unpleasant situation and wondering “how can this be?” The legal answer is not really what clients want to hear: the Bankruptcy Code specifically allows a bankruptcy trustee to sue companies or individuals that have received a payment from a debtor within 90 days before the bankruptcy was filed. If someone is an “insider” of the debtor — e.g., an owner of the bankrupt company — the “reach back” period is an entire year.

But that does not answer the question of “why?” The “why” is embedded in the word “preference”. One over-riding principal of bankruptcy is that there should be a fair and equitable distribution to all similarly situated creditors of a debtor. Coupled with that is a requirement that a debtor must list, in the bankruptcy schedules they must file, anybody and everybody to whom they owe money. When a company knows it must file bankruptcy, they could easily circumvent the requirement of listing all creditors, by paying certain “preferred” creditors before the bankruptcy filing. If the debtor does not owe someone on the day the bankruptcy is filed, then they would not have to list that creditor in the schedules. So, a debtor could — using scarce resources — pay favored vendors, or friends, or family members — in full, before the bankruptcy is filed. Then they file the bankruptcy, and all other creditors who were not paid before the bankruptcy end up on the short end of the stick. That is not fair or equitable, nor is it equal treatment to all like-creditors.

To remedy this, or prevent this from happening, the Bankruptcy Code put in the preference statutes. In essence, creditors who receive the preference payments are drawn back in to the bankruptcy case, to even the playing field with all other creditors.

Admittedly, this explanation seldom satisfies clients. Fortunately, even though a payment was received within 90 days of the bankruptcy filing, the debtor still must prove several elements (e.g., exactly when the payment was made; the existence of an antecedent debt; etc), and there are numerous defenses to the claim that can be asserted. Two of the most common defenses are “ordinary course” payment, and “subsequent new value.” The ordinary course defense is, basically, an argument that there was nothing out of the ordinary in the payment that was made and/or received, and thus the payment was not meant to “prefer” someone. The subsequent new value defense looks at transactions between the parties after the alleged preference payment was made. If a creditor, subsequent to the alleged preference payment, give some “new value” to the debtor (e.g., extends new or more credit to the debtor), then that would be a defense to the preference claim.

Quite frankly, another difficult discussion to have with a client about a preference claim is the cost to defend the claim. Fact is, it can be expensive to prove “ordinary course” or “subsequent new value.” If the trustee is seeking $5000, and it will cost that much to litigate a defense of the claim, why bother?

However, the trustee prosecuting the case has similar expenses, costs and risks. And, it is in the trustee’s interest to resolve matters as quickly, and inexpensively, as possible. Because of this, the vast majority of “low dollar” amount preference claims are settled, without going through expensive litigation. An experienced bankruptcy attorney can often quickly analyze the facts, and informally discuss with the trustee a settlement — before all-out litigation and costly litigation ensues. Often, the client saves money (even after paying their attorney to negotiate the settlement). The key to low dollar preference claims is to act quickly. Certainly, a preference claim should not be ignored. As strange as it may sound, it is best to attempt to settle a a preference claim right away.

Of course, if a preference claim is 5 or 6 figures, it is imperative that counsel be retained, and defenses asserted. But even in this case, the end result is often savings for the client.

What are you doing to prepare your business for the possibility of losses like these? Are there some claims too small for you to bother with? What is your threshold and why?

So Maybe We Now Know When A Claim Arises, But Can A Debtor Discharge The Claim?

Although not admitting that it succumb to acknowledged “universal disapproval” of its 1984 decision in Avellino & Bienes v. M. Frenville Co. (Matter of M. Frenville Co) 744 F3d 332 (3rd Cir. 1984), the Third Circuit Court of Appeals did, in fact, reverse Frenville on June 2, 2010, with its en banc decision In re: Grossman’s Inc. et al., Debtors JELD-WEN f/k/a Grossman’s Inc. Appellant, v. Gordon Van Brunt, Individually and in his capacity as Personal Representative of the Estate of Mary Van Brunt. However, the Court left open the question of whether a claim is discharged in bankruptcy.

