ABI Commission to Study the Reform of Chapter 11
May 21, 2013 Field Hearing
National Association of Credit Managers
Las Vegas, NV
Geoff Berman: My name is Geoff Berman. I'd like to welcome you on behalf of the co-chairs of
the American Bankruptcy Institute's Commission to Study the Reform of Chapter
11. I first want to thank NACM for hosting this hearing today, in particular, Robin
Schauseil and Darnell Foster for their enthusiastic support and help throughout.
Thanks also to the members of the Avoiding Powers Advisory Committee,
including its co-chair, Bruce Nathan, for coordinating with the witnesses for this
hearing. We will hear from a number of witnesses today on issues important to
trade creditors and credit professionals, including preference rules, the rule of
unsecured creditor companies, reclamation [claims], and administrative priority
claims under section 503(b)(9) of the Bankruptcy Code.
Trade creditors provide vital financing to American businesses and have long had
the incentive to work with financially distressed customers. The Commission is
aware of a growing sentiment among trade creditors that the Bankruptcy Code has
become imbalanced as to the treatment of trade creditors in favor of the debtor
and secured lenders.
We expect that today's witnesses, all senior credit professionals at some of our
nation's leading companies, will provide key insight into how the Code might be
revised to better balance the interest of trade creditor stakeholders. We thank you
all, the audience, for attending and being part of this today.
Let me introduce who is here. From my left is Michelle Harner. She is the
Commission's reporter, Associate Dean and Professor of Law at the Francis King
Carey School of Law in the University of Maryland.
In the middle is Steve Hedberg, [*] who is with Aequitas Capital.
On the far right in front is Bruce Nathan. Bruce is one of the co-chairs of the
Avoiding Powers Committee and with the Lowenstein Sandler firm. Up here with
me on my far right is Bill Brandt. Bill is the president and chief executive officer
of Development Specialists, one of the nation's leading turnaround consulting
firms.
On my immediate right is Deborah Williamson, lawyer with Cox Smith out of
San Antonio, Texas. Deborah is one of the ABI's early presidents and has been
integral in a lot of the work that the Commission has done around the country on a
number of topics.
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On my left is the immediate past president of the ABI, Jim Markus, who is with
Block Markus in Denver.
Why the need for reform and why now? It's been over 30 years since the
Bankruptcy Code was enacted, and a consensus has emerged that the current law
needs an overhaul. Some would contend that the Bankruptcy Code of '78 offered
a balance between creditor and debtor interest, establishing what was often
described as a level playing field. Detractors contend that the '78 Code was too
debtor-friendly, that it led to long and inefficient cases, and that it provided too
much discretion to bankruptcy judges.
For better or worse, most of the changes to the Code since 1978 have exempted
categories of claimants or transactions from the reach of bankruptcy law, have
added additional categories of administrative or priority claims, thus burdening
the already strained liquidity of distressed companies, have limited or eliminated
the discretion of the courts in administering chapter 11 cases, and have provided
for shorter time periods and faster, more truncated cases.
Supporters of the Code contend that many of the changes to the Code throughout
the years have not helped further the goal of restructuring or have unintended
consequences.
However, arguing about who is right or wrong in terms of the recent history of the
Code is, in this juncture, largely beside the point. Primarily, the world, including
the financial environment and the operation of the market, has simply changed,
and the Code, even as amended, was not designed to deal with these changes. For
the most part, a series of external factors drive the need for a rethinking of chapter
11.
Since the Code's enactment, there has been a marked increase in the use of
secured credit, placing secure debt at all levels of capital structure. Many of the
1978 Code provisions assume presence of asset value beyond secured debt and
asset value is often not present in many of today's chapter 11 cases.
The debt and capital structures of most companies are more complex, with
multiple levels of secured and unsecured debt, often governed by equally complex
inter-creditor agreements.
This is not to say that there is anything wrong with the growth of collateralized
debt per se. Indeed, that growth brought credit to many companies who could not
have attained it otherwise. However, the 1978 Code's baseline assumption of
value above the amount of liens on assets was challenged, if not cast asunder.
The growth of distressed debt markets and claims trading introduced another
factor not present when the 1978 Code was enacted, a factor which challenges
certain other premises underlying the Code. Again, in many ways, this
development was a net positive, providing creditors with means of monetizing
claims more quickly rather than awaiting the outcome of sometimes lengthy
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cases. However, the rapidity of the development of these markets also created
collateral consequences that the 1978 Code was simply not designed to deal with.
Many of today's companies are less dependent on hard assets, real estate,
machinery, equipment or inventory and more dependent on contracts and
intellectual property as principal assets. The '78 Code does not clearly provide for
efficient treatment of such cases and affected counterparties.
Debtors are more often multinational companies, with the means of production
and other operations offshore, bringing international law and the choice of law
implications. Today's debtor is likely to be a group of related, often
interdependent, entities. The impacts of these changes on the efficacy of the
current restructuring regime have been dramatic.
The way both courts and commentators discuss the purpose of chapter 11 has also
changed. Early decisions and the legislative history of the 1978 Code emphasized
the primary purposes of the Code were rehabilitation of businesses and the
preservation of jobs and tax bases at the state, local, and federal level. As time
passed, these purposes competed with the maximization of value as an equal, if
not competing goal.
More recent discussions of the purpose of chapter 11 tend to emphasize the value
maximization to the exclusion of other goals. This development also calls for a
fresh assessment of the purposes and goals of the U.S. restructuring regime.
