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Preference Litigation: The Fine Art of the “Aging Analysis”

 

overdue-invoices

SOURCE CREDIT: Fiona Robertson Graphics

An aging analysis is often needed to mount an ordinary course defense in a preference action that a debtor has initiated against your client creditor, who could be a supplier, a lender, a trade creditor, a landlord.

 

EXAMPLE: Debtor retail toy store buys toy inventory from Defendant Supplier Creditor on Net 30 day terms and has done so for years. Debtor always paid in about 45- 60 days (or 15 to 30 days late– the  “lag time”). The purchase history is evidenced by 1000’s of invoices, purchase orders, and checks.   As the Debtor started its “slide into bankruptcy”, it slowed down payments to this Supplier Creditor and started paying in 75 to 100 days after invoice within the 90 days prior to filing bankruptcy (35-70 day “lag time”).  Debtor paid Supplier $100,000 in those 90 days about 75-100 days after invoice.   Post- bankruptcy, the Debtor or a Trustee sues the Supplier Creditor for a return of the $100,000 alleging that the payments were preferential payments.

To argue the ordinary course of business defense provided for creditors in the Bankruptcy Code, the Supplier must show that the timing of the payments in the 90 day period was consistent with Pre-Preference Period transactions, that this was a typical supplier/debtor credit relationship where the Debtor and Supplier over time had fallen into a pattern of regularly paying and accepting payments on a late basis. The Supplier must show that during the Preference Period, the average lag times remained substantially the same. The Creditor had come to expect this and had accepted these payments to be made in the “ordinary course of business.”

As a debtor draws closer to the filing of a bankruptcy, it is generally the case that almost all invoices will be paid with less frequency. A creditor must prove more than just that fact. See Hansen Lumber, 270 B.R. 273 (even where representative of debtor acknowledged that as debtor got closer to filing bankruptcy, the invoices were being paid with less frequency and the creditor defendant was treated no differently than any of the debtor’s other suppliers, debtor’s batch payments to supplier were still preferential). Generally speaking, there have been two ways in which Courts have done an “aging analysis” comparing the timing of preferential payments to the course of dealings established by the payment history between the parties: the “ranging method” and the “averaging method”.

For the “ranging method,” the first step is determining the range of “lag times” for payments made by the Debtor to the Creditor during the Preference Period, (if possible, also taking into consideration both the number of invoices and the dollar amount of invoices).  The second step is determining whether this Preference Period range of “lag times” falls within, or close to, the range of lag times for payments made by the debtor to the creditor prior to the Preference Period. Calculating a “lag time” is described below.

For the “averaging method,” a creditor simply compares the average “lag time” for payments made during the Preference Period with payments made during the Pre-Preference Period.  To calculate the average, one must first count the days after invoice date for each invoice, add up the total number of days and divide by the total number of invoices. Global Distribution, 103 B.R. 949, 953 n.3 (citing In re First Software Corp., 81 B.R. 211, 213 (Bankr. D. Mass.1988). If a debtor is a making payment to the creditor which pays many invoices (a batch basis), there is an issue as to whether the “lag time” is calculated on a “batch” basis or on an “unbatched” basis (invoice by invoice).  Uh. yeah, this analysis can get more complicated.

As I have previously written here, I have developed an extensive series of excel spreadsheets to generate an “aging analysis” to defend preference litigation.  I am able to take a client’s 1000s of invoice transactions, input them into excel and do an analysis using both the “ranging” and “averaging” methods on both a “batched” and “unbatched” basis.  The analysis must also account for how the “Ordinary Course” defense interplays with the “New Value” defense (another defense to preference allegations).  More on that later.

In true scholarly fashion, I amassed 100’s of cases in various Circuits that scrutinize what is a reasonable “average” or reasonable “range” in determining whether a transfer is ordinary or not.

I know this is riveting stuff.  But, this type of litigation can make or break a creditor, thrusting the creditor also into a liquidation itself if forced to disgorge payments a Chapter 11 Debtor has made to it for bona fide goods or services.  Trust me, my clients are fuming after being hit with one of these lawsuits.

