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The Bankruptcy Reform Act of 1999:
What it May Mean for Vendors

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By Scott Blakeley 7/99
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

Spring has arrived and the United States Congress is again considering reforming the nation's bankruptcy laws. Congress came close to passing bankruptcy reform last year with legislation passing both Houses of Congress. The Senate voted in favor of reforming the Bankruptcy Code last year, in part, in an attempt to reduce the upsurge in personal bankruptcies. However, the bankruptcy reform bill last year was prevented from being finally voted on because of the impeachment proceedings and opposition from the President and some in Congress to the "means testing" provision for consumer debtors. During February and March, 1999, bankruptcy reform legislation was again introduced to the House of Representatives and the Senate (the 1999 Bankruptcy Legislation). What does the proposed bankruptcy reform legislation mean to vendors?

A. Rewriting The Preference Laws

The 1999 Bankruptcy Legislation proposes three points to reform the preference laws.

1. What Is A Preference?

The Bankruptcy Code vests a bankruptcy trustee with far-reaching powers to avoid payments to vendors and other creditors within 90 days prior to the bankruptcy filing (one year for insiders). The Bankruptcy Code defines a preference expansively to include nearly every payment by an insolvent debtor 90 days prior to bankruptcy. The purpose of the preference laws is two-fold. First, unsecured creditors are discouraged from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Second, a debtor is deterred from preferring certain unsecured creditors by the requirement that any unsecured creditor that receives a greater payment than similarly situated unsecured creditors disgorge the payment so that like creditors receive an equal distribution of a debtor's assets.

2. The Bankruptcy Review Commission Recommends Changes To The Preference Laws

The Bankruptcy Reform Act of 1994, wherein Congress overhauled the Bankruptcy Code, created a nine-member bankruptcy commission to make recommendations on whether further reform of the bankruptcy laws were necessary. The Commission found that the preference laws lead to abusive preference suits by bankruptcy trustees who bring actions often without analyzing a vendor's defenses, and to extract settlements from vendors because of costs to defend these actions.

3. Minimum Threshold To Sue For A Preference

Receiving a preference complaint by a trustee for under $5,000 has a special set of problems for a vendor. To employ counsel and defend the preference lawsuit usually is not cost effective, even if the vendor has valid defenses. Preference suits in this range appear nothing more than a "shakedown" and the beneficiaries of these preference actions often appear to be the trustee and his counsel. The 1999 Bankruptcy Legislation proposes that $5,000 is the minimum preference action that may be pursued. This change should protect smaller vendors most prone to abusive litigation tactics, and the threshold amount does not undermine the policy supporting the preference laws.

4. Venue Change: Suing The Vendor Where It Has Its Principal Place Of Business

For a vendor whose company is based, say, in California and sells goods nationally, being sued for $5,000 by a bankruptcy trustee where the case is pending, say in Delaware, is extremely inconvenient, thus making it more costly to defend. The 1999 Bankruptcy Legislation proposes that the preferences law should be amended to require that a preference action seeking less than $10,000 must be brought in the bankruptcy court where the vendor has its principal place of business. This change will protect vendors from a trustee taking advantage of the fact that it will cost the vendor more to litigate the action than the preference action itself seeks to recover. This change of forcing the trustee to litigate in the vendor's "home court" for amounts between $5,000 to $10,000, will require the trustee to focus on a vendor's defenses, such as the new value and ordinary course of business, thereby reducing abusive preference lawsuits.

5. Amending The Ordinary Course Of Business Exception

Congress has carved out seven exceptions or defenses to the preference laws, where the "preferred" transactions replace value to the bankruptcy estate previously transferred. The most commonly asserted defense to a preference action by vendors is the "ordinary course of business" defense. To qualify for the "ordinary course of business" defense, a vendor must establish that the payment is ordinary as between the parties and that the payment is ordinary in relation to prevailing business standards. The court determines a debtor's ordinariness of payments through comparison with prevailing business standards, which includes common terms used by other trade creditors in the same industry facing similar problems. Thus, only transactions between the parties so unusual as to fall outside the broad range of industry practice should be considered non-ordinary under this preference defense.

The policy supporting the ordinary course of business defense is two-fold: (1) protect customary transactions, and (2) encourage creditors to continue to extend credit to financially troubled debtors, possibly helping the debtor avoid bankruptcy.

The 1999 Bankruptcy Legislation rewrites the "ordinary course of business" exception to provide that the conduct between the parties alone should prevail to the extent that there was enough prepetition conduct to establish a course of dealing. If there is not enough prepetition conduct to establish a course of dealing, the industry standard should control.

B. Extending the Reclamation Period

1. What is Reclamation?

Reclamation is the right of a seller to recover possession of goods delivered to an insolvent buyer. The remedy of reclamation is needed when an unsecured vendor is unable to retrieve goods or stop them in transit. A reclaiming vendor need not prove fraud, although the premise of reclamation is that the vendor was defrauded. Under the common law and the old Uniform Sales Act, the seller could only exercise its reclamation rights if it proved the buyer obtained delivery by misrepresenting its solvency. However, the Uniform Commercial Code (UCC), section 2-702, has expanded this remedy where the buyer does not misrepresent solvency. The Bankruptcy Code, section 546, adopts the UCC, but is modified. The Bankruptcy Code requires (1) that the seller's demand for reclamation be made in writing; and (2) in certain circumstances extends the notice period from ten to twenty days. The Bankruptcy Code also provides the bankruptcy court with the ability to grant a seller a lien or priority claim in lieu of the goods. This allows the court to order that the goods remain with the debtor to help reorganize.

The UCC not only provides the seller with the right of reclamation, but with a stoppage in transit remedy. Whether the vendor asserts a right to stop in transit or a right to reclaim the goods, the effect is the same as that of rescinding the sale by the vendor.

2. 45-Day Reclamation Period

1999 Bankruptcy Legislation will extend the period of time in which a reclamation claim could be raised up to 45 days in certain instances.

C. A Faster Track for Small Business Bankruptcies

Under the Bankruptcy Reform Act of 1994, Congress established a fast track for small business reorganizations for the purpose of making a reorganization less complex and less expensive in Chapter 11. These provisions provide that a debtor must elect to be considered a small business debtor. A small business is defined as one whose aggregate, noncontingent liquidated, secured and unsecured debts are less than $2 million as of the date of the bankruptcy filing. The plan confirmation process is expedited for small businesses. The small business exception also may affect how unsecured creditors may protect their interests. The 1999 Bankruptcy Legislation provides that a small business is defined as a company with $5 million or less in secured and unsecured debts. The hearing on the disclosure statement and confirmation of a plan can be combined. Only the debtor can file a plan within the first 90 days. The debtor has a maximum of 150 days from the petition date to have the plan confirmed. Failure to confirm within 150 days will generally result in conversion to Chapter 7.

D. Reviewing an Individual Debtor's Ability to Pay: The "Means Test"

The 1999 Bankruptcy Legislation would make it more difficult for individuals to file for Chapter 7 by imposing a means test -- whether a debtor has any income available to pay creditors. Under the legislation, families with annual earnings of more than the median income (which is currently about $51,000) generally could not file for Chapter 7 protection if they are deemed able to repay 20% of their debt within five years. Instead, a Chapter 13 repayment plan would be crafted for the debtor. A senate version has a less stringent test that gives bankruptcy judges greater discretion in moving debtors out of Chapter 7.

The means test is relevant to the vendor with a delinquent account against a sole proprietorship, as well as the vendor pursuing a personal guarantee.

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