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Scrutinize Your Preference Settlement
Are you Giving Up Your Replacement Claim?

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By Scott E. Blakeley
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

The credit professional is well aware of the pain that a major customer�s Chapter 11 filing brings at the front end of the case, with the unsecured claim for unpaid invoices. But the back end of the customer�s Chapter 11 may be even more painful if the credit professional must face a preference demand. Unfortunately for the vendor, preference claims seem now to be a cost of business, and the credit professional needs to be schooled in all facets of the preference action.

Suppose a year after the major customer files Chapter 11, and after the plan of reorganization is confirmed, you receive a preference demand letter from the liquidating trust. The trustee demands that you return all payments received within the 90 days of the customer�s bankruptcy filing. Your preference analysis reveals that you have preference exposure based on your weak ordinary course of business defense. Through negotiations with the trust, a sizeable reduction in your preference exposure is made. However, you must pay back to the trust some payments received during the preference period. As part of the negotiations, the trustee insists that you waive your preference replacement claim. With those repayments, are you entitled to an unsecured claim, the so-called Replacement Claim? What is the Replacement Claim valued at? What happens to the recaptured preference payments?

A. The Bankruptcy Preference Law

The Bankruptcy Code vests the trustee with far-reaching powers to avoid transfers and transactions prior to a bankruptcy filing. The power to avoid preferential transfers is one of the trustee's most potent weapons. The Bankruptcy Code defines a preferential transfer expansively to include nearly every transfer by an insolvent debtor during the preference period. The preference law is intended to discourage vendors from racing to the courthouse to dismember a debtor, thereby hastening its slide into bankruptcy. Debtors are also deterred from preferring certain vendors by the requirement that any vendor that receives a greater payment disgorge the payment so that like vendors receive an equal distribution of the debtor's assets.

Not all transfers made within the preference period may be recaptured. The three most commonly used defenses by vendors are the contemporaneous exchange, new value and ordinary course of business defense.

B. Replacement Claim Under the Bankruptcy Code

Bankruptcy Code section 502(h) recognizes that a creditor is entitled to an unsecured, prepetition claim for every preference dollar repaid. Thus, the Replacement Claim shares equally with the general unsecured creditors. Given the Bankruptcy Code�s recognition that the vendor is entitled to the Replacement Claim, the vendor must consider the following statement from a debtor in pursuing a preference claim:

�Please note that, upon making this preference repayment, however, your company will not be granted a claim in the Debtor�s bankruptcy case for this amount paid, nor will this resolution effect any other claims between the debtor and your company.�

As the Bankruptcy Code recognizes a vendor�s right to a Replacement Claim, the vendor should agree to waive this claim only upon receiving comparable value for the Replacement Claim. But what is the value of the Replacement Claim? The debtor�s disclosure statement will set forth the range of estimated payment to unsecured creditors. Does the disclosure statement control the range of value for the Replacement Claim? Does the disclosure statement�s range of estimated payout control a distribution on a Replacement Claim, especially if the proposed payment on the Replacement Claim is well after confirmation of the plan?

C. Valuing Your Replacement Claim

Key in determining whether to waive your Replacement Claim in settling the preference suit is the value of the Replacement Claim. The party pursuing the preference action will usually assign a range as to the expected distribution on the Replacement Claim. However, there is no guarantee that is indeed what will be distributed on the Replacement Claim. You may again consider the disclosure statement to determine the range of distribution. However, that range may increase or decrease based on such factors as recoveries on preference claims and other litigation, as well as administrative costs from attorneys and ot hers. Further, the distribution range does not take into account the time value of money. There may be sizeable delays with a distribution to creditors.

D. Waiving Your Prepetition Claim

Separate from the Replacement Claim, to avoid paying fresh money to settle the preference claim, consider waiving your prepetition claim. The prepetition claim will have a bankruptcy dollar assigned to the claim. Offsetting the prepetition claim with your preference claim allows you to reduce or eliminate any money you must repay where you have preference exposure. Waiving your prepetition claim must be by agreement with the trustee, and may be subject to bankruptcy court approval.

E. Where Do Preference Recoveries Go?

Too often credit professionals that are forced to repay preference payments, and are attempting to determine when payment will be forthcoming are met with resistance by the parties pursuing the preference recoveries. After a plan has been confirmed, the vendor may be forced to request the bankruptcy court to order the preference plaintiff to disclose the amount of money they have recovered and the amounts they will be distributing to vendors holding Replacement Claims.

F. Scrutinize Your Preference Settlement Agreement

Preference actions may require you to return some payments. In that event, you are entitled to a Replacement Claim. Given this, you need to review your settlement agreement to ensure that you are not inadvertently waiving this claim. If you elect to waive the Replacement Claim, analyze the range of value to make sure that you are getting top dollar for the Replacement Claim.

Reprinted by permission from The Trade Vendor Quarterly Blakeley & Blakeley LLP Spring 05

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