Feel free to reach out if you have any additional questions about the “aging analysis” in a preference action.  The age of the transaction is only one factor in determining whether a transfer is or is not within  the ordinary course defense, but albeit a weighty one.

 This post does not constitute legal advice.  Consult an attorney about your specific case.

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#notalllawyershatemath: Where Mathematics and Lawyering Meet in Business/Bankruptcy Litigation

greetings from phoenix, aZ •.jpgI am analytical. I like numbers. I like clear answers. Black and white. Not grey.

I was the Calculus member of my high school’s academic team in high school. Dad was an industrial engineer and the visual lens through which he viewed the world rubbed off on me. I initially majored in Physics because I appreciated how Calculus concepts could be applied to real life.

Fast forward 25 years. I love my work as a business lawyer. But, I still crave that opportunity to solve math problems (I did have a chance to be a financial analyst for two years before I started the firm). I just recently realize that, whenever I can, I attempt to solve my clients’ legal problems using spreadsheets and finite alternative scenarios.   I reduce chaos and moving parts down to a formula, decision tree, or spreadsheet. There are only so many scenarios. There is a range of only so many possible outcomes. The law can only go so many ways.

Such an approach has worked really well for me in the context of settling business litigation. Recently, in bankruptcy litigation, I had to resolve the extent, amount, and priority of competing lien positions of 5 creditors (2 mortgage holders and 3 taxing bodies), on my clients’ commercial assets (including a building) and one of the owner’s residence. We tried to negotiate for months and no one was budging, but then I busted out my spreadsheets. I kept running the numbers given different assumptions regarding the value of the assets, whether to include interest and penalties, and given the two alternative legal outcomes as to whom should be first in lien priority.  With the help of an esteemed mediator, we resolved the matter and successfully confirmed the plan of reorganization.

My abstract skills and fancy excel handywork also came in handy when I was about 29 (12 years ago, gasp), and working as a young associate. I developed an extensive series of “aging analysis” excel spreadsheets to utilize math to resolve a special type of bankruptcy litigation: preference litigation. The cases we handled were large dollar amounts in controversy, ranging from $15k- $8 million. Where a creditor is sued in a preference action (see first post on What the Heck is a Preference Action: Paying Off Favorite Creditors As a Business Tanks), there is an ordinary course of business defense. In order to mount this defense, a defendant should present an “aging analysis” of the length of time the parties were engaged in the transactions at issue.

We settled every time (with only one exception) and I am sure my extensive volumes of “aging analysis” spreadsheets helped.  Maybe Dad would have preferred that I became an engineer like him. I don’t know. I do know that he would be proud of the way I approach my work now. Both my clients and I can thank my science and math teachers (Mr. Pete Karpyk, Mr. Phil Carey, Mrs. Kladakis, Mr. J.) for helping me be able to create these frameworks in which I can more readily resolve legal problems. So remember, #notalllawyershatemath.

Stay tuned for another post on exactly what is an “aging analysis” to be used to mount an ordinary course defense in a preference action.

Salene is a business and bankruptcy lawyer.  This post does not constitute legal advice and does not constitute a guarantee of any legal outcome.  The facts and legal issues vary from case to case; and not all outcomes will be the same.

The Company You Own Files Bankruptcy: Can Creditors Still Come After You?

automatic-stayAs is almost always the case, principals of a distressed business have personally guaranteed the debt on a credit line or property or equipment lease. When a business files bankruptcy, an automatic stay is imposed against any adverse actions taken against the business entity, the Debtor. But what about the owners of the business? Often, I find myself seeking to extend the automatic stay injunction to those principals. This issue came up in a recent case we had pending in the Fourth Circuit. We were compelled to find case law regarding the standard for relief.

