Storm Preparation: Dealing With Financially Troubled Companies and Avoiding Clawbacks

The current state of the U.S. economy is relatively strong.  That said, every economy remains subject to the normal ups and downs of the business cycle.  Eventually, dark clouds will gather and businesses will be required to weather an economic tempest.  Prudent businesspeople are aware that effective storm preparation should take place well in advance.  Such preparation should include an understanding of potential “claw back” actions such as preferences and fraudulent transfers.  If a customer is beginning to teeter on the edge of insolvency, certain actions can be taken to lessen the risk of ultimately facing a bankruptcy court judgment requiring payment into the estate.  Being prepared has the potential to reap significant savings of time and money.

When a company files bankruptcy, an estate is created under the law.  The goal of any bankruptcy case is to maximize the value of that estate for the ultimate benefit of the creditors of the bankrupt party (known as the debtor).  A bankruptcy estate consists of all the property of the debtor, both tangible and intangible.  Litigation claims – whether or not such claims were asserted at the time of the bankruptcy filing – are included among the intangible property.  For example, a debtor’s breach of contract action related to pre-filing matters may be brought by a debtor as a means for augmenting the estate by obtaining a monetary recovery.  Preferences and fraudulent transfers are causes of action designed to bring back (that is, claw back) money into the bankruptcy estate so that the money can then be equitably distributed to all creditors pursuant to the claim priorities of the Bankruptcy Code. 

As to preferences, the policy reasoning for requiring money to be paid back into the estate is that a creditor who was “preferred” by getting paid by the debtor in the period immediately prior to the bankruptcy case should be placed on the same level playing field as other creditors who were not paid.  Once the preference defendant pays the money back into the estate, the defendant will have a claim for such amount and will seek to recover on such unsecured claim alongside other creditors.  However, this is very often an unsatisfactory situation for the defendant, because unsecured claims in bankruptcy cases are often paid at pennies on the dollar.  Debtors are able to claw back payments made 90 days prior to the bankruptcy filing, or one year prior to the filing if the recipient and the debtor are closely related.  In order to establish a preference, the debtor must meet a number of different elements including that the payment was on account of a past “antecedent” debt and that the payment placed the recipient in a better position than it would have been in a Chapter 7 liquidation case.  In addition, there are statutory defenses to preferences, including that the payment was made in the ordinary course of business or the defendant provided new value to the debtor following receipt of the payment.  Preference defendants typically seek to avoid liability by either asserting that the debtor is incapable of establishing all of the elements and/or establishing one or more defenses.  A common tactic to avoid preference liability is requiring cash on delivery rather than extending the soon-to-be debtor further credit.  In addition, a potential preference defendant should be mindful that its pre-bankruptcy behavior may someday be closely scrutinized by a bankruptcy court.  Hardball or otherwise unusual collection practices are likely to affect the creditor’s ability to successfully assert an ordinary course of business defense.

Fraudulent transfers are another type of claw back remedy available to debtors.  Fraudulent transfers are available under both state law and the federal Bankruptcy Code.  Generally speaking, a transfer will be deemed fraudulent – and therefore subject to claw back – if: (1) the transfer was made with actual intent to hinder, delay or defraud creditors, or (2) the debtor received less than a reasonably equivalent value for the transfer and the debtor was insolvent or became insolvent as a result of the transfer.  Under the Bankruptcy Code, debtors are able to claw back fraudulent transfers made up to two years prior to the bankruptcy filing.  That “lookback period” may be longer under state fraudulent transfer law.  Once again, the lesson for companies dealing with financially unstable parties is to understand that the transaction may be the subject of a lawsuit in a future bankruptcy case.  If a debtor or a bankruptcy trustee is able to characterize the transaction as a sweetheart deal, the transaction could be unwound.

Like preferences, there are a number of defenses to a fraudulent transfer action.  However, the main take-away for both preferences and fraudulent transfers is that receiving payment or property from a financially troubled company comes with the risk of liability in a future bankruptcy case.  Red flags of warning include late payments or calls to request certain financial accommodations.  When those red flags arise, storm preparation efforts to minimize preference and fraudulent transfer liability should be top of mind.