How To Manage Bankruptcy Issues As A Creditor
- By James R. Vann
Preferential Transfers in Bankruptcy: How to Minimize the Preference Risk
For suppliers of goods and services, nothing may be more unsettling than discovering that a customer has filed for bankruptcy. To add insult to injury, there is a risk that any recently received payment or settlement might be recaptured by the bankruptcy trustee as a preferential transfer or “preference”. Do not give up on issues in bankruptcy thinking that creditors cannot win in bankruptcy court. Approach the process with the thought and goal of winning!
Fortunately, there are defenses that can be raised against preference claims. Creditors should be aware that there are contexts in which payment can be extracted from a debtor without fear that the transfer will be avoidable at some future date. Below, we provide a basic overview of the criteria that gives rise to bankruptcy preferences, and also highlight some common defenses available to creditors in preference actions.
What is a “preference” payment?
Section 547 of the Bankruptcy Code governs preferences. Under this section, a trustee or debtor-in-possession may recover – as preferences” – any payments or other transfers of assets by a debtor to a creditor within 90 days of the debtor’s bankruptcy filing. There are two main purposes for this policy: to prevent a debtor from favoring any of its general unsecured creditors over others and to discourage creditors, upon hearing that the debtor is about to file bankruptcy, from storming the courthouse to collect their individual debts.
The elements of a preference claim are typically stated as follows: (1) the debtor transferred property to or for the benefit of the creditor (i.e., made a payment); (2) the transfer was made on account of a debtor’s pre-existing debt to the creditor; (3) the debtor was insolvent at the time of the transfer; (4) the transfer was made within 90 days of the debtor’s bankruptcy filing, or within one year if the creditor is an insider on account of an old debt; and (5) the creditor obtained a larger sum from the transfer than they would have in a Chapter 7 liquidation had the transfer not occurred. Note that payments to a fully secured creditor fail to meet these criteria, as the secured creditor will not receive any more from the debtor than the value of the collateral, which is what he would receive in bankruptcy.
Common Preference Defenses
The bankruptcy code provides a series of defenses that creditors can assert to evade preference claims. These defenses are primarily aimed at encouraging creditors to continue doing business with financially troubled companies. Some of those most frequently asserted are (1) the contemporaneous exchange for new value defense, (2) the ordinary course of business defense, and (3) the small transfer defense. If a creditor is to routinely evade preferences, a working knowledge of these defenses is imperative.
1. The Contemporaneous Exchange for New Value Defense
The contemporaneous exchange defense is codified at Section 547(c)(1) of the Bankruptcy Code. It excuses any payment or other transfer that the debtor and creditor intend as a contemporaneous exchange for new value, and that is, in fact, a substantially contemporaneous exchange. In other words, if a creditor provides new goods and/or services and receives payment at substantially the same time, the payment will not receive preference treatment. An example of such a contemporaneous exchange would be payments received on a C.O.D. basis.
2. The Ordinary Course of Business Defense
Under Section 547(c)(2) of the Code, payments received in the ordinary course of business on debts incurred in the ordinary course of business are excepted from preference treatment. A creditor may utilize the ordinary course defense in either of the following contexts: (1) where payment is received in its ordinary business with the debtor, or (2) where payment is received according to the ordinary business in that industry.
As to the first test, the court’s basic inquiry involves a subjective evaluation of the debtor/creditor relationship. This generally takes the form of a consideration of the length of time the parties have had a business relationship, and whether the amount or form of payment at issue differed from past business practices between the parties. The longer the business relationship, and the lesser thedifference between the payment history before the preference period and that within the preference period, the greater the likelihood that the supplier will prevail.
As to the second test, a more objective inquiry is utilized. The supplier must establish that the terms by which it extended credit to the debtor were “ordinary” within industry standards. This does not mean that all invoices are required to be paid within the invoice terms. The creditor need only show that payments are made sporadically or outside invoice terms in the particular industry involved, or at least in a manner and form consistent with the payment practice being challenged.
3. The Small Transfer Defense
This defense bars preference claims in the case of primarily non-consumer debt for payments of up to $5,000. Creditors should keep this ceiling amount in mind when structuring payment from debtors. As a matter of strategy, creditors may prefer payments of $4,999 to payments not appreciably greater than that amount. However, a caveat is in order: any payments received during the 90-day preference period cumulate against the maximum protected amount. Thus, if a monthly payment schedule is in place, the $4,999 maximum must be distributed among the preceding three months.