Moreover, given the added complexity and a statute that often does not have the
tools or clear answers to deal with the problems that arise, even the cases that do
reorganize seem to cost more. Reorganization may be less efficient, but it is more
costly. Practitioners and the courts have achieved amazing and creative results
despite the statute's shortcomings. However, recognition that the world has
changed in significant ways since the enactment of this Code in 1978 and the
related concerns bring a restructuring community to consider the need for a
prompt and thorough reevaluation of the Code in light of these changes. A better
set of tools is required.
What is the ABI Commission? The charge of the Commission is nothing less than
the study of the need for comprehensive chapter 11 reform, by which we mean the
consideration of starting from scratch and reinventing the statute. Accordingly,
the Commission's mission statement is equally ambitious.
In light of the expansion of the use of secured credit, the growth of distressed-debt
markets, and other externalities that have affected the effectiveness of the current
Bankruptcy Code, the Commission will study and propose reforms to Chapter 11
and related statutory provisions that will better balance the goals of effectuating
the effective reorganization of business debtors, with the attendant preservation
and expansion of jobs and the maximization and realization of asset values for all
creditors and stakeholders.
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More than a year ago, I tasked the Commission's co-chairs, Robert Keach and Al
Togut, to assist me in assembling a working group of the best and brightest from
among chapter 11 practitioners, academics, bankers, and Congress, to study the
possible business bankruptcy law reforms. With the ABI Commission, we feel we
have accomplished this task.
The Commission members are listed on the screen to my right. I won't take the
time to go through all of them again. A number of them are here today.
As I mentioned, the Commission is ably assisted by its reporter, an eminent
bankruptcy scholar in her own right, Michelle Harner, Associate Dean, Professor
of Law, and co-director of the Business Law Program at the University of
Maryland Francis King Carey School of Law. Professor Harner oversees the work
of the advisory committees, provides critical research assistance, records the
deliberations of the Commission, and will assist in the production of the
Commission's final work product.
The work of the Commission is also underwritten by grants from the ABI
Anthony H.N. Schnelling Endowment Fund and by the ABI. We also wish to
acknowledge the tireless and dedicated efforts of Sam Gerdano, who is here with
us today, who has helped in the organization of these field hearings on top of
everything else ABI does.
The Commission, in a series of meetings, selected a number of topics for initial
study. For each topic, the Commission has selected an advisory committee of
distinguished judges, academics, practitioners to assist the Commission in the
study of each of those topics, to research the topic and possible reforms, and,
where warranted, to develop arguments for reform alternatives.
Over 150 of the best minds from the judiciary, academia, the bar, financial
advisory services, and the worlds of finance and banking have all agreed to serve
on these committees, and like the Commissioners, all do so without charge to the
ABI or the Commission. This is a volunteer effort. These committees are
organized and now in the midst their important work. The topics of these
committees are on the screen. The Commission is also addressing other issues at
the Commission-level as well.
The field hearings are a function that the Commission realized that, despite the
breadth of knowledge and expertise on the Commission and the advisory
committees, many others around the country, from the bar, judiciary, academics,
financial professions, business and people like yourselves with NACM, have
critical information, experience, knowledge, data, and ideas to contribute to this
important process. Accordingly, with this wealth of knowledge, and information,
the Commission decided to hold field hearings around the country to hear and
collect testimony on various issues.
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The ABI Commission held six public field hearings in 2012, Washington, D.C.,
New York, San Diego, Boston, Phoenix, and Tucson. In those hearings, the
commissioners heard testimony and asked questions of more than 20 witnesses
from various organizations, industries affected by potential restructuring reform.
The witness testimony covered various topics, including secured lending, the
effect of reform on the credit markets, claims trading, the interface of procedural
rules and substantive restructuring reform, sales of businesses via chapter 11, and
a number of other topics.
The testimony has been illuminating on a number of fronts. Among other insights,
the Commission has heard that it must consider the impact of reforms on the
broader market for credit for both distressed and healthy companies. The
Commission is fully mindful of that guidance.
The Commission will hold at least eight field hearings in 2013. We've already
conducted hearings this year addressing valuation, labor and benefits issues, fees,
and middle market companies. In addition to today's hearings, additional hearings
are scheduled for Chicago, New York, Atlanta, and Austin, Texas. Those hearings
will cover topics such as governance, sales in chapter 11, administrative claims,
and burdens on liquidity. The Commission is also soliciting and accepting written
submissions on all issues. We hope to hear from every interest affected by
potential restructuring reform.
Armed with this information, the Commissioners will discuss each topic, debate
and search for consensus for reform. The final result will be a comprehensive
report, part blueprint for reform and part catalog of open issues and current
options to be considered in updating chapter 11. At the end of the day, the
Commission's work may lead to consideration of reform legislation but legislation
that is fully informed by the careful and thorough process of the Commission and
the input of the entire insolvency community.
We could not be more excited and energized about both the quality and quantity
of the contributions of the community to date and the future of this study, and this
hearing is a great component of that.
If anyone is interested in the witness statements that are part of this hearing today,
there are copies of every witness statement at the back table. You're welcome to
take one at the end of the session or whenever you need to leave.
Our first panel today is dealing with [section] 503(b)(9) and related issues. Our
witnesses are Joseph McNamara, director of financial services and business
operations from Samsung Electronics U.S.A.; Paul Calahan, credit manager at
Cargill, Inc.; Sandra Schirmang, senior director of credit, Kraft Foods Global,
Inc.; and two attorney advisers, Deborah Thorne and Jeffrey Carlino.
I don't know who is going first from the panelists, so let me turn it over to the
witnesses. Thank you.
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Paul Calahan: I'm Paul Calahan, and first of all, I'd like to acknowledge the Commission for
their time and efforts to allow credit professionals an opportunity to express their
thoughts and concerns about the Bankruptcy Code and the bankruptcy process. I
also would like to acknowledge the ABI members who will be able to view this
hearing later today on their website.
