specialist at Cooley in New York, creditors want to stay fully secured or over-secured. “If you’re fully secured, there’s
not going to be a preference,” he says.
Perfection of a security is obviously
key in defending against a preference
claim. This starts with the simple filing
of the paperwork.
“You’d be surprised that people don’t
do what in hindsight is common sense,”
says Corrigan. Filing the UCC- 1 Form is
completely routine but people sometimes just don’t do it, he says.
“It happens every day,” agrees
Dobbs. “People fail to perfect their liens
on some or all of the collateral.”
It is also important, Zuzolo notes, to
make sure that the security is continu-
ous, with no lapses that could expose
the lender to a preference claim.
Dobbs emphasizes the importance
of perfecting a security in a timely
fashion. For instance, a security that
is created before the 90-day period is
exempt from preference claims even if
it is perfected after that date, provided
it is within 30 days of the grant of the
letter of credit can be helpful in some
cases and is becoming more prevalent.
However, it is not a surefire guarantee. For one thing, opening a letter of
credit within the 90-day period prior
to a bankruptcy filing could itself be a
preference, Corrigan warns.
Schnitzer warns clients to be careful
when returning to the estate any ex-
cess letter of credit proceeds in return
for a preference waiver. “Since the
company is in bankruptcy, most things
need court approval,” Schnitzer says. “A
return of the excess in exchange for a
preference release is a settlement and
must be court approved and on notice
to the proper-parties. A settlement that
did not get court approval, or did, but
based on improper notice, might bind
the actual parties to the settlement,
but it may not bind a subsequent Chap-
ter 7 trustee.”
Similarly, relates Howard Steinberg
at Greenberg Traurig in Los Angeles,
a creditor that drew down a letter of
credit collateralized with the debtors’
assets without first obtaining permis-
sion from the bankruptcy court attract-
ed the ire of the court because it had an
impact on other creditors even though
a third-party lender was involved. For
this reason, Indyke says, lenders should
try to get a letter of credit that is not
secured to the debtor.
Once a debtor has filed for bankruptcy,
lenders need to be careful about offending the bankruptcy court by taking
action without its approval. “You don’t
want to kick sand in the eyes of the
court,” says Steinberg. A secured creditor with a strong hand can be placed
on the defensive by exercising rights
without court approval.
general, notices to other creditors
can be very important. Steinberg cites
another case where a secured lender
claimed sale property as part of its collateral, so the purchaser wrote a check
to the lender for part of its claim and
gave the lender a broad release. However, the case was converted to Chapter
7 and the trustee filed an avoiding action claim against the lender. The court
ruled the lender had not given proper
notice of its prior deal and the compromise had to be renoticed to creditors
and considered anew by the court.
The moral of these stories is to get
court approval before taking any steps,
even though a request to the court may
get an answer you don’t like.
“Cross your Ts and dot your Is” on the
documentation and notice, Schnitzer
advises. “If the debtor really needs
the money, the debtor may try to cut
corners in terms of court approval and
notice. You need to push back if you
want to be protected.”
New;value”;and;“contemporane-ous;exchange”: Two other standard
defenses against preference claims are
“new value” – pre-petition advances
made during the 90-day preference
period – or contemporaneous exchange
– when payment is roughly contemporaneous with the transfer. Both of these
have their own “gotchas,” however.
In a new-value defense, if the lender
alters the customary terms, say, to
shorten the period of the advance, it
undermines the affirmative defense.
“You risk losing some of the benefits if
you alter the terms,” Steinberg says.
However, says Corrigan, extend post-petition credit to a debtor in possession
in Chapter 11 in exchange for waiving
preference claims can be a very effective tool.
“There’s an opportunity at the begin-
ning of the case to negotiate this,” he
says. “Optimism it at its highest point,
though most of these cases fail.”
You may end up taking a haircut on
the new credit, but you are shielded
from preference claims.
A contemporaneous exchange – when
payment and shipment are relatively
contemporaneous – can be a protection
against a preference claim, provided it is
intended to be contemporaneous and, is
in fact, substantially so. Cash on delivery
and prepayment for delivery qualify, but
courts have also deemed payments within two or three weeks to be considered
Perhaps the ultimate “gotcha” in
avoiding preference claims is to refrain
from doing business with companies
that are likely to go bankrupt.
“Stay on top of creditworthiness,”
advises Corrigan. “Companies that
file for bankruptcy don’t just fall off a
cliff.” Once a company starts to scale
back terms, dispute invoices, or show
other signs of distress, it might be a
good time to wind down the business
Darrell Delamaide is a financial journalist
based in Washington, D.C.
The staff of The Secured Lender would
like to thank Ed Dobbs of Parker, Hudson,
Rainer & Dobbs LLP for his guidance in the
development of this article.