The Risks and Rewards of Selling Your Bankruptcy Claim

Concern over whether a customer is having financial problems has always been a central issue for credit managers. Their role is defined by being able to pick which companies are worth the risk. With bankruptcy filings rising, default and delinquency rates also trending upwards, its the issue of insolvency that’s getting the spotlight at the moment.

Even worse for credit departments is the customer on the verge of filing a Chapter 11 petition. These creditors face the risk of a decrease in or a substantial delay to the recovery of their pre-petition unsecured trade claim. Not to mention the additional risk of continuing to extend credit to the customer. 

But there are options. Creditors can gamble by selling their pre-petition unsecured claim or by entering into a put agreement that shifts the credit risk of dealing with a financially distressed company to a third party. Debt markets continue to flourish and over the last two decades have evolved tremendously with the amount of public information available through the Internet and services like PACER, providing an educated seller or buyer with a sizeable advantage. 

“It all sounds wonderful. And the market allows trade creditors to cash out of their claim,” said Bruce Nathan, Esq., partner, Lowenstein Sandler PC. “But, when you get that offer to buy the bankruptcy claim you’ve got to tread carefully. You’ve got to do your homework and make sure you’re getting the best price.”

Nathan talked about two options available to credit managers in the CMA-sponsored teleconference “Selling Your Bankruptcy Claim—the Risks and Rewards.” First, there are buyers that will purchase a put agreement—a product equivalent to credit insurance—for a trade creditor’s claim in the event of their customer’s bankruptcy filing. 

A put agreement is an agreement for the buyer to purchase the claim in the future at an agreed-upon price. It’s used as protection against insolvency. They require the creditor that is entering into the put agreement with the buyer to pay a non-refundable fee, which could be as much as 1% to 3% per month of the amount being insured. They can be for a claim against a financially distressed company that has not filed bankruptcy yet, or they can be for an administrative claim where the creditor has sold goods or provided services to a company that is in Chapter 11.

“They are two very different products,” explained Nathan. “There are more pitfalls for a put with respect to a Chapter 11 administrative claim if it is not drafted appropriately, but the benefit of a put agreement is that it induces creditors to continue to extend credit to a financially troubled company, whether that company is in or out of bankruptcy.”

The difference between a put agreement and credit insurance is the credit insurance usually involves insuring a pool of receivables—good receivables and the more troubled accounts. Put agreements are insuring against the insolvency of a particular company that is in financial distress. Because of this, puts can be a lot more expensive than credit insurance.

“If you’re paying a hefty fee, you want to make sure you are getting the best for your bargain,” said Nathan. 

As in all contractual environments, signers need to be wary. Some agreements may contain objectionable provisions that are intended to shift the risk off of a bad investment from the buyer back to the seller. Others may allow the buyer, in circumstances of their choosing, to force the seller to buy the claim back because of some breach of agreement. Nathan warned that there are many outs in these agreements a good claims buyer can take advantage of if they decided they no longer want to invest in the claim, or they found out information after the fact. So, the standard mantra applies: credit managers must review the documentation that they are being asked to sign. 

“The key is that if you are an informed buyer, or an informed seller, and you know what needs to be changed and what needs to be negotiated, with the help of counsel you can have an agreement that works really well for you,” said Nathan. “One that allows you to liquidate your claim and to insure yourself against the risk of bankruptcy. But if you carelessly sign on the dotted line, you may find that while you sold the claim and realized some cash, or what you thought may have required a buyer to buy the claim in the event of a bankruptcy, you find out that there are lots of horrors and lots of outs.”

Another option available for creditors is selling their claim against a financially distressed company to a prospective buyer. In cases of puts or a sale of claim, there is typically a discount in price if the company is already involved in a bankruptcy. In both products, there are a number of matters to be considered, as well as a cadre of pitfalls to avoid.

“When you are negotiating a put agreement, or for that matter a sale of claim agreement, you need to make sure that the debtor—the customer—is properly identified,” warned Nathan. “In more and more cases, you are dealing with multiple entities where there may be lots of different companies that make up the debtor.”

