Behind The Curtain—Chapter 11 From The Inside—Chapter 13—Lawsuits In Bankruptcy

The prior chapter of Behind The Curtain can be found with the following link:

MORE FROM FORBESBehind The Curtain-Chapter 11 From The Inside-Chapter 12-Other StuffBy Robert Bovarnick

When most people think of lawsuits, they think of cases filed in either state or federal court. The bankruptcy code provides certain types of litigation that can be brought during a case. One is called a preference and the other is called a fraudulent transfer.

A preference, or preferential transfer, is, in part, a counter-intuitive concept. In essence, the company gets to “clawback” money that was paid to a creditor that was owed. Here is an example of how it works. Fifteen years ago, when Brett took over Brettco, he started purchasing most of its supplies from Superior Paint Supplies. Over the years, Brett became friendly with Andy, the president of Superior. The normal payment terms with Superior are 30 days net, meaning that a bill must be paid within 30 days. Because of their friendship (as well as cash flow), Brett very rarely paid on time, and, about 3 months before the bankruptcy was filed, Brettco owed Superior about $75,000.00. Even though Brettco didn’t have enough money to pay Superior in full, Brett wanted to show his appreciation to Andy, so a week before the bankruptcy was filed, Brettco paid $50,000 of the $75,000 that was owed.

Even though there is no question that (1) Brettco owed Superior $75,000 and (2) the $50,000 was a legitimate pay down of the receivable, it is considered a “preferential transfer,” as Brettco “preferred” Superior over the other unsecured creditors. This comes from a concept of all similar types’ of creditors being treated the same way.

The next question is who files the lawsuit. While, theoretically, Brettco should file the lawsuit, since it has a fiduciary duty to maximize the return to all creditors, the reader can decide the likelihood of Brettco filing a lawsuit against his friend. Does that mean that Superior is in the clear? Not necessarily. First, either the UST or a creditor can try and get Brettco to bring the lawsuit. Also, under certain circumstances, a creditor can bring the lawsuit on behalf of the estate. So, let’s say that Sampson makes a demand for Brettco to file the lawsuit and Brettco refuses. Sampson then asks the Court for permission to bring the lawsuit on behalf of Brettco. Even if the Court says yes and Sampson files the lawsuit and is successful, Sampson doesn’t get the money. It will go to the estate to be paid to all of the creditors.

A couple of other things to keep in mind. First, there are several defenses that can be raised by Superior. The two most common are “ordinary course of business” and “new value.” “Ordinary course of business” means that the payment was within the ordinary course of business of the two companies. For example, if a company gets paid 30 days net and the payments were made within that time frame, then there is a defensible preference. While there is more to the ordinary course of business defense, that shows the general idea. The $50,000 payment by Brettco to Superior is not in the ordinary course of business. “New value” means that, after the payment by Brettco, Superior provides more product.

Second, the law changed in 2019 so if the potential preference claim is for $25,000 or less, it has to be brought where the defendant resides. So, if (1) the payment made by Brettco was $25,000 and not $50,000 and (2) Superior was located in California and the Brettco case was filed in New York, if Brettco wanted to file a preference claim against Superior, it would have to file it in California.

The second main type of litigation is for a “fraudulent transfer.” While a preference case is only found in the bankruptcy code, a fraudulent transfer case can be brought either under the bankruptcy code or state law, as each state has its own fraudulent transfer statute.

The purpose of the fraudulent transfer law is to prevent a company from transferring something, without receiving appropriate value and then filing for bankruptcy. Otherwise, an unscrupulous company could make a transfer to a third party but keep what was transferred outside of the bankruptcy estate. For example, if there was no fraudulent transfer law, Brettco could “sell” a $75,000 piece of equipment to Superior for $1.00 a month before it filed for bankruptcy. Or, Brettco could “sell” that same piece of equipment to his cousin, Nicole, and then have Nicole sell the equipment and give the money to Brett.

There are two “flavors” of fraudulent transfers, “actual fraud” and “constructive fraud.” Actual fraud occurs when the transfer was made within 2 years of the filing with the “actual intent to hinder, delay, or defraud any entity” a company that is owed money.

“Constructive fraud” is a bit more involved. For a court to find the existence of constructive fraud, two things have to be shown. First, the transfer has to be for “less than reasonably equivalent value.” Second, there has to be a showing of one of 4 things, the most common that, at the time of the transfer, the company was insolvent, or became insolvent as a result of the transfer.

The most important thing to remember about a fraudulent transfer is that it goes back 2 years before the bankruptcy was filed. Before a company makes a transfer and decides to calendar 2 years before filing, there is something else to keep in mind. Many state fraudulent transfer statutes go back 4 years. The bankruptcy code allows the trustee to file a lawsuit based on the state law. As a result, a trustee can look back 4 years in filing a fraudulent transfer case.

It is also important to note that fraudulent transfer is often lengthy and expensive. There are a lot of issues that have to be proven and there are a lot of defenses that are normally raised.

This is another reason why it was so important for Brett to hire Jeff, because Jeff knew to ask Brett if there were any transfers that Brettco made that might be looked at as fraudulent.

There are other types of lawsuits that can be brought during a bankruptcy case, but these are two of the most common.

Earlier chapters of Behind The Curtain can be found at the following links:

MORE FROM FORBESBehind The Curtain-Chapter 11 From The Inside-Chapter 1By Robert Bovarnick

MORE FROM FORBESBehind The Curtain-Chapter 11 From The Inside-Chapter 2-The Initial MeetingBy Robert Bovarnick

MORE FROM FORBESBehind The Curtain-Chapter 11 From The Inside-Chapter 3-PrefilingBy Robert Bovarnick