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?

In today’s economic environment, businesses are looking to modify and re-structure debt to pull through until the economy turns around. Rather than allowing so many loans to go bad, lenders are working with debtors to re-structure loans in a manner that allows the debtor to stay in business. For example, a lender may allow a debtor to cease making payments for six months in exchange for increasing the interest rate for the life of the loan. Another example would be a lender who might agree to reduce the principal amount of a loan increasing the probability of receiving some return of capital rather than risking that the borrower would stop paying altogether.

In re-structuring debt, a borrower (debtor) needs to be aware of potential tax consequences that will cause the debtor to recognize taxable income even though not receiving any additional payments. If a debtor is relieved of a valid debt (or any portion of a loan), the debtor must recognize ordinary income in the amount of the debt cancelled. Although there are some situations where such “cancellation of indebtedness income” or “CODI” may be excluded, in many situations a debtor must pay tax when relieved of debt.

For example, business X owes Bank $500,000 and Bank agrees to accept $400,000 in full payment of the loan. Because Bank has forgiven $100,000 of indebtedness for X (and no exclusion from income applies), X must recognize $100,000 of ordinary income in the year the debt is forgiven. If X is an individual or the sole owner of a pass through entity (such as a limited liability company), and if X pays tax at the highest income tax rates, the forgiveness of debt results in $35,000 of tax payable to the IRS (plus additional tax for state income tax).

Although the example above appears bad (with the accrual of phantom taxable income), at least the taxpayer can see it coming and try to take steps to avoid it. There are other situations where CODI can accrue even though no actual debt was forgiven. This problem is most severe, and perhaps least fair, in certain debt modifications. Thats right, a business can modify a debt, maybe agree to a higher interest rate, and have to pay tax because the statute will deem CODI to arise.

Accrual of CODI will not occur in all debt modifications, but in some cases such accrual of income can surprise everyone involved. If the debt is traded on an “established market”, then any significant modification to the debt will be deemed to be the re-purchase of the debt by the debtor at the debts fair value and then the re-issuance of new debt to the lender. When such debt is deemed to be re-purchased by the debtor, the debt’s fair value will most likely be less than the face amount. For example, business X owes Bank $1,000,000, but at the time of the modification, the fair value of the debt is $700,000. X will be deemed to have purchased the debt for $700,000, and accrue CODI for the remainder of the debt of $300,000. The debtor is then deemed to have issued to the lender new debt. Therefore, even if the only debt modification is that X agreed to an adjusted interest rate, X will have to be tax on $300,000 of phantom income.

The problem described above occurs only if the debt is traded on an established market. However, the meaning of “traded on an established market” can be broader than it at first appears. The Treasury Regulations describe a debt as traded on an established market if: (i) it is traded on a registered national securities exchange, interdealer quotation system, or certain foreign exchanges; (ii) it is traded on a designated contract market or “interbank market”; (iii) it appears on a system of general circulation . . . that provides reasonable basis to determine fair market value by disseminating either recent price quotations (including rates, yields, or other pricing information) of one or more identified brokers, dealers, or traders or actual prices (including rates, yields, or other pricing information) of recent sales transactions (a quotation medium); or (iv) it is a debt instrument for which “price quotations are readily available from dealers, brokers, or traders”. Although the description contained above is somewhat simplified, in today’s banking environment, many loans taken from large national banks will fall into one of the categories listed above and therefore the debt will be deemed to be “traded on an established market”.

Although it is unclear what modifications will be deemed to be “significant modifications”, clearly an interest rate change will qualify. Also, some modifications to the number or terms of payment will qualify.

Congress has taken action to provide some relief for taxpayers getting caught in this CODI trap during the current economic conditions by adding new Section 108(i) to the Internal Revenue Code. New Section 108(i) allows taxpayers to elect to defer taxation of CODI on “applicable debt instruments” on transactions which occur in 2009 or 2010. If a taxpayer accrues CODI during 2009 or 2010, the taxpayer can elect to defer recognizing such income (and thus deferring the obligation to pay tax on such income), until 2014. The taxpayer can then further defer the recognition of such income by recognizing only a pro rata portion for each of the years 2014 – 2018. Therefore, even though the taxpayer will eventually have to pay the tax on such income, the taxpayer can elect to defer that obligation to later years (and spread out the pain over a 5 year period).

An “applicable debt instrument” is any debt instrument issued: (i) by a corporation; or (ii) by either an individual or a pass through entity (such as a partnership or limited liability company) if such debt was issued in connection with a trade or business.

The moral is that you need to involve your tax advisor in most business transactions that involve loan modifications. Even if you simply agree to pay more interest (and thus not receive any increase to your net wealth), you could suffer an adverse tax consequence.

The first two provisions of the Credit Card Accountability, Responsibility, and Disclosure (“CARD”) Act of 2009 went into effect Thursday, August 20, 2009.  The CARD Act is designed to protect consumers from unfair and deceptive practices by credit card companies. 