I serve as a senior credit consultant for Cargill Inc., and, prior to that, I was
divisional manager of credit for Continental Grain Company. I have worked in the
agricultural industry for 37 years. Cargill is the leading agricultural company in
the world, with sales of $135 billion and employment of 137,000 people. Cargill
is heavily concentrated in the food chain for both livestock as well as human
consumption.
I serve as a senior credit consultant for two major business units at Cargill, with
aggregate sales of more than $20 billion. I serve on Cargill's Financial Risk
Committee where all requests for extensions of credit greater than $25 million
must be approved.
I've been a member of NACM for 36 years. I had served in the past on NACM's
Legislative & Government Affairs Committee and I have lobbied for bankruptcy
reform.
In the area of reclamation [claims] during the past years, the Bankruptcy Code
and the economic environment has made it more difficult for unsecured creditors
to realize fair payment of their claims. For this reason, when I evaluate a
distressed debtor, we become more restrictive in the extension of credit and credit
terms. Frequently, we withdraw credit altogether when we identify a distressed
debtor or a potential payment risk.
Years ago, we could rely upon the reclamation [claims] for deliveries made within
10 days of the bankruptcy filing. Reclamation was designed as a remedy to
protect sellers of goods from buyers purchasing goods when the buyers were
insolvent or planning on filing bankruptcy or some other form of insolvency
proceeding. Reclamation was really intended to prevent fraud against good-faith
sellers.
Unfortunately, [a] reclamation [claim] is no longer a remedy that protects sellers
of goods. Reclamation claims are usually denied because debtors had secured
lenders who exercised their right to have liens over all their inventories. The
distressed debtor typically does not have the inventory at the time the reclamation
[claim] is even made, or the inventory subject to reclamation [claim], in our case,
is commingled with other similar products and is not easily identifiable.
For example, from the inception of Bankruptcy Abuse Prevention and Consumer
Act, my department has experienced 300 bankruptcies, with exposure of $19.2
million subject to claims of reclamations in 43 of those cases. It is generally our
practice to file reclamation demands in each case where deliveries were made 10
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days prior to petition date. In each case, Cargill did not recover any goods or
receive any recovery of any kind in those 43 reclamation demands. Generally, that
was the result of lenders exercising their lien rights on inventories and that goods
were consumed. It's not uncommon in our industry that distressed debtors are not
able to keep large amounts of inventory and use very quickly what they do have.
In the case of Vera Sun, an ethanol producer, they filed bankruptcy in 2008 in the
State of Delaware. We served a reclamation demand to recover 10 cars of ethanol
with a value of $1.2 million three days prior to the bankruptcy petition date. At
the time Cargill delivered the 10 cars of ethanol to Vera Sun, Vera Sun had
stopped producing ethanol and was buying ethanol from other suppliers to honor
their commitments to their buyers. We filed a reclamation [claim] immediately,
but because the cars had shipped and been re-consigned to a third party for Vera
Sun's account, we were not successful in reclaiming those goods, and Cargill lost
$1.2 million.
The last major successful collection of a reclamation [claim] was in the early '80s,
when Lane Processing, an Arkansas poultry company, filed bankruptcy. We filed
a reclamation [claim] for a corn train that we had sold them with an approximate
value of $800,000, and we were successful in obtaining those monies.
While a reclamation [claim] is really no longer helpful in recovering inventory
shipped just prior to the bankruptcy filing, the addition of [section] 503(b)(9) in
2005 did assist sellers of goods delivered to the debtor on the eve of bankruptcy.
Section 503(b)(9) has encouraged Cargill to sell on credit to potential debtors,
knowing that the deliveries made within 20 days will be protected with an
administrative claim. We often modify our credit terms knowing that our
exposure will be somewhat protected and mitigated by [section] 503(b)(9).
As Hostess Brands edged closer to their second filing, Cargill was managing our
exposure very closely and continued to extend credit to Hostess Brands, knowing
that we had [section] 503(b)(9) available to us. At the time of Hostess Brands'
second filing, Cargill was owed $1.6 million, of which, $1.2 million was covered
by [section] 503(b)(9). Without the availability of 503(b)(9) administrative claim,
we would have withdrawn credit to Hostess Brands.
Section 503(b)(9) has provided needed protection for unsecured trade creditors
selling goods and likewise has enabled many potential debtors to continue in
business. Why should secured creditors or secured lenders agree with the clause?
Simply, [section] 503(b)(9) allows trade creditors to deliver value to the debtor's
business. It is trade credit that often allows a debtor to maximize the going
concern of the debtor's business. This, in turn, helps lenders protect the value of
their collateral. When a distressed debtor is having liquidity problems, it is
oftentimes trade credit that keeps and allows that business to continue.
Section 503(b)(9) allows unsecured creditors of goods to continue to work with
the distressed debtor knowing that the [section] 503(b)(9) clause is a means to
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mitigate risk. Without the provision, typically, the response is to reduce or to
withdraw credit.
Currently, Cargill is working with a company that is not yet and hopefully will
not file bankruptcy. For this reason, I will not mention their name. The company
is a major retail chain and may have been in the process of restructuring their debt
as well as selling assets. Cargill has trimmed their credit line discounting by
$8,000,000, and as we speak, we're owed twice that.
Section 503(b)(9) has been critical to our negotiations as well as our developing
our strategy. Very simply, as important as this customer is to Cargill, we will not
knowingly throw away millions of dollars to a distressed debtor. Without the
protection offered by [section] 503(b)(9), shipments would have stopped, and
store shelves would not be replenished.
