Bankruptcy Preference Claims Timing – The Statute of Limitations, Other Factors
Last Modified on January 31, 2010
The timing of preference claims is affected by 3 major factors:
- the statute of limitations;
- the desire of the debtor to re-establish goodwill (and trade credit) with the supply base; and
- the discontinuation of the debtor’s business operations.
The Statute of Limitations for Bringing Bankruptcy Preference Actions
The statute of limitations period for bringing preference actions is ofter quoted as being 2 years from the date of the filing of the bankruptcy. Actually, the calculation of the statute of limitations is more complicated.
Section 546(a) of the Bankruptcy Code has a 2 part test for determining the time limit for bringing of bankruptcy preference actions. Bankruptcy preference claims are time barred after the later of (1) 2 years after the bankruptcy filing or (2) 1 year after the appointment of a trustee. Under this calculation, if a trustee is appointed in the second year of a bankruptcy, it will have a full year to decide whether to bring preference claims. For example, if a debtor’s bankruptcy is converted from a Chapter 11 to a Chapter 7 18 months after the bankruptcy if filed, the statute of limitations or the trustee to bring preference actions is extended to 30 months (2 1/2 years) from the original petition date.
Because most trustees are appointed within the first year of a bankruptcy filing, as a general rule of thumb, 2 years from the date of filing of the bankruptcy is going to be the cut off date for filing of bankruptcy preference claims. However, to properly determine the statute of limitations in a case that has been converted from Chapter 11 to Chapter 7, it is necessary to know the date a trustee was appointed.
Many business bankruptcies that are filed under Chapter 11 (even if subsequently converted to liquidations under Chapter 7) remain open beyond 2 years from the petition filing date. The process of prosecuting bankruptcy preference claims often comes right down to the wire. Frequently, in the days preceding the expiration of the statute of limitations the customer’s bankruptcy representative will file a rash of bankruptcy preference adversary proceedings.
Finally, bankruptcy preference claims in all instances must be brought before the case is closed or dismissed.
The Debtor’s Desire to Re-Establish Goodwill with the Supply Base
The intent to pursue bankruptcy claims is often kept hush, hush or at least obscure until well after the plan of reorganization is approved. The reason? The bankrupt customer often needs to maintain supplier relationships in the months following bankruptcy in order to continue business. Needless to say, these relationships would be strained if the suppliers knew that they would be receiving a demand for return of payments.
One of the best articles describing this phenomenon in real- life terms is a Today in Finance article in CFO.com “Delphi Files Secret Preference Claims” dated October 2, 2007. In this article, the customer’s bankruptcy representative’s motivations are summarized as follows:
Under the law, a trustee must file a preference claim within two years of the company’s Chapter 11 filing, in most cases. But trustees usually wait until the last possible moment to file a preference suit so as not to ruin the company’s relationship with vendors while negotiating bankruptcy settlements with them. Indeed, if the company emerges from Chapter 11, it will need strong vendor relationships to keep the operation viable.
This failure to mention the prospect of preference claims is not seen as an effort to “hide the ball” from the creditor. The creditor is presumed to be sophisticated and to know that the prospect of preference claims exists. As one Bankruptcy Court noted when talking about the separation of preference claims from the resolution of other matters with a creditor:
“[I]n large chapter 11 cases sophisticated creditors typically are well aware of prospects and risks of preference litigation. In this chapter 11 case when the petition was filed creditors knew that it was a liquidation case that would very likely result in preference actions. Thus, it seems unlikely that creditors could be surprised or caught off guard when such preference complaints are finally filed.
TWA Inc. Post Confirmation Estate v. City and County of San Francisco Airports Commission, 305 B.R. 221 (Bankr. D. Del. 2004).
In representing clients who are concerned about exposure to bankruptcy preference claims, we continually try to determine the status of the bankruptcy preference claims process. We are sometimes told by the bankrupt customer’s counsel that the answer is in the plan of reorganization. But the plan of reorganization will only contain language “reserving” the right to pursue preference actions. For example, in a recent case the plan of reorganization, in addressing preference actions said:
Avoidance Actions shall be prosecuted, settled, or compromised as deemed appropriate by the board of directors of Reorganized Debtor in an exercise of its business judgment under applicable corporate law.
The Discontinuation of Debtor’s Business Operations
The discontinuation of the debtor’s business operations is the third factor affecting the timing of bankruptcy preference claims. Discontinuation of business operations puts an end to a debtor’s efforts to reorganize. The most common instances where a debtor ceases operations are:
- conversion of the Chapter 11 case to a Chapter 7; and
- completion of a section 363 sale in which all or substantially all of the operating assets are sold.
We have only seen one instance in the past 2 years where bankruptcy preference claims were brought before the debtor ceased business operations. We view that case as an aberration.
The need to fund operations will usually determine how quickly bankruptcy preference claims are brought after discontinuation of business operations. If there is cash available to pay for the continued wind up of operations, then there may be a futher delay in bringing of preference claims. If there is no cash available, then it is common for bankruptcy preference claims to be brought quickly.
Lessons for Bankruptcy Preference Negotiation
From a negotiation perspective, only the bankrupt customer and the customer’s bankruptcy representative are benefited by the separation of bankruptcy preference claims from the process of negotiating the terms of a continued supply of goods and services. From the supplier’s perspective, giving up the leverage of negotiating terms of a continued relationship before resolving a preference claim puts the supplier at a big disadvantage.
For this reason, it is critical that supplier’s counsel: (1) look for and evaluate any opportunity to include the resolution of preference claims as part of negotiations on other matters; and (2) include a release of preference claims, where appropriate, in any settlement documentation resolving matters with the customer’s bankruptcy representative.