Advice from CMA’s Legal Workshop on Credit Agreements

On January 24th and 25th, attorneys Bruce Nathan, Esq., Lowenstein Sandler PC,
and Wanda Borges, Esq., Borges & Associates LLC, hosted the first of three
sessions in CMA’s 2008 Legal Workshop series. The two attorneys are familiar
faces in the association’s educational programs, and teamed up to speak in-depth
about credit applications and guaranties and the information that should and
should not be included in them.

The two-day session provided a wealth of information and advice on topics
ranging from references, stoppage of delivery, reclamation, compliance with
federal law and the “Battle of the Forms” to navigating antitrust violations,
and oft overlooked protections.

First and foremost, both agreed that every credit application should include
language, in bold, that verifies that the grantor adheres to the provisions of
the Equal Credit Opportunity Act (ECOA) and that there must be some reference to
the grantor’s standard terms and conditions, either by including them in the
credit application or noting that they are posted on the creditor’s website.

“Your terms and conditions have to be prevalent,” said Borges. “If the first
time your customer sees them is on the back of an invoice, you’ve got a problem.
More and more companies are putting the data on their website. If you’re going
to put your terms and conditions on your website, you have to make them readily
available.”

Under Article II of the Uniform Commercial Code (UCC), the failings of which
took centerstage, if the first time a customer sees terms and conditions is on
an invoice, it won’t always serve as confirmation or agreement to those
terms.

“The thing I love about Article II is that everybody is right,” said Nathan.
“There are court cases that say the invoice serves as confirmation of terms and
conditions, there are others that disagree. Do something such as posting them on
a website to lock in the terms and conditions.”

In terms and conditions, grantors want to make sure that the laws of the state where they are headquartered are recognized to rule in any legal proceedings. The two also suggested that interest rate charges and the
reimbursement of at least a portion, such as 25%, or all legal fees are included in the terms and conditions or on the credit application as well. Credit executives need to be wary though that if they do include interest charges on
invoices they must make their best effort to collect on them. If they are only collecting the charges from certain customers and not all, they may find themselves facing antitrust violations of the Robinson-Patman Act.

Common practices, such as asking for the social security numbers and home
addresses of board members, officers and other executives may not always end in
results, as most credit executives will know. The new privacy laws provide
individuals protection against having to submit these on a credit application,
and denying credit because an application is without these pieces of information
may lead to violations. Though the majority of attendees of the workshop
included sections on their applications asking for the social security numbers,
they all agreed that it was irregular for those to be given.

Other basic measures Nathan and Borges discussed were the importance of
verifying a company’s legal name before granting credit, as well as verifying
that the individual signing the application or a personal guaranty has the
authority to do so. They suggested checking the Secretary of State records and
website, and touted a subscription with court document websites such as PACER as
a must.

 

For more information on CMA’s education program, visit www.CreditManagementAssociation.com/events

How Setoff and Recoupment are Hidden Gold for Trade Creditors

When dealing with an insolvent or bankrupt debtor, creditors will do everything in their power to reclaim the money they were owed. Whether securing transactions prior to sale or using specific legal defenses in the courtroom,
every credit manager can get hit by a debtor who won’t or can’t pay, so it’s best to have as many tools available as possible to better protect a company’s assets. Two of the most overlooked options that creditors can use to get back
part of what they’re owed are setoff and recoupment.

“What I find interesting in all of these conversations is the lack of knowledge that creditors have of this right,” said Bruce Nathan, Esq. in a recent CMA-sponsored webinar entitled “Setoff and Recoupment: Hidden Gold for Trade Creditors.” Nathan noted that setoff, although not explicitly listed in the Bankruptcy Code, is a state law right that is viewed as a self-help measure that creditors can use whenever they’d like. It can be used when a creditor and debtor are doing business with one another and owe each other money. It makes little sense to pay a debt when the payee owes the payor money, so setoff allows both parties to reduce their obligations to one another by setting off one claim against another.