To get you a flavor of what empty store shelves look like. When Hostess Brand
shut their doors here a few months ago, store shelves went empty because they
were not replaced by goods of other companies, they just remained empty. Bread
and snack foods were not on shelves where they once were. In comparison, when
disasters or storms are forecast, people will frequently go and stock up their
refrigerators and their shelves with goods. [*]
Another example where section 503(b)(9) made a difference was in the
Townsends case. 2011 was the worst year for the poultry industry in their history.
Anything and everything that could go wrong did. The poultry industry, for some
years, has struggled with over capacity, over supply, the inability to pass on
higher ingredient cost to their buyers. Many poultry companies expanded into the
wrong areas and leveraged their balance sheets. All these factors, including the
decline of exports, made losses astronomical into the industry, and Townsends
was no exception.
Townsends was one of many poultry companies that would file bankruptcy in
2011. Townsends was a poultry company located in the Southeast, and they have
been distressed for some time. They hired outside consultants to determine what
their options were, which would eventually lead to a bankruptcy filing. When they
filed bankruptcy, Cargill was owed $1.3 million. Cargill was concerned about
recovery, as were the lenders who were owed approximately $73 million and
were believed to be undersecured on their loans.
There was near unanimous perception that Townsends was administratively
bankrupt. At the time Townsends filed bankruptcy, the prevailing view was that
the debtor's business was worth $30 million less than what the lender's claim was.
In addition to that, they also filed for immediate liquidation. Cargill and other
creditors were concerned with the chapter 11 filing because it would potentially
allow the lender to recover a better recovery on the sale of the assets and of a
higher return than if they had not foreclosed on the property outside of
bankruptcy.
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I participated on the Creditors' Committee, and as a committee, we retained
professionals. To make a longer story short, the lenders did not want to carve out
any monies for [section] 503(b)(9) claims or administrative claims for goods sold
or services provided to the debtor during the chapter 11 proceeding case. Lenders
were concerned that if the assets weren't sold quickly, administrative expenses
would exceed dip financing by millions of dollars.
The committee objected to the financing and negotiated a settlement that assured
the payment of chapter 11 administrative claims and provided a graduated scale to
recover 503(b)(9) claims. To give you an idea of the graduated scales, the
business sold for X dollars, 503(b)(9) claimants would receive Y dollars; if sold
for A, it would receive B dollars. This was up to $15 million and if the assets
were sold for $63 million.
The recovery in the Townsends case was beyond everyone's expectations because
the assets sold for a lot more. Because of [section] 503(b)(9), Cargill recovered
$1.2 million, nearly its entire [section] 503(b)(9) claim.
There was another favorable aspect of the Townsends case in that creditors were
permitted to include their [section] 503(b)(9) claims in their proof of claim form.
Creditors were permitted to assert their Section 503(b)(9) claims in their proof of
claim because there was a court order permitting them to do so. Creditors should
be allowed to do this in every bankruptcy case so it is easier and less expensive on
the estate rather than having to assert the [section] 503(b)(9) claims in court.
Unfortunately, there is nothing in the Bankruptcy Code or in the Rules of
Procedure that allows creditors to include their [section] 503(b)(9) claims in their
proof of claim. This has created a lot of uncertainty on how creditors should be
asserting their section 503(b)(9) claims in bankruptcy cases.
Townsends also illustrates the value that a strong creditors' committee can bring to
a case, particularly in the case that was at risk of administrative insolvency.
Frequently, there is discussion that creditors' committees increase the cost of
chapter 11 proceedings. The voice for unsecured creditors is clearly needed and
provides a valuable insight to the court and to other parties. Creditors' committees
frequently explore transactions and underlying conduct which may not have any
interest to the debtor's management and maybe not even to the secured lenders but
by pursuing the assets, the committee brings value to the unsecured creditors and
maybe just even to the underwater secured lender.
Other important contributions of creditors' committee is that they provide an
essential role in the representation of all unsecured creditors, and they bring
balance to the proceedings that ensure a more equitable administration of the
estate for all classes of creditors. To strip away any rights and/or representation
for unsecured creditors would deny unsecured creditors any role in chapter 11
cases.
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Creditors' committees bring balance to the proceeding and will challenge the
status quo positions of the debtor, the secured lender, and/or other insiders where
appropriate.
I'm currently involved in a bankruptcy proceeding with John and Catherine
Burger. The Burgers have five limited liability companies, of which four filed
bankruptcy at the same time. The meetings were conducted by phone with the
judge, the debtor, secured lenders, and some unsecured creditors. Before anyone
convened in person, the lenders had decided that they would not fund the
creditors' committee. From that point, the committee could not find any attorney
to represent the committee, with only a hope of being paid by the estate.
Briefly, some issues that appeared in that case include a debtor and his wife
operating five limited liability companies. They did not keep separate books.
They operated all of their businesses out of one single bank account. They
commingled their assets. They had audited financials that were overstated and not
only were they not able to pay Cargill and other unsecured creditors, it's our belief
they had no intention to pay Cargill and others.
Although the committee was formed, because the committee was not funded and
professionals could not retain counsel to raise such issues as fraud, insider trading,
the likelihood of improperly perfected security interest on some assets,
officer/director insurance, the reconstruction of the debtor's books over the last
year to see what has transpired, potential lender liability, and the fact that the
debtor had lost millions of dollars, the debtor was unable to infuse money into the
business, was in poor health, was unable to secure dip financing, chances are, the
most logical step in this bankruptcy proceeding was to liquidate the business.