A factual example would be as follows: A distressed business ABC Recylcing owns a building, and the building has a mortgage on it in favor of Meanie Bank, N.A.  The business falls behind on payments. Meanie Bank initiates a foreclosure action to set an auction to sell the building. Jake, the owner of the business had to sign a guaranty in order for ABC Recycling to get the loan with Meanie Bank. ABC Recycling still operates with the faint hopes of reorganizing through a Chapter 11 bankruptcy. Once the Chapter 11 is filed, the foreclosure action is stayed as to ABC Recycling, but now the Meanie Bank is going after Jake. Help, my clients say.

ISSUE: Pursuant 11 U.S.C. §105 and §362 of the Bankruptcy Code, is a court likely to grant an injunction to protect the principal of a bankrupt business?

CONCLUSION: Where the principal Jack is a primary guarantor of the mortgage and Meanie Bank now intends to secure a judgment against the principal, the principal will only be able to obtain an injunction by demonstrating a mutuality of identity with the Debtor such that allowing Meanie Bank to proceed against Jake will substantially deprive the Debtor of a primary asset (its owner’s time and attention).  In Plain English, how important is the principal Jake to the Debtor’s operations?  A four-part test is employed to make that determination.

While automatic stay proceedings are usually only available to the Debtor, under unusual circumstances, the Fourth Circuit has held that the Bankruptcy Court can enjoin proceedings against third parties.  In re F.T.L. Inc., 152 B.R. 61 (Bankr. E.D. Va. 1993).  However, where no compelling or unusual circumstances exist, then under §362 the Debtor’s guarantors must file their own bankruptcy petition in order to be protected by the Bankruptcy laws.  Id. at 63. (this also happens often).

A court is only likely to grant an injunction to a third party non-debtor principal in the unusual circumstance that it is evident that the identity of the debtor and the non-debtor third party is so interconnected that it is clear that the creditor is proceeding against the debtor.   Under such circumstances, the court may apply a four-part test and equitably grant an injunction where the court finds that:

  • the plaintiff principal has a greater likelihood of succeeding on the merits;
  • plaintiff principal has shown that lack of relief will result in irreparable injury;
  • an injunction will not substantially harm other interested parties, and;
  • preserving the status quo until the merits of the controversy is decided will serve public interests. Id.

In re F.T.L., the primary secured creditor to a car wash company debtor, secured a judgment lien against the debtor’s guarantors, the plaintiffs. Plaintiffs are the primary owners and guarantors of the car wash and the creditor perfected its lien against plaintiffs’ personal residence.  Id. at 62.  Noting that the collection activities against the owners arose from the car wash’s debt to the creditor, the court applied the four-part test and found that the debtor was likely to succeed on the merits by proposing a confirmable chapter 11 plan; the debtor’s chapter 11 plan would be impossible if the owners were forced to file their own chapter 11 petition; very little harm was likely to come to the creditor if it was enjoined from collection activities against the owner, and; lastly the creditors as a whole were best served if the debtor were allowed to propose a plan for reorganization. Id.  The Court extended the injunction to the owners.

If you own a business and are wondering the same questions,  you should review the facts and circumstances of your workout with your attorney.  I think, by and large, the automatic stay is difficult to extend in Bankruptcy Court.  You have to make a really compelling argument that the principal will be so consumed with his or her own bankruptcy that the Chapter 11 reorganization will suffer.

Inside the Trenches of a Chapter 11 Bankruptcy Case-Preparing the Initial Filing

       In the world of business law, many seem to be mystified by the chapter 11 bankruptcy process.   When I tell my friends and colleagues what I do, they still don’t seem to understand me.  I get that glazed, deer-in-headlights look.   I just recently filed a Chapter 11 case and I decided to write a series of blog posts as we are going through the process.

        The chapter 11 process is expensive but can be a worthwhile option and a financially prudent decision for certain businesses wishing to reorganize, restructure their debts, reject undesirable contracts, and/or orderly liquidate certain assets under the jurisdiction and protection of the bankruptcy court.

