The Bankruptcy Preference Recovery Decision – Who Makes It, How It Is Made

The pursuit of bankruptcy preference claims is not mandatory under the Bankruptcy Code.FN1 Whether or not bankruptcy preference recovery will be pursued is determined by a combination of 3 factors:

  • who is the holder of the right to pursue the claims;
  • the potential amount of the total recoveries; and
  • the course of the bankruptcy.

Identifying Who will Make the Decision to Bring Bankruptcy Preference Claims

The right to decide to whether or not to pursue bankruptcy preference actions usually ends up being held by one of 5 potential players in a bankruptcy:

1.  the debtor in a Chapter 11 bankruptcy, if the debtor is still operating as a debtor in possession;

2.  the creditors committee in a Chapter 11 bankruptcy, if the right to pursue such claims as been assigned to the creditors committee pursuant to court order;

3.  the plan administrator or liquidating trustee in a Chapter 11 bankruptcy, following the approval of a plan of liquidation if avoidance actions are property of the liquidating estate;

4.  the trustee in a case was filed as a Chapter 7 or filed as a Chapter 11 and converted to a Chapter 7; or

5.  a Section 363 sale purchaser in a Chapter 11 or a Chapter 7 bankruptcy, if the purchaser acquired the rights to the preference actions.

Of these 5 players, a purchaser in a Section 363 sale and a debtor seeking to reorganize are the least likely to pursue bankruptcy preference recoveries.  These two players are more interested in preserving the goodwill of the supply base and re-establishing trade credit as soon as possible.

If the authority to pursue bankruptcy preferences has been given to the creditors committee, it is almost a certainty that bankruptcy preference actions will be brought.  The creditors committee is unlikely to seek such authority without having already determined that pursuing such claims will benefit the unsecured creditors.

Next to the creditors committee, a plan administrator/liquidating trustee or a trustee are the most likely to pursue bankruptcy preference recovery.  Either of these players is going to carefully evaluate the potential amount of bankruptcy preference recoveries and the costs of pursuing such recoveries.  If this cost-benefit analysis justifies the pursuit of bankruptcy preference claims, then it is highly likely that such claims will be made.

The Potential Amount of the Total Recoveries

The economies of scale apply to bankruptcy preference recovery.  If the total dollar amount of recovery from bankruptcy preference actions is small, there is a reduced likelihood that any bankruptcy preference claims will be pursued.  Conversely, if the decision maker sees that there is a potential for recovery of substantial amounts through preference actions, the likelihood that all such claims will be pursued is increased.

Bankruptcy preference claims within each bankruptcy case are very similar to one another.  The more preference claims are asserted, the lower the cost of each such action.  Once the template for analysis is established and the form of initial demand letter, the second demand letter and the preference complaint are prepared, it is a relatively simple matter for this material to be used over and over again.

The Course of the Bankruptcy

There also are some key events that will signal that bankruptcy preference claims will be brought.  One of these signals is the conversion of the Chapter 11 case to a Chapter 7.

It is easier, however, to identify the situations when bankruptcy preferences claims will not be asserted.  Certain of these instances are:

1. The case has been filed as a “prepackaged bankruptcy”;

2. There has been a Section 363 sale of substantially all of the debtor’s business operations as a going concern and the purchaser acquired all rights to avoidance actions;

3.  The debtor is going to be able to pay all its pre-petition unsecured creditors;

4. The fair value of the debtor’s assets exceeded its liabilities when the bankruptcy petition was filed;

5. The debtor was able to continue to pay its debts on time in the 90 days preceding the bankruptcy;

6.  The debtor was in obvious decline for many months and most of the creditors already had placed the debtor on COD before the start of the 90 day preference period; and

7. The bankruptcy court finds that the case should be dismissed.

With respect to the fourth scenario, you may wonder “Why would a company file bankruptcy if its assets exceeded its liabilities and it was not insolvent on a balance sheet basis?”  There are a number of reasons, but a common one has to do with commercial leases. For example, a retailer may have several non-performing stores. It wants to shut them down and limit its operations to only the profitable stores. The landlords are not going to let the retailer out of the leases. Bankruptcy provides a means for those leases to be “rejected” and the landlords to receive an unsecured claim calculated using a formula provided for in the Bankruptcy Code. The bottom line is that bankruptcy is a way for a customer to end unfavorable contracts.

The seventh scenario used to be very rare, but there were at least 2 recent instances in which the bankruptcy court dismissed the bankruptcy after a 363 sale on the grounds that there was no reason to continue the case just to pursue preference actions.


FN1 See, e.g., 11 U.S.C. § 547(b) (“the trustee may avoid any [preferential] transfer of an interest of the debtor in property”); 11 U.S.C. § 548(a)(1) (“The trustee may avoid any [fraudulent] transfer”); 11 U.S.C. § 549(a) (“the trustee may avoid a [postpetition] transfer of property of the estate”) (all emphases added). See also 11 U.S .C. § 704 (listing the duties of a trustee, with no mention of any duty to pursue chapter 5 causes of action).