Let's just take one of those potential events, improperly perfected security
interests. This would have the result of making the secured lender an unsecured
lender subject to a pro-rata share of the proceeds with sale of the assets. However,
given that the creditors' committee had no voice, most of these issues will never
ever be explored, and the debtor and the lenders will simply just work this stuff
out by themselves. This was because the committee did not have professional
representation, could not explore these issues in depth, and the motions and the
objections were appropriate on behalf of unsecured [creditors].
I would further suggest that whether a debtor is administratively insolvent or not
should not be the criterion to decide whether or not a creditors' committee should
be formed. Simply, there would be no creditors' committee in most cases where,
at the beginning of the bankruptcy, there is a risk that the debtor is
administratively insolvent. Bankruptcy already assumes the debtor is insolvent.
That means unsecured creditors would have no vehicle for investigating and
challenging secured lenders' unperfected security interests, improper conduct, and
conduct of the debtor's insiders prior to bankruptcy. These claims might be the
only source of recovery for creditors in this case.
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Objectivity, fairness, and balance would be lost if the debtor and lenders were left
to resolve the issues. [*]
In conclusion, section 503(b)(9) is a valuable provision of the current Bankruptcy
Code and should be retained to provide a meaningful incentive to sellers to
continue selling on credit. It protects trade creditors from insolvent buyers of
goods stocking up on inventory just prior to a bankruptcy filing much in the same
way a reclamation [claim] was intended to prevent fraud during the initial days of
the Uniform Commercial Code. Frankly, if unsecured creditors were to lose their
hard-fought ground they received, the most likely trend would be the more
conservative approach to the extension on credit to distressed debtors. Credit will
become more restrictive, if not withdrawn. Liquidity issues will accelerate, and
chances are, it will hasten those bankruptcy filings.
Finally, we understand that it's not necessary to have creditors' committees in
every chapter 11 proceeding. However, when there is interest to form a
committee, a committee should be formed and not be prohibited from doing so
because a debtor may appear to be administratively bankrupt. Thank you.
Geoff Berman: Thank you, Mr. Calahan. If I can, before we start, in the interest of time, please
understand that the Commissioners have read your written statements, and so that
there is enough time for questions and answers when you're done with your
testimony, if you could summarize them as best as you can, we would appreciate
it. Who is next? Mr. McNamara?
Joe McNamara: Thank you. First of all, I would like to thank the ABI and the ABI's Commission
to Study the Reform of chapter 11 in allowing me to speak today.
My name is Joseph McNamara, and I'm the director of financial services and
business operations at Samsung Electronics America. I have the responsibility for
financial services throughout the United States of America and basically all the
Samsung products, with the exception of cell phones. I had been with Samsung
for 10 years in a senior manager position before moving on to become the
Director of Financial Services. My role encompasses the entire credit, collections
and accounts receivable function. Prior to Samsung, I worked for several
companies, including BP Castrol, Panasonic, and Crown Vantage Paper
Manufacturing, but I have maintained a position in management of trade credit for
the last 20 years.
During the last 10 years, 25 of Samsung's customers have been debtors in chapter
11 proceedings. There was one filing in 2004, none in 2005 or 2006, and three
accounts filed in 2007. Then, between 2008 and present, there have been 21
filings: six in 2008, three 2009, five in 2010, three in 2011, and three in 2012.
Electronics Expo Electronics Retailer was the most recent filing [*]when they
sought chapter 11 protection at the end of March.
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Three of these accounts also involved the second filing for the same said
company, a so-called "Chapter 22". These were Tweeter Entertainment, Ultimate
Electronics, and Ritz Camera. In my experience, over the last half decade,
companies have had a harder and harder time successfully reorganizing their debt
and using the chapter 11 process, and thus are more prone to either fold their
reorganization procedure into a liquidation or successfully exit and then re-enter
bankruptcy a few short years later.
I'm going to address several issues today that I think are important for the
Commission to consider. My testimony includes [section] 503(b)(9) claims,
reclamation [claims], and the importance of creditors' committees.
Of the bankruptcies that I've been involved with, the Circuit City filing was the
largest and most noteworthy, and from what I understand has become a poster
child of how retailers are often unable to successfully navigate their way through
chapter 11. Samsung was a member of the unsecured creditors' committee of
Circuit City, and I was the representative for Samsung on that committee.
Among the reasons floated by legal pundits for Circuit City and other retailers'
demise is the fact that the section 503(b)(9) of the Bankruptcy Code provides
vendors with administrative claims on goods shipped to the debtor in the 20 days
preceding their bankruptcy, and this is a burden that proves to be too much for the
debtor to bear because they have to pay these claims in full as administrative
claim for the chapter 11 to be approved.
When they cannot do so, the argument goes that it forces them to liquidate.
However, suggestions that section 503(b)(9) is responsible for the demise of
companies like Circuit City ignores several fundamental facts to these cases that
precluded their success. A closer look at Circuit City from Samsung's perspective
and more generality is helpful to understanding the big picture.
Samsung was one of Circuit City's largest unsecured trade creditors, and we were
owed approximately $122 million at the time that they filed in Richmond,
Virginia. Samsung had a 503(b)(9) claim, an administrative priority claim of
approximately $19 million.
We also had a reclamation claim, which we filed twice. We filed prior to their
bankruptcy, for a claim of $74 million, and then a week later after they filed, we
filed again for just over $6 million. In both cases, the reclamation [claim] was
rendered valueless [*] for two reasons. First, Circuit City successfully offset its
claims against Samsung for deductions, chargebacks and other amounts that
Circuit City claimed was owed by Samsung. Samsung was also hamstrung by the
bankruptcy court order relying on section 502(d) of the Code that temporarily
disallowed section 503(b)(9) claims, pending the resolution of the debtor's alleged
preference claims.