These provisions are:

1. 21-day grace period.  Beginning on August 20, credit card issuers must mail your bill at least 21 days before it is due instead of the current 14 days.  This gives consumers who pay attention a little more time to get their payment in on time. 
2. 45-day advance notice of interest rate increases.  Also beginning on August 20, credit card issuers will be required to give consumers at least 45 days notice about interest rate increases, instead of the current 15-day advance notice requirement. This allows consumers additional time to contact credit card issuers or to move balances – if consumers open and read these notices. 

The bulk of the protections go into effect in February 2010, with a few final changes coming in July 2010.

According to the White House, the key elements of the CARD Act are:

• Bans Unfair Rate Increases
• Prevents Unfair Fee Traps
• Plain Sight /Plain Language Disclosures
• Accountability
• Protections for Students and Young People

 The CARD Act will also limit over-limit fees, apply payments over the minimum payment to the balance with the highest rate, and spell out more clearly how long it will take a consumer to repay a debt.  ,

The Center for Responsible Lending has looked at credit card issuer practices since the legislation was proposed and found that while issuers are voluntarily implementing some of the CARD provisions, they are also suddenly cutting credit limits and raising all sorts of fees.  Some of these practices will be forbidden next year. 

What are your recent experiences with credit?  Have your accounts been closed, credit limits been lowered or additional fees imposed?  Are you able to get business credit?  If so, we’d love to know who’s interested in doing business.

It is the mid-1980′s. Savings & Loan institutions are failing at an alarming rate. So many are insolvent, in fact, that the Federal Savings & Loan Insurance Corporation (FSLIC), the deposit insurer of thrifts at that time, is running out of money to close insolvent thrifts. What does FSLIC do? It seeks out purchasers, who will buy, or recapitalize, a failing thrift. To entice such purchasers, FSLIC agrees to grant valuable financial inducements to the purchasers, including “forbearances” in counting bad loans against capital requirements, or allowing “goodwill” to count towards capital requirements.

The program worked well — several hundred “deals” were struck, in which insolvent institutions were taken over by purchasers who were given the many incentives. Thus, FSLIC did not have to close those institutions.

Happy ending to the story? Not by a long shot.

In 1989, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA”). Among other things, FIRREA immediately took away all the incentives FSLIC had given to the purchasers of insolvent thrifts. With the incentives taken away, many S&L’s were immediately insolvent, since suddenly all bad assets did count against capital, and goodwill could not be counted toward capital. Millions of dollars were lost by those who were initially given the FSLIC promises.

Lawsuits were, of course, filed, commonly, known as “Winstar” or “Goodwill” litigation. In United States v. Winstar (hence, the “Winstar” reference), the Supreme Court ruled that FIRREA breached the forbearance agreements FSLIC had given. However, the litigation proceeded for years on the issue of the amount of damages the Government had to pay, if any.

Fast forward to Summer, 2009. The headlines declare the Federal Deposit Insurance Corporation (FDIC) is now low on funds, since once again banks are failing at an alarming rate. Once again, the headlines say the FDIC wants to “attract” buyers of failing banks (and more here). To do so, it is willing to offer deals and incentives. (Sound familiar?) One such incentive may be to soften regulations on allowing private equity firms to buy failing banks. Traditionally, the FDIC was wary of private equity buying banks, for fear they will engage in more risky lending, or only be a short-term investor in an industry that many believe requires stability.

The FDIC Board will soon decide how it will address its problem of the depleted deposit insurance fund, and the increased number of bank failures. Other proposals are being considered in addition to the private equity solution. But with history as our guide, any prospective purchaser willing to accept “inducements” in purchasing a failing bank, should be very cautious, or at a minimum recognize its risks.

“We may be seeing the beginning of the end of the recession,” President Barack Obama said yesterday in Raleigh.  Indeed, parts of the country are starting to experience some economic stability, according to the latest figures issued by the Federal Reserve, but the Fifth District of Virginia, North Carolina and  South Carolina remains weak. 

Eight times a year in anticipation of the Federal Reserve Board’s meetings, each Federal Reserve Bank gathers anecdotal information on current economic conditions in its District through reports from Bank and Branch directors and interviews with key business contacts, economists, market experts, and other sources. Commonly known as the Beige Book, this information is summarized by District and sector and an overall summary of the country’s economy is given. 

On balance, economic conditions in the [Richmond] District remained weak in June and early July. Retail and services firm revenues continued to shrink, and contacts reported falling wages and steady or declining employment levels. Price growth in the service sector was slow. Commercial real estate activity softened further, with declining rents, increased concessions, and rising vacancy rates in some markets. Commercial lending activity continued to decline as loan demand remained subdued and some institutions reported tightened credit standards. Meanwhile, residential real estate contacts gave mixed reports about housing activity. Residential lending slowed as the slight increase in purchase loans was offset by a drop in demand for refinances. On a brighter note, manufacturing activity continued to strengthen in recent weeks as contacts reported increased shipments, new orders, and capacity utilization, and a moderation in the employment decline.

The other significant economic news is that new house sales increased nationally by about 11 percent, the steepest increase in more than eight years, as buyers apparently took advantage of low interest rates and a federal tax credit for first-time home-buyers. 

How is your business weathering the recession and recovery? What programs would help your business?