Conclusion
Often, bankruptcy trustees will file preference claims against all creditors who have received payment from the debtor in the 90 days immediately preceding a bankruptcy filing. The strategy is to file the claims upfront, and then sort out the merits later in the process. A basic understanding of preferences can help creditors avoid making a reflexive, yet unnecessary, refund payment. Nonetheless,as demonstrated by the cursory outline above, these matters can be complex and are best addressed with the assistance of a lawyer with experience representing creditors in bankruptcy cases. More importantly, do not give up on issues in bankruptcy thinking that creditors cannot win in bankruptcy court. Approach the process with the thought and goal of winning!
Post Judgment Remedies: What to do when all seems lost
- By James A. Beck
Obtaining a judgment is only the initial hurdle in collecting a debt. On many occasions, a Writ of Execution will be returned by the Sheriff unsatisfied. The initial response may be to cease collection efforts. However, there are several mechanisms provided for by the law to assist creditors in their post-judgment collection efforts. These methods can be used to identify assets and even expose additional individuals and entities that can be held liable for the debt. Though not the most exciting subject area, this is where a solid understanding and application of the few creditor-friendly statutes can pay off.
North Carolina law provides for various “supplemental proceedings” to help creditors discover assets, including supplemental examinations, interrogatories and document production of the debtor’s books and records. In addition, the law allows creditors to question the debtor about property that the debtor refuses to apply to satisfaction of the judgment, order the arrest of a debtor attempting to leave the state, and require debtors of the judgment debtor to satisfy the debt.
Supplemental examinations and written interrogatories are similar in that various questions are asked to the debtor to explore their financial situation, identify assets, and to find out whether any assets have been sold or transferred. The benefit of the supplemental examination is that the creditor can ask follow up questions and create a dialogue with the debtor. A supplemental examination should be used in conjunction with a document production so that the creditor can view the debtor’s records and ask questions as necessary.
Of course, many debtors have a knack for avoiding creditors’ attempts to collect, even when a creditor knows assets exist. If a creditor believes a debtor owns assets that it refuses to apply to the satisfaction of the judgment, a creditor can obtain an order requiring the debtor to appear in court and answer questions regarding those assets. Then, the judge can order those assets sold.
Sometimes, debtors will attempt to leave the state or hide. If so, and if the creditor has reason to believe the debtor owns assets that he refuses to apply to the judgment, the court may enter an order for arrest, and require the debtor to be examined under oath. The court can then forbid the debtor from leaving the state while supplemental proceedings are carried out.
Finally, if a creditor learns that the debtor is owed money by another individual or entity, the creditor can obtain an order requiring that individual or entity to appear and testify, and the court can order that the funds or property must be used to pay the judgment.
This is just a summary of the postjudgment remedies available to creditors. Please feel free to give us a call if you would like to discuss the application of these remedies to your benefit.
The Shade of the Corporate Veil
- By Chad J. Cochran
Nine times out of ten, a corporation is formed to utilize its most famous characteristic – limited shareholder liability. In legal terms, the corporate veil protects the shareholder’s personal assets from business debts. In principle, this makes sense as the market would enjoy much less capital if an investor’s family home were at risk each time John Q. Public decided a business might be worth the chance of risking a few dollars. However, corporations must act in accordance with an established body of rules. Otherwise, shareholders should be fearful that the corporate veil may contain holes.
Through litigation, we are often presented with potential judgments which could exceed corporate assets. In these situations, the creditor becomes very interested in the shareholder’s multi-million dollar beach house, and the shareholder becomes very interested in protecting it. North Carolina courts balance these competing interests by examining the doctrine of piercing the corporate veil and the following four factors:
1. Inadequate capitalization – New businesses are cash hungry, and the sad reality is that the majority of new corporations will fail. Obviously, not every failed corporation subjects the owner to personal liability. However, a corporation’s initial bank account must give it a fighting chance. In addition to starting with inadequate corporate funds the easiest means to lose protection of the corporate veil is to distribute unfair shareholder dividends while neglecting to pay corporate debt.
2. Corporate formalities – Regardless of the size of a corporation, certain formalities are required:
A. Shareholder Meetings – at least one per year is required.
B. Shareholder or Director Consent Actions – without a meeting, a signed writing is required and must be stored.
C. Annual Financial Statement – within 120 days of the fiscal year end, a corporation must deliver or make available its annual financial statements to shareholders.
D. Annual Report – within two and a half months of fiscal year end, a corporation must file its annual report with the Secretary of State.