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The judge effectively denied the [section] 503(b)(9) claims by using Circuit City's
other alleged claims against Samsung and also on the mere allegation of a
preferential payment even before Circuit City was required to prove that Samsung
actually received a preference. In reality, except for a couple of rogue invoices
that totaled approximately $1 million, the preference claim asserted against
Samsung was meritless. We never changed our terms in Circuit City’s case, and
their payments were made in a timely schedule without issue. Still, Circuit City
argued that their portion of the payments made to us on open terms during the 90day preference period were preferential, without any justification.
Based on part by the mere assertion of Circuit City's bogus preference claims, the
court tossed out Samsung's legitimate [section] 503(b)(9) claim. Technically
speaking, the [section] 503(b)(9) claim was 100% recoverable, and practically
speaking, it was completely null and void.
Samsung's claim, which was for $122 million, was filed in two separate
components: one for the [section] 503(b)(9) claim of $19 million and a second for
the remainder of the $103 million. Circuit City asserted a baseless preference
claim against Samsung for approximately $50 million and argued that their
preference offset the [section] 503(b)(9) claim and sought to disallow it.
Circuit City also was seeking to disallow Samsung's [section] 503(b)(9) claims
based on the claims recovery of deductions, chargebacks, and other related claims
against Samsung. Rather than attempt what would have been a protracted and
expensive process of litigating these issues, Samsung ultimately chose to settle
with Circuit City in such a way that it reduced the [section] 503(b)(9) claim to
zero and reduced its unsecured claim in exchange for the release of Circuit City's
preference claim against Samsung.
Samsung's experience in the case is not unique. Many creditors' [section]
503(b)(9) claims weren't paid for the same reason Samsung's weren't: because the
[section] 503(b)(9) administrative claims were denied due to alleged preference
claims, or they were unpaid based off of Circuit City's pre-bankruptcy deduction,
chargebacks, and other claims against the creditor. Considering that the debtor
had never had to pay many of these [section] 503(b)(9) claims, I personally
cannot see how section 503(b)(9) contributed to Circuit City's demise.
My experiences dealing with Circuit City provided a whole host of reasons why
the company was bound to fail in chapter 11. In addition to the weakened U.S.,
global, and credit meltdown that was in full swing at the time, Circuit City was a
poorly managed company. Although they did bring in competent management
during the case, it was too little, too late.
Second, their stores were older and not in the best locations. If you can recall
from your own experience where there was a Circuit City in your area, usually it
wasn't located in the most popular shopping malls. They were often found in odd
locations hard [that were] to get in and out of. This might have been a good
* Language clarified in transcription process.
13
strategy for Circuit City 25 or 30 years ago because it allowed them favorable
pricing on real estate and leasing, but once competitors such as Best Buy entered
the market, they took an opposing strategy and became anchor stores in high-end
strip malls. There might be a Dick's Sporting Goods, a Costco, a Home Depot, a
Lowe's, or even a Best Buy, but that was never the case with Circuit City [*].
Third, Circuit City also made a major mistake when they exited the appliance
sales sector. They thought that the sector wasn't a benefit for their business, but by
exiting the sector, their stores missed out on a great deal of foot traffic. At home,
when your dishwasher or your refrigerator or washer/dryer breaks, instead of
opting to fix them, you might go out and decide to replace them altogether, so you
go to purchase a new one. You would go to a store like the former Circuit City to
buy the appliance, and when you were there, you would walk past the TV section,
the computer section, or another area of the store that didn't even bring you there
in the first place. Many times, this increased foot traffic led to additional sales.
After getting out of the appliance business, Circuit City lost all of that attach-on
clientele, and the business suffered.
Fourth, Circuit City was considerably overleveraged and burdened by more than
$1 billion in secured debt, while owning none of their real estate at the time of
their filing. All things considered, it defies logic to blame [section] 503(b)(9)
claims, a portion of which were never paid, for Circuit City's demise, when so
many other factors had already left the company doomed to begin with.
Both Circuit City's court treatment of the [section] 503(b)(9) claims and the
possibility of losing [section] 503(b)(9) altogether has created a chilling effect on
the extension [of credit] that will only hurt troubled companies. For instance, it
has negatively affected my ability, as a credit and risk manager, to feel safe in
selling on open terms to our customers when they appear to be headed for
financial trouble.
Up until the Circuit City case, section 503(b)(9) enabled the vendor to sell more
freely to distressed customers because it was a remedy that could be relied on and
an element of the statute that was part of the credit decision process. We could say
that even if this particular customer were to file, we'd still be able to collect a
certain amount of money and secure ourselves with a higher claim position
because of section 503(b)(9).
As it was in Circuit City, and as it has been in other cases, the claim could be
worth millions of dollars, and so being able to rely on it makes us considerably
more likely to ship product to a company that wouldn't be able to ship to without
knowing that the remedy was available.
Of course, in Circuit City, some of the claims were rendered valueless, including
Samsung's. So what ends up happening is after we have been stung by the court,
and considering the differences from circuit to circuit, we're less able to rely on
the 503(b)(9) priority claims, and thereby less likely to extend credit to distressed
* Language clarified in transcription process.
14
companies. This results in our company [stopping] business with distressed
customers faster, weakening their cash position more quickly, impairing their
ability to transact business, accelerating their financial demise, and ultimately
increasing the likelihood of them filing bankruptcy sooner rather than later.