Triggering Event.  Usually an event triggers the filing (a pending auction of assets, an inability to payroll, the threat of a shut-off notice for utilities, a impending freezing of bank accounts, a filed lawsuit, etc.).  A debtor can file an emergency petition in such an instance.

Emergency Petition.  To file an emergency petition, at the very minimum a debtor needs to submit the 2-page petition, its list of 20 largest unsecured creditors, and a creditor matrix (listing all of the creditors the debtor believes it currently has).    This sounds like a simple initial filing; but, it might not be.   The preparation of the debtor’s bankruptcy petition and related schedules can be very time-consuming depending upon the nature of the debtor’s business, how orderly its books and records are, and how many divisions or locations, it has etc.

Automatic Stay.  Once the minimal skeletal documents are filed, an “automatic stay” goes into immediate effect; the automatic stay is basically an injunction against any and all actions against the debtor and is property.    If a creditor violates the stay, it is a serious infringement and the bankruptcy court can award sanctions  against the creditor.

After the initial bankruptcy petition is filed, a Ch. 11 debtor has another 14 days within which to file its complete schedules and statement of financial affairs.   This timeframe can be extended for cause.

“Debtor In Possession” Bank and Insurance Information.  Also once the petition is filed, generally within 10 days, the debtor and its counsel have to submit certain bank account and insurance information to the United States Trustee (part of the Department of Justice).    Importantly, a business must close its books as of its bankruptcy “Petition Date” and open up  a new set of financial books and records.  New “Debtor-in-Possession” (“DIP”) Bank accounts must be opened at certain approved banks;  the United States Trustee’s Office has the “approved” list of banks.  The debtor and its counsel also may have an initial debtor interview with the agent for the United States Trustee (depending  upon the district in which you file), at which the debtor discusses its business operations and assets and liabilities.

The Bankruptcy Court Is Watching.  Once a bankruptcy petition is filed, a business will then have to seek bankruptcy court approval prior to taking many actions (paying its lawyers and accountants, paying pre-petition wages, utilizing cash (“cash collateral”) to pay expenses, selling anything outside the ordinary course).   A business debtor post-petition generally CANNOT pay any pre-petition obligations, otherwise serious consequences may ensure, including “avoidance” lawsuits. 

Drama.  The initial filing process can be intense for everyone involved.  Lots of information gathering, document review, fact checking.   Many phone calls may be made to and from creditors about the impact of the filing of the case.

Often, a distressed situation, not surprisingly, involves drama.  In some instances I have had to file the case right before the auction on the courthouse steps, right before the repossession crew found the vehicle, or right after the doors to a business were locked and the business suddenly went dark.  After the petition is filed and is made known to the public, media outlets may starting calling to find out more about the future of the business.

STAY TUNED FOR MORE DETAILS REGARDING INSIDE THE TRENCHES OF A CHAPTER 11 BANKRUPTCY CASE

MAZURKRAEMER represents debtors and creditors in bankruptcy courts all over the country.   The information, comments and links posted on this blog do not constitute legal advice. No attorney-client relationship has been or will be formed by any communication(s) to, from or with the blog and/or the blogger. For legal advice, contact an attorney at MAZURKRAEMER or an attorney actively practicing in your jurisdiction.

What the Heck Is a Preference Action: Paying Off Favorite Creditors as a Business Tanks

       Preferential Treatment.  My two older siblings Nathan and Nicole and I often teased my folks about being the favorite kid, each of us jockeying for the favorite position (not really).  I will be writing a series of posts on paying a favorite creditor and the consequences of a debtor doing so as his or her business slides into bankruptcy.  This is the first post.  (I have a 50 page research treatise that I wrote, from which I am pulling to create these posts!).  I will try to make the subject matter as interesting as possible.

Favorite Child      I have been prosecuting and defending the recovery of alleged preferential transfers since my first few weeks as a bankruptcy associate at a large firm in Philadelphia and Wilmington, DE.   I have developed a massive library of research regarding this special type of litigation that arises only  in a bankruptcy case.   So let’s start with the basics; what is a preference action?