The facts of the JELD-WEN case were as follows:

• In 1977, the claimant purchased products containing asbestos from Grossman’s Inc. when remodeling her home. In April 1997, Grossman’s filed a Chapter 11 bankruptcy petition in the U.S. Bankruptcy Court for District of Delaware and the plan of reorganization was confirmed in December 1997. The claimant did not file a proof of claim before confirmation of the plan because, at the time, she was unaware of any claim she had because she was not diagnosed with mesothelioma until March 2007, and had manifested no symptoms related to asbestos exposure until 2006.
• Shortly after her diagnosis, claimant sued JELD-WEN, the successor-in-interest to Grossman’s, in a New York state court. JELD-WEN moved the Bankruptcy Court to reopen the chapter 11 case, seeking a determination that the claims were discharged by the plan. Claimant died in 2008, and the spouse was substituted as the representative of her estate.

Significantly, the Court noted that in the Grossman’s bankruptcy case “[a]t the time of the [bankruptcy], Grossman’s had actual knowledge that it had previously sold asbestos-containing products such as gypsum board and joint compound”; “Grossman’s knew of the adverse health risks associated with exposure to asbestos”; it “was aware that asbestos manufacturers had been or were being sued by asbestos personal-injury claimants”; it “was aware that producers of both gypsum board and joint compound were being sued for asbestos-related injuries” and it “was not aware of any product liability lawsuits based upon alleged exposure to asbestos-containing product had been filed against [it]….”

In first overruling its Frenville decision, the Court concluded that the Frenville “accrual” test was too narrow an interpretation of a “claim” under the Bankruptcy Code. The accrual test of Frenville established that the existence of a claim depended upon whether the claimant possessed a right to payment, and when that right “arose” as determined by the relevant non-bankruptcy law. If the right to payment, per state law, arose post-petition, it is a post-petition claim, even though (for example) the exposure to toxic materials happened pre-petition.

Now, the Third Circuit is “persuaded that the widespread criticism of Frenville’s accrual test is justified.” In its place, the Third Circuit now says “a ‘claim’ arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a ‘right to payment’ under the Bankruptcy Code. See 11 U.S.C. Section 101(5)”.

But then, the Court stated that their new definition of when a claim arises did not, necessarily, mean that the plaintiff’s claim was discharged. For that, the case had to be remanded to the District Court. The Court did give some guidance in this regard — raising the issue of due process. The Court noted that notice is “[a]n elementary and fundamental requirement of due process in any proceeding which is to be accorded finality….”  Also, inadequate notice can “preclude discharge of a claim.” In this regard, one wonders if the plaintiff was accorded proper due process. Recall, Grossman knew it had sold asbestos-containing products and that asbestos caused health problems, and knew that the manufacturers of asbestos and products that use it had pending personal injury claims litigation.

For claimants seeking to not have their claims discharged, it appears a due process argument is an avenue of attack. For debtor companies filing bankruptcy and seeking to discharge potential future claims — perhaps the notice of claims bar date should have language regarding potential tort liability.

So what do you think? Should Frenville have been overturned? Has the Court pointed to a due process attack?

On March 23, 2010, the U.S. Supreme Court issued a 9 – 0 opinion in United Student Aid Funds, v. Espinosa  (08-1134) in which the Court affirmed the 9th Circuit’s holding that a chapter 13 debtor can obtain a discharge of a student loan by including it in a chapter 13 plan, if the creditor fails to object after notice and opportunity to do so, and the BK court enters an order confirming the chapter 13 plan. In bankruptcy, a student loan is not discharged unless the bankruptcy court makes a determination that excepting the student loan would be an undue hardship on the debtor. Under Bankruptcy Rules, the court is required to make such a determination in an adversary proceeding — a lawsuit within the bankruptcy case. In Espinosa, the debtor did not bring an adversary proceeding. Rather, the debtor put in his plan that only the principal amount of the loan would be paid through the plan, but that accrued interest would be discharged. The student loan lender did receive a copy of the plan, and even filed a Proof of Claim. But, the lender did not object to confirmation.