The last creditors' committee that I served on was in Archbrook Laguna. They
were an electronics and small appliance distributor in New Jersey. They filed
bankruptcy and ceased operating and there was nothing left after liquidation to
pay the section 503(b)(9) claims and general unsecured claims. In this case, there
wasn't even enough to pay off the bank in full, who was a secured lender. The
case was pretty much a mess from the get-go.
We also filed a reclamation claim in the Archbrook case, which was $1.6 million,
but it made no difference because there were basically no assets left to liquidate to
even make the bank whole. As you can see, with section 503(b)(9) claims,
unsecured creditors are often left with little to no payment for goods received,
essentially through fraud. In the days leading up to a bankruptcy filing, section
503(b)(9) is a useful tool but not without its shortfalls. It is not, however, the
reorganization buster that some pundits have suggested.
I disagree with the policy arguments by some secured lenders that the repeal of
section 503(b)(9) is needed to once again restore the balance between the
relationship of secured and unsecured creditors. An April 16, 2013 study by Fitch
Ratings suggested that tremendous disparity remains, as one might expect,
between the payment of secured and unsecured claims.
Specifically, Fitch studied bankruptcy cases that detail 20 large retail
bankruptcies. While first-lien creditors experienced outstanding recoveries, with
at least one being paid in full in each of the 20 cases, unsecured recoveries were
considerably lower, with the median recovery being about 10%,and the average
recovery about 20%.
When Samsung sees a customer's bankruptcy coming, we now take the steps to
exit the market before the actual filing. Doing so, it has allowed us to avoid
leftover unsecured claim in the majority of the 25 cases that we've seen since I
joined the company in 2003. The only two cases where we held an unsecured
claim were Circuit City and Archbrook Laguna.
In Circuit City, we settled our claim for $50 million less than the thing was worth
and have so far received three installment payments totaling 15% of our
settlement value. In Archbrook, since the bank wasn't even made whole, I expect
that we'll either receive less than 5% or most likely nothing at all.
Finally, I would like to emphasize to the Commission the importance of a strong
creditors' committee in a chapter 11 process. Chapter 11 is a process that best
works when all parties are at the table and part of the process involves funding an
unsecured creditors' committee. If the goal of the proceeding is to merely sell the
* Language clarified in transcription process.
15
debtor's assets in order to satisfy the secured lender, there are other alternatives
for the company and lenders hoping to do that. Debtors looking to successfully
reorganize using chapter 11 should be required to “pay to play” and have the
resources necessary to ensure that all parties are involved in the process.
There is certainly less liquidity and more secured debt in this market today, and
reorganization is more difficult as a result. A creditors' committee brings
credibility to the process by allowing creditors to determine whether the liens of
unsecured creditors are valid, to examine other assets that may have value, [to
review] fraudulent conveyances and preference claims against insiders, and make
sure that the process is fair and economical. Creditor committees also bring a
valuable perspective to the case for the court, as the vendors, unions, and other
parties who are part of the committee’s body are knowledgeable about debtors in
the industry and in business.
Again, I'd like to thank the Commission for allowing me to speak today, and I'm
happy to answer any questions.
Berman:
Thank you, Mr. McNamara. We're going to save questions until Ms. Schirmang is
done.
Sandra Schirmang: First, I'd like to thank the Commission and the American Bankruptcy
Institute for having me here to speak today. My name is Sandra Schirmang, and I
am Senior Director of Credit at Kraft Foods. I'm a former member of the
American Bankruptcy Institute's Board of Directors and former co-chair of the
ABI's Unsecured Trade Creditor Committee.
In the nearly 30 years that I've spent working for Kraft, it's safe to say that Kraft
has been involved in every major bankruptcy case in the food industry because
our products are so ubiquitous. Fleming companies' filing in 2003 was the largest
bankruptcy case in which I participated. It also had a distinction of being a case
where Kraft was able to successfully leverage the Bankruptcy Code's reclamation
[claim] provisions as a creditor remedy.
In the Fleming case, I served as the co-chair of the General Unsecured Creditors'
Committee. In that case, a separate Reclamation Committee was formed. I
supported its formation and ultimately benefited from its work. In Fleming, the
reclamation claims were paid. Considering that the Fleming case was expected to
be a total liquidation when it was filed, largely through pressure from the OCUC
and the Reclamation Committee, we were able to reorganize around Fleming's
Core-Mark subsidiary, which still gets strong business results, and then its
remaining assets were sold.
The Reclamation Committee promoted a pragmatic reconciliation of all claims of
those creditors against the debtor, using a three-prong approach that
simultaneously addressed reclamation claims, unsecured claims, and preferences.
* Language clarified in transcription process.
16
The allowance of the reclamation claims provided unsecured creditors with a rare
and remarkable recovery.
A general reclamation [claim] recovery was always a risk for creditors because of
the way it was structured. It seemed that, as case law developed, any lien wiped
out reclamation [claim] rights, and these claims became secondary to the interests
of a secured lender's liens in inventory. Coupled with the growth in secured debt,
which has been addressed elsewhere, this fact essentially made reclamation
claims valueless.
Debtors often incur second and in some cases third-lien debt in an effort to stave
off bankruptcy, but they are frequently unsuccessful. While the acquisition of this
type of financing is often used by debtors to reassure trade creditors like me, it
often has the opposite effect. With each new tier of debt, Kraft's chance of being
paid what we are owed declines.
Ultimately, I believe that the growth in secured debt has actually pushed more
companies into liquidation, because as secured debt levels increase, debtors can
find it more difficult to purchase inventory on credit. My colleagues up here have
confirmed that. Vendors are less willing to continue selling on credit when they
are not confident that they are going to receive payment.
