Bankruptcy Reform Act of 2005: What it Means to the Credit and Financial Professional, The

Credit & Financial Management Review, Second Quarter 2005 by Blakeley, Scott

Abstract

After eight years of political wrangling, the U.S. Bankruptcy Code has finally been overhauled, through the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "2005 Act"). So how does the 2005 Act impact you as a commercial creditor? Do you have greater protections and rights as a result of these amendments? What strategies might you consider to maximize payment on a delinquent account where a customer may consider bankruptcy? This paper will address these issues and more.

2005 Act Effective Date (Sections 1406 and 1501)

On April 20, 2005, the 2005 Act was enacted, and most provisions become effective for new cases filed 180 days after this date, which is October 17, 2005.

What it Means for Vendors

During the 180 days from enactment of the 2005 Act and the legislation taking effect, vendors may experience more sole proprietor customers and personal guarantors filing Chapter 7. Sole proprietors and guarantors may file Chapter 7 prior to the 2005 Act becoming effective so as to have their debts discharged, rather than risk having their Chapter 7 petition converted to Chapter 13 or dismissed. If converted to Chapter 13, the debtor will have to propose a plan to pay off a portion of their debt as a result of a creditor invoking the means test provision (discussed further in this paper) contained in the 2005 Act. If the bankruptcy case is dismissed, the debtor will have to deal with the creditor's collection efforts, unimpeded by the automatic stay.

Rewriting the Preference Laws

The 2005 Act reforms the preference laws in the following ways.

Background - What is a Preference? (section 547)

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 purposes of the preference laws are 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 there may be an equal distribution of a debtor's assets.

Minimum Threshold to Sue for a Preference (section 410)

A vendor sued for a preference for an amount less than $5,000 poses special problems for the vendor. For the vendor to employ counsel and defend the preference lawsuit may not be cost effective, even if the vendor has valid defenses. Preference suits in this dollar range appear from the vendor's viewpoint as a "shake down" and the beneficiaries of these preference actions appear to be the trustee's professionals. The 2005 Act provides that $500 is the minimum preference action that may be pursued.

What it Means for Vendors

This change protects smaller vendors most prone to abusive litigation tactics, and the $5,000 threshold amount does not undermine the policy supporting equality of treatment of like creditors.

Venue Change:

Suing the Vendor Where it has its Principal Place of Business (section 410)

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 inconvenient, and more costly to defend. The 2005 Act requires 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.

What it Means for Vendors

This change protects vendors from a trustee taking advantage that it will cost the vendor more to litigate the preference given the inconvenient forum. This change of forcing the trustee to litigate in the vendor's home court for amounts between $5,000 to $10,000, should require the trustee to carefully consider a vendor's defenses, such as the new value and ordinary course of business before filing suit in a foreign court.

Amending the Ordinary Course of Business Exception (section 409)

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 both 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.

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.