3. Complete Domination and Control – A corporation with only a few shareholders is the most susceptible to having the veil pierced. A corporation with only a handful of shareholders should be very careful in ensuring that each shareholder is treated fairly and that minority shareholders are given opportunities to express opinions in shareholder meeting, participate in consent actions, and vote on directors.
4. Excessive fragmentation – Whenever a single business divides itself into separate corporations beyond any reasonable justification, a shareholder should become very weary. This type of internal insulation of liability is prohibited.
The Search For The Perfect Credit Application
- By Nan E. Hannah
Frequently, our office is asked to review and revise credit applications for clients. It is always an interesting process. The lawyer’s perfect credit application would probably be four to five pages in length (including the personal guaranty) and cover every conceivable issue which might arise. And, we would revise it almost weekly as we read new case law and encounter new issues which could have been addressed had a single clause been in the agreement. Most clients want a one page credit application and would prefer it be one page as in only the front of a piece of paper. Such a document is so much more customer-friendly but presents legal challenges in terms of protecting our client.
The challenge then is to find the appropriate middle ground. That middle ground is truly client driven and generally based upon the credit manager’s experiences in what can go wrong.
One issue to be considered is whether your business operates locations in more than one state. It is relatively simple to draft attorney’s fees and interest provisions for a contract which will be entered into, performed, and enforced in the same state. In North Carolina, we know that by statute the maximum amount of interest which may be charged on an open account is 18% APR (1.5% per month) and that “reasonable attorney’s fees” – defined essentially as those attorney’s fees to which parties agree in a contract or which will be enforced no matter what the terms in the contract might be – is 15% of the principal balance. And, in North Carolina, if the contract includes specific language, the 18% interest can be enforced ostjudgment. If the language is missing, then the “legal rate” in North Carolina is 8% APR.
In our neighboring states, interest may be permitted at a rate as high as 24% APR (2% per month) and attorney’s fees provisions vary widely. Some permit post-judgment interest above the legal rate, while other states have a very different formula for determining the legal rate. So, if your business has branches in multiple states, your perfect credit application is going to need to address interest, attorney’s fees, and jurisdiction issues applicable in each state. This can be done in a single application, but makes the document longer.
Also with multiple state branches, you need to be certain that your application conforms to any and all debt collection acts. Different states tend to have different points of emphasis. And, of course, there are certain provisions related to federal laws that must be included. Add to that the ever changing requirements related to Identity Theft issues and the puzzle gets more complicated.
So, what is essential in a credit application? That answer is not easy, but to start with the basics, you want to include your payment terms, a provision for service charges and the recovery of collection expenses including attorney’s fees. You definitely want to include some form of jurisdiction clause to keep things on your home turf.
Language setting out the obligations for the debtor in terms of any changes to the business form, location, officers, or other vital information collected at the time of application can protect you when a proprietor incorporates and fails to tell you. The same holds true if a partnership dissolves and one partner later claims not to be responsible for the debt – no notice to you should mean he cannot dodge liability, but a contract provision will make that notice a condition of the contract or guaranty.
Recently, issues have arisen involving when the 15% for attorney’s fees is computed. We now suggest that you add language to your credit application stating “reasonable attorney’s fees defined as 15% of the principal balance due and owing at the time the matter is referred to counsel or a collection agency.” This removes most of the questions if a customer initially owed $25,000.00 ($3,750.00 in attorney’s fees), but makes a partial payment prior to judgment reducing the principal balance to $10,000.00 ($1,500.00 in attorney’s fees). Lately, we have encountered judges who compute the attorney’s fees award based upon the amount owed at the time of judgment. A term establishing the point of computation for the fees would help your counsel recover the higher (and to my way of thinking more appropriate) amount.
Every industry and every business has specific warranty and payment issues which they seek to address in the credit application. Some businesses choose to address delivery and the requirement for signatures on delivery tickets. Others include numerous disclaimers in terms of pricing, delivery, special orders and limits on credit. There are terms for default, converting an account to C.O.D. or requiring pre-payment for specially manufactured or ordered goods. There must be language dealing with the right to access and check credit for officers and related businesses.
So, what is the “perfect” credit application? It is the one which addresses your business needs most completely while not being so onerous as to scare away customers. Generally, we approach the drafting process by providing an initial draft which includes our idea of an ideal (all-inclusive credit application) and then allow clients to edit and eliminate as they see fit to match the application to their needs. We will notify you if we believe a deleted provision is essential, but will continue working until the application protects a client from a legal perspective while meeting the client’s needs and their customer’s patience level.
Take a look at your company’s credit application and make sure it still fits your needs. If not, then consult counsel and update the document to protect your bottom line.
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