The court did, subsequently, enter an order confirming the plan as proposed. After confirmation, the chapter 13 trustee sent a notice to the lender, saying that the Proof of Claim amount differed from the amount stated in the chapter 13 plan, and that if the lender disputes the amount in the plan, they should notify the trustee within 30 days. After the debtor completed his plan payment, the student loan lender tried to collect the remaining amount due. The debtor filed a motion seeking enforcement of his bankruptcy discharge.

The lender filed a motion seeking to declare the order confirming the chapter 13 plan void — which was the issue before the Supreme Court. That is, the student loan lender argued that the BK Court order confirming the chapter 13 plan void because they (the lender) was denied due process regarding the required statutory finding of undue hardship, which did not happen here.

The Supreme Court, in looking only at Bankruptcy Rule 60(b)(4), which permits a court to relieve a party for a final order or judgment, found that the lender was not denied due process, since the lender did receive the plan, filed a claim, and received the notice from the chapter 13 trustee. The Court agreed that the confirmation of the plan without an undue hardship determination was legal error, legal error does not void the order. The Court noted that Rule 60(b)(4) strikes a balance between the need for finality of judgments, and the right of parties to have a full and fair opportunity to raise issues.

The lesson to be learned — creditors should indeed carefully review proposed chapter 13 plans, and raise objections to disputed issues before a plan is confirmed.

Just this week, another big financial company — CIT Small Business Lending Corporation — filed bankruptcy. CIT filed a “prepackaged” filing, in which terms for restructuring are negotiated before the bankruptcy case is filed. In more conventional bankruptcy filings, it can take a year or more before a plan is confirmed; in a pre-pak, filers may have a plan confirmed in a month or two.

Having a confirmed plan, of course, achieves the desired reorganization, and allows the company to continue in business under a new business plan or model, with workable debt load and other stable financial underpinnings. The faith of investors and vendors must be strong for the enterprise to exit and prosper. During the negotiations prior to the filing, the terms can be worked out in a mutually-acceptable manner, rather than with the heavy leverage that courts often apply when they control whether a firm exits intact or is dissolved.

On Tuesday CIT was granted Bankruptcy Court approval to immediately tap $125 million of a debtor-in-possession loan through Bank of America Corp. when Judge Allan Gropper of the U.S. Bankruptcy Court for the Southern District of New York signed off on numerous routine “First-Day” motions. Included was permission to continue making intercompany loans and pay essential employees and vendors. There is a December 8 hearing date to consider approval of CIT’s reorganization plan, which reportedly already has secured the preliminary approval of 90 percent of eligible debt-holders who signed off on the prepackaged chapter 11 plan.

We sincerely hope that CIT can exit and get back to the essential role of lending to small business quickly. In this economy where glimpses of recovery compete with reports of continued losses in employment and consumer purchasing, a stable and friendly source of capital may be the only sure salvation of many of our best small companies and entrepreneurs.

What else can be done to help small business survive and thrive in the tough times we’re in?

(Hat tip to Stefan Calos for contributions to this article.)

In Wednesday’s Business Week, Ben Steverman’s anaylsis of the possiblities of upcoming bankruptcy activity indicates that filings, rather than slowing as the economy gains its footing again, will instead swell with the failure of numerous entrepreneurial and high-debt companies. His opinion is that this will be due largely to the continuing spin-down in consumer demand and tight credit markets.

I don’t know if Mr. Steverman is right, but the fact is his article concerns me. Granted, I could just look forward to another busy sixteen to eighteen months. After all, business failures contribute to the activity in my practice. But the part of me that is hopeful about our financial system and small business in general wonders if another long and sustained decline in employment and the lost wages, profits and taxes that those jobs represent will cause our government to borrow even more against our country’s future and add inflationary pressure to the other effects of the recession from which we suffer.