Federal Reserve Chairman Ben S. Bernanke is testifying today to a joint hearing of the House Oversight and Government Reform Committee, and House Domestic Policy Subcommittee. The purpose of the joint hearing is to examine events surrounding Bank of America’s $50 million acquisition troubled investment house Merrill Lynch in September 2009 and its receipt of Federal financial assistance.

The acquisition was supposed to save the American financial system from a destructive down cycle started by the imminent Lehman Brothers investment bank bankruptcy.  Within days, however, the entire global financial system was collapsing.

A blogger at the Wall Street Journal calls this acquisition of Merrill a “deal from hell” because it was negotiated in 48 hours; within a month of the acquisition, several key Merrill executives left; Bank of America required an additional $20 billion in Treasury support; $118 billion of government backstops; a $15 billion loss at Merrill that came after repeated assurances from both sides that due diligence was solid; the massacre in Bank of America shares, which have fallen 78% since the bank agreed to acquire Merrill on Sept. 15; lawsuits surrounding the surprise announcement of the Merrill Lynch loss; the revelation that Lewis himself contemplated calling the whole thing off in December; and widespread fears of even steeper losses on Merrill’s troubled assets.

Last week, these same committees heard testimony from Bank of America CEO Ken Lewis on its acquisition of Merrill. Lewis testified that his job was threatened after he expressed second thoughts about the deal. Lewis said then-Treasury Secretary Henry Paulson and federal regulators made clear that if Charlotte-N.C.-based Bank of America Corp. reneged on its promise, that he and the bank’s board members would be ousted.

For more information on the merger and the effect on the economy, check out this Frontline story.

For nearly two years, the credit markets have been tightening, making it difficult for consumers and businesses to get credit for purchases and operations.  Several financial institutions declared bankruptcy or were on the brink of failure.  The federal government has used a variety of strategies to prevent a full-scale financial meltdown, including slashing interest rates, lending money to financial institutions, buying “toxic assets” and investing public monies in automobile companies.  This week, President Obama announced a second tactic to support the American economy:  preventing another banking crisis from occurring. 

It is an indisputable fact that one of the most significant contributors to our economic downturn was a unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess. A culture of irresponsibility took root from Wall Street to Washington to Main Street. And a regulatory regime basically crafted in the wake of a 20th century economic crisis — the Great Depression — was overwhelmed by the speed, scope, and sophistication of a 21st century global economy.

To read the entire remarks, click here. 

The plan proposes new regulation on financial firms and heightened protection of consumers with regard to purchase of financial products.  The Federal Reserve (“Fed“) will get significant new powers to regulate and oversee a wide variety of financial institutions, including stress tests of companies “too big to fail” like AIG and Lehman Brothers and regulation of parent companies and all subsidiaries, including unregulated units and those based overseas.

Executive pay and complex financial products will receive more scrutiny. 

A new agency to be called the Consumer Financial Protection Agency will have broad authority over consumer-oriented financial products, such as mortgages and credit cards. This agency would work with state regulators.

The Securities and Exchange Commission (“SEC”) would have broader powers to regulate hedge funds and venture capital funds. 

For a detailed summary of the plan, click on this Wall Street Journal Article. 

More details need to emerge before the plan can be adequately reviewed, but even the broad outline raises some questions:

• Is the SEC able to monitor/regulate hedge funds and venture capital funds?  Arguably, it did a poor job of catching the Bernie Madoff fraud. 
• What checks will be on the Fed’s power?  It is one of the least open and transparent agencies now. 
• Why does this proposal not restore some of the restrictions on banking contained in the repealed Glass-Steagall Act, which created the Federal Deposit Insurance Corporation (“FDIC”) and implemented a variety of checks on banks and financial institutions?

It is going to be very interesting to review this new regulatory scheme as the details emerge.  How do you feel about these changes?

From the Triangle Business Journal, an update to our previous news on regional bank BB&T: 

BB&T Corp. will pay $3.1 billion to buy back preferred stock sold to the federal government, marking the Winston-Salem banking giant’s exit from the Troubled Asset Relief Program (“TARP”).

In a news release issued Wednesday, BB&T (NYSE: BBT) said it also would pay a dividend of about $13.9 million, bringing to $92.7 million the bank’s total amount of dividends paid to the feds.

“This was, in fact, an excellent investment for the American taxpayer,” said BB&T CEO Kelly King. “Our strong capital position allowed us to pay back TARP in a very short amount of time. But what’s important today is that we’ve repaid the government, and now we have a singular focus on the business of serving our clients.

BB&T, which ranks third in market share by deposits in the Raleigh-Durham area, also has informed U.S. Treasury officials of its intent to buy back a warrant that allows the Treasury to purchase as many as 13.9 million shares of BB&T common stock.

The amount of that buyback, which has yet to be determined, will be accounted for in BB&T’s second or third quarter of this year, the bank said.

“Throughout this period, BB&T has experienced very good loan growth,” King said. “We will continue to actively pursue and make every good loan we can find.”

With $143.4 billion in assets, BB&T is the nation’s 10th largest financial holding company.

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.