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Date: June 23, 1993

Location: Totowa

Title: Don”t Panic, But Be Prepared, if Your Customer Declares Bankruptcy

Author: R. R. Willard

Subject: You could lose the money owed you–and be forced to give back some that was paid

One of the worst nightmares executives face is getting a letter, saying a company that owes them lots of money has declared bankruptcy. The increase in business failures during the long recession and sluggish recovery have unfortunately made such incidents common. Small businesses, which usually live a more tenuous existence than large ones, are hit particularly hard when their debtors go out of business. In fact, owners of small firms find even late payments difficult to handle. So when a letter arrives announcing a debtor”s bankruptcy filing, the news can be truly traumatic.

Select Brands, a 13-employee manufacturer of beauty supplies in Totowa, has been going through this unpleasant experience. The company was informed in 1990 that one of its clients, Milo Beauty & Barber Supply, a retail distributor in Ohio, had declared bankruptcy under Chapter 11. At the time, Milo owed Select Brands more than $4,800. But in addition to the prospect of losing the money, Select Brands had a worse shock in store. Last November, it received a letter from a trustee appointed by the bankruptcy court, referenced “Alleged Preferential Transfer in the case of Milo Beauty & Barber Supply.” The letter asked Select Brands to return $4,872.37 it had received from Milo just before the company went bust. Cathy Villopoto, executive vice president of Select Brands, was mystified at the letter. Says she: “I lost $4,800 when this client filed Chapter 11, and now, almost two years later, the bankruptcy court wants back the $4,800 that Milo did pay me!”

As shocking as the trustee”s action may appear, it is not far-fetched. The trustee, a court-appointed individual who is reviewing Milo”s solvency and is responsible for paying off its debts, has to recoup as much money as possible so that all creditors can be paid fairly. The trustee alleged Select Brands was given an unfair advantage–or preferential treatment–over other creditors when it was paid the $4,872.37. Complains Villopoto: “I realize other suppliers were owed more than we were, but I don”t understand how my payment constitutes a preference.”

Villopoto is not alone in her confusion; preferential treatment is one of the most misunderstood aspects of bankruptcy proceedings. To sort out the allegations and the responsibility of Select Brands, Hal L. Baume, a bankruptcy lawyer at the Woodbridge law firm of Wilentz, Goldman and Spitzer, reviewed the letters that Select Brands received from the trustee. Baume is not involved in the specific case of Select Brands or Milo Beauty & Barber Supply, but he offers information that all businesspeople should know about preferential treatment claims, and how to deal with them.

“Bankruptcy is designed to distribute the assets of the debtor company to its creditors in accordance with their various rights and interests under the law,” Baume explains. “Its purpose is to make sure no one gets an unfair advantage over anyone else.” Companies that get letters from court trustees sometimes rush to send back the money requested. Baume believes, however, that this is a mistake. He suggests that before they mail out checks, companies should look into the many nuances, qualifications and exceptions that may disallow the claim of preferential treatment.

Preferential treatment basically means that when a company goes bankrupt, no one creditor should get an edge over the others, notes Baume. Creditors are divided into two classes: secured and unsecured. Secured creditors–those who hold collateral, such as a mortgage or other property securing the debt–have senior rights in collecting on their debt. “Such creditors have rights to property and can liquidate it to recoup the debt,” says Baume. In contrast, unsecured creditors–those who provide a product, service, or financing under a contractual agreement–share proportionately in the funds that remain after taxes and wage claims are settled. “Bankruptcy courts make sure that if one unsecured creditor takes a hit, they all take a hit, and they all get paid in proportion to their claims,” says Baume.

To ensure that no unsecured creditor has an edge, the trustee scrutinizes all payments made within 90 days of the bankruptcy filing. The court assumes that at that time, the company was insolvent–that is, its debts exceeded its assets. Not all companies that declare bankruptcy under Chapter 11, however, are insolvent. Some companies file for reorganization for reasons other than lack of assets. In such cases, the creditor company has to prove that the debtor wasn”t insolvent, which can be costly, Baume says. The creditor company must hire auditors to sift through the accounting and determine the solvency of the debtor. The books may be a mess, if they exist at all. Some companies” books may consist of just a checkbook.

The best course for a creditor to pursue when a client declares bankruptcy is often difficult to decide. “The creditor must decide how important or how costly the reimbursement is,” says Baume. In Select Brands” case, for instance, Milo Beauty & Barber Supply, the debtor, is in Ohio and has filed for bankruptcy in an Ohio court. Baume thinks if Select Brands chose to defend its position, the lawsuit could cost the company more than $4,000 in attorney fees alone.

Companies like Select Brands may be better off trying to negotiate a settlement with the trustee. “It may pay companies that face repayment requests to call the trustee and negotiate a repayment,” says Baume. “If a lawsuit is filed, the trustee will be spending the bankrupt company”s money to defend his position, which will reduce the fund for all creditors. Sometimes, a call or letter of compromise will be accepted; in some cases, no negotiations are accepted,” he adds.

How can a company determine if it is bound by alleged preferential treatment? The best way may be to work closely with a bankruptcy lawyer, because the issues involved are complex and often confusing. The case law on the subject is shot through with nuances and qualifications, and exceptions abound. Says Baume: “If a payment is an exchange in normal business terms, such as a payment made within 30 days, it is not considered a preference. The bankruptcy code does not want to hurt people who continue to do regular business with the debtor right up to the time of declaration of bankruptcy. The key is to get money back from those who got an edge,” explains Baume.

Another major issue in deciding preference is how much money the creditor would receive if the debtor company were to be liquidated. In the Select Brands case, the question the trustee has to decide is, if Milo Beauty & Barber Supply”s assets were liquidated, and all unsecured creditors were paid proportionately, would Select Brands have received more than $4,800, or less? If Select Brands would have received more than the money that it was paid, the payment is not a preference.

Still another question concerns payments made as a condition to extend more credit. “If Select Brands said, ”Pay my bill from six months ago, and I”ll give you new credit,” this is no longer a preference,” says Baume. Other gray areas involve creditor companies that have received personal guarantees of payment from a debtor, or payments made to insider creditors, who may be relatives or partners of the company declaring bankruptcy.

Baume emphasizes the law is “specific, intricate and inclusive, but open to discussions.” It would thus help companies to investigate matters before rushing to pay when a trustee demands repayment. A letter from a trustee alleging preference should not be taken as proof of a preference, Baume adds.

Select Brands has answered the trustee”s claim, and presented its viewpoint. It is now waiting for a decision. u