On the other hand, maybe the doom and gloom that Business Week predicts will be made less credible by the recovery of financial standing by large businesses which have slashed debt and costs as a survival strategy. How are you feeling about your business’s prospects over the next year or so?

Federal Bankruptcy Court Judge Robert Gerber approved the sale of most General Motors assets to a new corporation to be owned by the governments of the United States, Canada and the province of Ontario, the United Auto Worker’s Voluntary Employee Benefit Association trust (“VEBA”), and GM bondholders.  Gerber today also denied a “fast track” appeal to the Second Circuit Court of Appeals, by groups of people with product liability and asbestos-related claims.

Gerber stated that he would not stay (hold) the sale while the groups appealed to the Second Circuit because he saw no “substantial possibility” that the groups would prevail, given how that court previously ruled on Chrysler’s similar sale.

The sale is expected to go through on or before Friday.  The US government has pledged to cut off $50 million in funding to GM if the sale isn’t approved by Friday, which would force GM to liquidate.

The new GM will include Buick, Cadillac, Chevrolet, and GMC brands, with the automaker divesting itself of Hummer,  Saab, and Saturn. It will also include some overseas operations, including those in China and Brazil. Pontiac will be closed.

GM has indicated it will back warranties on existing cars, although it has closed 1,000 dealers.  As with the Chrysler bankruptcy, consumers may have to travel farther for sales, service and warranty claims.

According to the Detroit News, General Motors reversed the closing of 41 of the 2,100 dealerships originally targeted to be closed as part of GM’s bankruptcy and restructuring. 

GM has listened to appeals from hundreds of dealers, and has allowed 41 so far to remain open.  This is in stark contrast to Chrysler, which received Bankruptcy Court permission to close 25% or 789 dealerships although it had no dispute or appeals process of any sort. 

A group of influential members of Congress, including House Majority Leader Steny Hoyer, D-Md., introduced a bill last week to try to force GM and Chrysler Group LLC to keep dealers open. The Automobile Dealer Economic Rights Restoration Act of 2009, would restore the economic rights of automobile dealers to protect jobs, workers and small-business owners. It has 40 House co-sponsors, although it is unclear whether Congress has any power to change the Chrysler closings. 

A House Energy and Commerce subcommittee chaired by Rep. Bart Stupak, D-Menominee, has held hearings on the closing dealerships and heard from GM CEO Fritz Henderson and Chrysler President James Press.

It has been reported that Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, is considering a similar bill in the coming weeks. Sen. Bob Corker, R-Tenn., has a separate bill that would make closing dealers financially whole by forcing automakers to buy back unsold parts and inventory.

The problem with this legislation is that federal bankruptcy law trumps state contract law by allowing existing contracts to be “rejected” by the Debtor, with Court approval.  This is exactly what happened to the Chrysler dealers.  Chrysler filed a motion to close certain dealers because it would strengthen Chrysler’s economic position, testimony was presented, and the judge ruled to grant the motion.

This afternoon, the United States Supreme Court issued a stay of the sale to Fiat SpA of the assets of Chrysler LLC, currently attempting to exit bankruptcy proceedings so that it may proceed as a going concern in the global automotive industry.

Late last Saturday, a group of Indiana pension funds opposed to the sale of Chrysler to Italy’s Fiat filed an emergency motion with the U.S. Supreme Court, asking that the sale be “stayed” or put on hold while they continue their attempts to block it. The motion came after the Second Circuit on Friday upheld the Bankruptcy Court’s approval of the sale.  The stay asks for the extension of a temporary hold put in place by the appeals court until Monday at 4 p.m. EDT or when the high court decides whether to intervene.

With the stay approved, the Chrysler deal with Fiat could be delayed for weeks or months.  Fiat can pull out of the deal if it does not go through by June 15. 