There are, however, legal requirements that need to be satisfied for creditors to use setoff, and, in his presentation, Nathan discussed these, making certain that attendees knew how to avoid any legal missteps that might preclude any successful setoff. Nathan also noted that after a debtor has filed for bankruptcy, setoff needs court approval before it can be used. “Once a debtor files for bankruptcy, setoff rights are restricted,” said Nathan. “The automatic stay arising under Section 362 of the Bankruptcy Code would prevent a creditor from unilaterally exercising setoff rights.” Nathan also noted several other legal hoops that creditors have to jump through prior to successfully
reducing their claim using setoff, whether before or after a bankruptcy filing.

Recoupment, said Nathan, is very similar to setoff but with one important difference. “All that is required for recoupment to take place is that it arises from a single claim or transaction,” he said. “Recoupment is essentially a
defense to a debtor’s claim against a creditor.” Nathan also noted that recoupment is a slight improvement over setoff, because it is not governed by the automatic stay rule and does not require a creditor to get the permission of
the court to exercise the right.

How to Better Prepare Against Preferences

Preferences can be a daunting challenge for creditors but Bruce Nathan, Esq., of Lowenstein Sandler PC of New York, presented information on how to better defend against them. The information was disseminated during a CMA webinar Feb. 12, 2007 entitled, “Preferences: Defenses That Can Reduce Exposure and Case Law Update.”

Nathan, a private attorney who specializes in bankruptcy law, noted the large amount of case law on preferences over the last year, and noted how bankruptcy cases are now making their way to court under the authority of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). One big change under BAPCPA cited by Nathan was that the “ordinary course of business” defense against preferences is more advantageous to creditors. In defining a preference, Nathan said that generally it is a transfer of property of the debtor to or for the benefit of the creditor on account of existing debt owed by the debtor before the transfer was made. Furthermore, to be a preference, the transfer has to be made while the debtor is insolvent, it must have been made within 90 days before filing of the bankruptcy petition and the transfer must enable the creditor to receive more than he would receive in a liquidation.

Defenses to preferences are found in section 547(c) of the Bankruptcy Code, Nathan said. He pointed out that generally no preferences are applied to COD payments. Also, creditors can rebut the presumption of insolvency that is afforded debtors within 90 days of a bankruptcy filing, although that may be difficult to prove. “If you have financial statements that show a company (filing bankruptcy) was solvent close to that 90-day period of presumption of insolvency, you may make a case,” Nathan said. “A court, in determining insolvency, may include assets and liabilities that aren’t on a balance sheet.” Nathan also noted that those creditors defined as insiders, are exposed to a longer preference period of one year. Nathan advised creditors who receive preference claims to review their payments from that debtor within the last 90 days prior to the filing of the bankruptcy. He pointed out that some trustees just look at the check register of the debtor and send out preference demand letters to those creditors listed on the debtor’s check register during that 90-day period. However, while a payment may have been listed on a debtor’s check register, the creditor may not have received it. On the extemporaneous exchange of a product, which is new value, for payment, as in COD transactions, Nathan warned that if the check bounces and is replaced, the replacement of the check is considered an extension of credit. In that case, a preference claim could be made on that transaction. He also said, “The COD claim is only for goods that are exchanged for payment, not for the payment of old invoices.”

The ordinary course of business defense against preference claims has now become easier under BAPCPA Nathan said. “Under the old statute, there were a number of things that could cause the loss of the ordinary course of business defense.” Under the old law, a creditor had to prove a payment was made in the ordinary course of business with that customer and within the industry. He noted that if a creditor was doing business for the first time with a customer, there would be no payment history to establish an ordinary course of business with that customer. “Some courts would say the first transaction couldn’t be viewed as ordinary course of business.” Now creditors have to show that a payment was ordinary between that creditor and customer or that it was ordinary for the industry.

One of the attendees of the teleconference asked Nathan if trustees couldn’t be sanctioned for merely sending out preference demand letters from a debtor’s check register. “This is an abuse and it’s unfortunate,” Nathan said. “There are some circumstances where sanctions can be assessed. There are a few judges that have ruled that with obvious defenses, abuses have been committed.” However, he noted that it is difficult to have a judge sanction a trustee regarding sending out preference claims. “A judge would only sanction if you went to trial and won.” Another attendee asked a question about preference claims having to be related to a payment in the amount of $5,000 or more and whether that amount refers to individual payments or total payments? Nathan answered that it refers to lump sum and not each individual payment from a debtor.