an oversecured creditor (i.e., one
whose collateral exceeds in value the
amount owed to it) cannot be deemed
to have received a preferential payment on the oversecured obligation
because the payment did not enable
the creditor to receive more than it
would have received in a Chapter 7
case if the pre-bankruptcy payment
had never been made.
While litigation is what keeps pushing the envelope on this knotty issue,
lenders will very rarely want to go to
the trouble and expense of a trial and
will usually settle.
“You always end up paying something,” says Bill Fabrizio, a workout
specialist at Wells Fargo in New York.
Law firms take preference claims on
contingency and take a shotgun approach on all payments. “You’ve got to
give them something to make them go
away,” says Fabrizio.
Rarely does any of that money make
it back to creditors, he says. For lenders,
it is always cheaper to be able to settle
before it is necessary to file an answer
and get to the discovery stage, which
requires outside counsel. “Otherwise, it
can cost you a fortune,” Fabrizio says.
“The goal,” as Ed Schnitzer, partner
at Hahn & Hessen in New York, says, “is
to be paid in full and return as little as
possible.” In practical terms this means
keeping the settlement amount as low
as possible by being aware of what the
best defenses are.
“What you’re going to pay,” says
Kevin Zuzolo, a bankruptcy specialist at
Otterbourg P.C. in New York, “is usually
based on the strength of the defense.”
This sampling of “gotchas” is, of
course, far from exhaustive, and lenders
should always seek expert legal advice
for their particular situation.
One golden rule, in the words of
Terry Corrigan, a former practitioner
who now works as a consultant, is
“always take the money.” Even a check a
year late should be deposited immediately. “You’re always better off with the
money,” says Corrigan, even if you end
up giving a portion of it back.
said, one of the best defenses against
preference claims is that a payment
was made in the ordinary course of
business. So, one of the first rules is
to establish an ordinary course and
stick to it.
“Keep the customer in trend of invoicing,” says Corrigan. If payment term
is 30 days and you accept payment up
to 45 days, try to keep payments in that
Determining whether you actually
succeeded in doing that may be easier
said than done when hit with a preference claim, says Fabrizio, when a factor,
for instance, has 20 clients or more for a
“It’s a tremendous job for a factor
to back a year and three months for all
these clients to see if payments are in
the same box,” he says.
On the other hand, Corrigan cautions, you have to be careful about
exerting pressure on borrowers.
“You never want to threaten,” Corrigan says. Courts are sensitive to pressure on a debtor, so a gentle reminder
“You don’t want to get in situation
where you’re still shipping after the
credit limit is reached,” he says. “Be en-
couraging,” he adds. “Tell the borrower
that it’s simply too much exposure for
you to keep lending until he pays some
of the open invoices.”
Zuzolo urges factors to keep the
back-up documentation – invoices, bills
of lading – to support their defenses,
especially when the borrower has paid
off the facility.
Corrigan has been surprised that
more lenders don’t rely on the objective
standard for ordinary course of business permitted in a 2005 amendment to
the bankruptcy law as an alternative to
your own practice – namely, what is the
normal payment pattern in the industry
as a whole.
Those who conducted business under
old rules didn’t change their thinking, he
says. “People should be more focused
on ordinary in the industry defense,” he
says. “Courts are reluctant to give wide
latitude” on the individual practice.
must be careful to monitor the value of
collateral because it can change. “The
value of the collateral and whether
the lender is under- or over-secured is
determined at the time of the bank-
ruptcy filing,” says Zuzolo, “not when
the transaction begins.”
For one thing, the value of the
collateral in a going concern may be
far higher than it would in the case of
Also, there may be hidden “gotchas”
in the collateral itself. Collateral may
be seasonal – like Christmas cards that
largely lose their value in January – or
Ed Dobbs at Parker, Hudson, Rainer
& Dobbs in Atlanta, cites a case where
an apparel manufacturer had licenses
for logos from Disney and the NFL, but
when these expired, much of the merchandise became unsaleable. Another
case involved a maker of diapers that
lost a patent case to Procter & Gamble,
rendering its inventory worthless
Borrowers may misreport the value
of collateral, intentionally or not, cautions Dobbs. Accounts receivable might
contain pre-billing or overbilling.
Prudent lenders advance only a
percentage of the assets, Corrigan says.
They get appraisals from someone they
can trust on the collectivity of receivables and value of inventory. He recommends a physical count of inventory
and a sampling of receivables to guard
Even though there is an exception in
the bankruptcy law for floating liens,
this only applies, Dobbs notes, when
the lender is over-secured on the 90th
day before bankruptcy filing so that
there can be no improvement in its
position during the period leading up to
If, however, the lender is under-se-cured on that cutoff date, there may be
preference exposure for any improvement in the position of the borrower in
the 90-day period up to filing.
emphasizes Jay Indyke, bankruptcy