The pension funds contend that secured creditors would have fared better if Chrysler had sold its assets piecemeal instead of in bulk to the Fiat consortium.  They also object to the sale because secured creditors are in a worse financial position than unsecured creditors as a result of the sale. 

Justice Ruth Bader Ginsburg hears all emergency motions arising from the Second Circuit.  She issued the one sentence ruling herself. She could have refered the motion to the entire court, rejected the appeal outright or requested other parties involved in the case file briefs.

Until the stay, the sale could have closed today.  

A group of citizens with product liability claims against Chrysler filed a brief with Ginsburg early Sunday that supported the Indiana pensioners’ case. Consumers are concerned that “New Chrysler” is not assuming product liability claims for cars sold prior to the sale, and that “Old Chrysler” will not have enough assets to take care of these claims.

Now that the Bankruptcy Court has approved the sale of Chrysler’s assets to a consortium of buyers lead by Italian carmaker Fiat, the next major issue is which Dealer Agreements will be assumed and which ones will be rejected. 

On May 17, Chrysler filed a motion (the “Rejection Motion”) in the Bankruptcy Court seeking authority to reject almost 800 Dealership Agreements.  Under the Bankruptcy Code, Chrysler can review dealer agreements on a dealer-by-dealer basis, to consider if it makes sense in its “business judgment” to continue with current pending contracts, such as dealer agreements.  If, in Chrysler’s business judgment, a contract has more burdens than benefits, it is allowed to reject that contract.  A rejection of a contract is a breach of that contract, but the other party to the contract is only left with filing a claim in the bankruptcy case.  

For all of the dealer agreements that Chrysler does not reject, they will, as part of the sale of assets to Fiat, et. al., assume the agreements and assign them to the new owners.  This means the contract remains in effect, and is binding on the dealer, and the new owners of Chrysler. 

Car dealers whose agreements are rejected (the “Affected Dealers”) are at risk of losing everything, severely affecting local jobs and economies.  If the Court approves Chrysler’s Rejection Motion (the hearing on this motion is this week), Affected Dealers will no longer be able to sell their new inventory with manufacturer warranties, offer rebates or incentives, or use the Chrysler, Jeep or Dodge trademarks on their dealerships. Many will essentially become used car lots, with new vehicles being sold as used. The dealers who sold exclusively Chrysler, Dodge or Jeep products (rather than selling Jeep and Nissan, for example), many at Chrysler’s insistence, will be the hardest hit.

Affected Dealers have filed 197 responses to the Rejection Motion, including objections, statements, briefs, letters and separately filed declarations.

Generally, these responses argued that the rejections violate certain antitrust laws; the rejections were based upon bad faith, discrimination or other improper considerations; Chrysler failed to satisfy the traditional business judgment rule for various reasons, such as cost analysis; the Court should consider the harm to the Affected Dealers from rejection (and deny the rejection because of it) rather than relying solely upon the Chryslers business judgment; and the Affected Dealers are not getting their day in court and are not getting due process .  Chrysler filed a response to the objections, claiming that the issues raised by the Affected Dealers are inconsequential, because it is Chrysler’s “business judgment” that counts and, even if flawed, it must prevail, unless there is “bad faith, whim, or caprice.” Chrysler further urges the Court that it should not “balance the equities” between the losses by the dealers, and Chrysler’s need to reject franchise agreements.

Affected Dealers did have the opportunity to enter into an “accommodation” with Chrysler in which Chrysler promised to try to help dealers redistribute the existing inventory, parts and special tools/equipment.  Nothing specific, is promised, however, and dealers still would still have to accept substantial discounts on vehicles.

Evidence on these issues was taken yesterday.  If necessary, oral argument on the motion will be today.

Meanwhile, the Senate Committee on Commerce, Science and Transportation is reviewing Chrysler’s decision to close 789 dealerships and GM’s decision to close 1,100 dealerships.  According to the Washington Post:

Because the federal government is slated to own most of General Motors and 8 percent of Chrysler, some of the senators said they have a responsibility, as major shareholders do, to review company decisions.