As business owners and management see the tell-tale signs that they are going to close their doors or reorganize, the issue always comes up—who can I pay now and in what order?  Often, we see significant outstanding tax liability, much of which consists of trust fund taxes (i.e., payroll, sales taxes, etc.) for which the owners of the company are personally liable.  We also see mom and dads or related companies (aka insiders) lend an ailing business sizable chunks of money on an unsecured basis.   We also see business owners who feel terrible stiffing their long-term business buddy suppliers because they know if that last payment is not made, then the suppliers’ business will become troubled too.   In their darkest hour of distress, as the lights are about to go out, the owners scurry to pay “preferred” creditors.

But, the Bankruptcy Code provides a recourse to protect those creditors who are not on the preferred list.   Specifically, pursuant to 11 U.S.C.§ 547 (aka Bankruptcy Code §547(b)), a preference action is a statutory right unique to bankruptcy that allows a debtor-in-possession or trustee to recover transfers made to a creditor within 90 days of a bankruptcy filing or within 1 year if to an insider, where such transfers were made to pay pre-existing debt.   By initiating preference lawsuits inside of a bankruptcy proceeding, a bankruptcy trust or debtor is able to sue the creditors that it once “preferred” (either voluntarily or involuntarily) in order to claw back those monies into a debtor’s estate for fair distribution to all unsecured creditors.

The five basic elements of a preference are as follows:

  • The transfer must be made (1) to or for the benefit of a creditor,
  • (2) on account of an antecedent debt,
  • (3) while the debtor is insolvent,
  • (4) within ninety days before bankruptcy (for non-insiders) or within one year (for insiders); and
  • (5) the transfer must enable the creditor to receive a greater amount had the transfer not occurred and had the creditor received payment in a hypothetical Chapter 7 liquidation.

All of these elements of a preference under Section 547(b) of the Bankruptcy Code must be present.  If the plaintiff trustee/debtor-in-possession cannot prove a transfer’s avoidability by a “preponderance of the evidence” (generally the ability to prove as “more likely than not” that the five preference elements exist) then a defendant creditor will prevail.  Note that, neither the debtor nor the creditor’s intent regarding the transfer is a material factor in the consideration of an alleged preference (more on this later).

I have been on both the prosecuting and defending side of numerous preference cases.  When a debtor initiates preference actions, often a debtor is directed to pull its check register to identify payments and persons that the debtor has paid over the last year.  Sometimes, those names, addresses and payments are placed into an excel spreadsheet that is then merged with a form complaint.  The preference lawsuits are then filed in “batches.”   I have seen hundreds of preference actions filed in a batch.   Truth be told then — often, not a whole lot of diligence is put into determining whether a debtor’s actually preferred a certain creditor defendant (i.e., whether the debtor or trustee can satisfy each of the statutory elements of a preferential transfer  and/or whether a defendant will have any valid defenses to the action that will either limit or eliminate liability).    So the lawsuit is set in motion and now each creditor defendant to hire a bankruptcy lawyer and defend the lawsuit by either asserting that the plaintiff has not satisfied each of the prima facie elements set forth in the statute and/or asserting an affirmative defense.

Preference laws were designed to facilitate a fundamental bankruptcy policy of equality of distribution among creditors of the debtor.  Nonetheless, in practice, preference actions are often viewed by creditors as extremely punitive, inasmuch as their effect is to cause creditors to disgorge funds that they have received for legitimate, undisputed bills.   Fortunately, as referred to above, the bankruptcy statute also provides numerous defenses to a preference claim that can often substantially reduce or eliminate liability that would otherwise arise if the defenses are not timely asserted.   I will discuss defenses in another post!  Stay tuned.

MAZURKRAEMER represents debtors and creditors in bankruptcy courts all over the country. The information, comments and links posted on this blog do not constitute legal advice. No attorney-client relationship has been or will be formed by any communication(s) to, from or with the blog and/or the blogger. For legal advice, contact an attorney at MAZURKRAEMER or an attorney actively practicing in your jurisdiction.