Too often in the past, unsecured suppliers have sold to debtors and have been left
with little or nothing in a bankruptcy proceeding. The frustration of unsecured
creditors also makes it difficult for debtors to get the supplier credit they need to
successfully function after emerging from bankruptcy.
Before BAPCPA, in my opinion, when reclamation claims were paid, it was
because the debtors felt compelled to maintain good relationships with their
suppliers. Payment of reclamation claims wasn't necessarily a certainty, but it was
something that a debtor had to consider doing if they still wanted credit after
making it out of chapter 11.
Generally speaking, the company that is emerging from reorganization is not
stronger, so if a supplier was owed $1 million pre-petition and if they're lucky,
they get .20¢ on the dollar, they are then asked to double down on that and reopen
another million-dollar credit line for the emerging customer who comes up with
bankruptcy. It's hard for suppliers to come to the table and take that risk. This fact
also makes it hard for the company that just went through a reorganization, raising
a question about whether or not the debtor will be able to get the inventory that
they need in order to function competitively on open unsecured credit terms.
If their new credit from their unsecured supplier is tighter, it makes it harder for
the new debtor to operate effectively and could actually send them back into
liquidation eventually.
Since BAPCPA, although we do send out reclamation [claim] letters, we rarely
actually fight for payment of the claims, choosing instead to focus our recovery
* Language clarified in transcription process.
17
efforts on the section 503(b)(9) 20-day administrative priority claim. This is a
remedy that is much more straightforward than a reclamation [claim], which, as
I've said, has become much less effective. The [section] 503(b)(9) process
provides a much-needed dose of certainty for the unsecured suppliers to continue
shipping to a company in the days leading up to a bankruptcy.
In consumer products industries, we sell on reasonably short terms of sale, and the
implications of [section] 503(b)(9) are very important to us from a financial
standpoint. I would imagine that it's even more important for smaller companies.
Kraft is certainly big enough to absorb a reasonably-sized loss, but when you
think about smaller companies and other businesses that are operating on thin
margins, the disallowance of their [section] 503(b) claim or the elimination of the
statute altogether would cause a great deal of damage to them if, say, one of their
biggest customers were to file bankruptcy.
For large suppliers like Kraft, our ability to rely on section 503(b)(9) allows us to
continue selling to a customer that might be circling the drain because we have
some reasonable certainty of recovery. When a company decides that Kraft
restricts credit to a customer, it can often speed the customer's descent into
bankruptcy.
For instance, for Fleming and A&P, if the debtors' major suppliers had abruptly
restricted credit, these companies would have been forced into bankruptcy more
quickly and less prepared or unprepared. Once a company starts having its credit
lines reduced, it can greatly affect their ability to [maintain] the marketplace,
thereby pushing them in bankruptcy sooner.
Repealing [section] 503(b)(9) would cause much more uncertainty in the supplier
community. It would make such precautionary damaging actions much smarter
moves for suppliers, to the detriment of debtors. As unsecured creditors, we're
willing to take a reasonable risk but not to an outrageous extent and not if we
think that the money won't ever be paid to us. [Section] 503(b)(9) provides
assurance for suppliers to keep struggling companies afloat, since we can be
certain that whatever we ship in that 20-day period has a good probability of
recovery.
Section 503(b)(9) also provides incremental assurance for companies that don't
provide their suppliers with financial statements. Many of our customers are small
to mid-sized companies that are family-owned or otherwise private and don't
release financial information. If there is no public debt on a company, then the
supplier is essentially shipping into a black hole. There are some customers that
won't even provide financial statement to companies the size of Kraft. We base
our credit decisions for these companies on how they pay and other information in
the industry, but we also rely on section 503(b)(9) administrative claims to give us
the assurance we need to sell to such customers.
* Language clarified in transcription process.
18
[*]
Losing this creditor remedy could drive even more bankruptcies [*] as suppliers
are quicker to become more restrictive or pull credit altogether. The key with
section 503(b)(9) is that it creates greater level of certainty, much greater than
we've had with reclamation [claims]. It encourages trade suppliers, who really are
the lifeline of the company, to continue providing support as it works to
restructure outside of bankruptcy.
I think, in a lot of ways, the supplier class has a much closer relationship to the
debtor in bankruptcy than the bankers and the bondholders do. Ours is a symbiotic
relationship. My company can't sell macaroni and cheese unless we've got shelves
to sell it on, and the customers are less likely to attract shoppers without wellstocked shelves. I think we have a greater vested interest in the survival and
reorganization of our customers, and the debtor wants a strong relationship with
their suppliers because they're going to need us [in order to be] to be successful.
In addition, sellers of goods, who are usually wholesalers, are often asked to
deliver goods to parties other than the debtor. This is known as drop shipping.
Various bankruptcy courts have taken the position that a drop shipment is not
eligible for section 503(b)(9) treatment because the goods were never received by
the debtor. However, if the seller of the goods does not deliver to the party to
which the debtor directs them, this would be a breach of contract. So to withhold
administrative claim status provided by section 503(b)(9) in a situation such as
this is very unfair to unsecured sellers of goods. It would be my suggestion that in
reviewing [section] 503(b)(9), the Commission clarify that this section's treatment
supply to drop shipment transactions.
One key element of the Code that allows debtors and the supplier class to work
together while preserving value for the unsecured creditors is through the
unsecured creditors' committee. I have served on several of these committees and
chaired others, and I can attest to how important they are and worthwhile they can
be when all of the players and their professionals in the case are at the table
working for the best overall outcome.
Firstly, the unsecured creditors' committee serves as an important source of
information about the case to the rest of the unsecured creditor. In the initial
confusion after a bankruptcy filing, it's difficult, especially in a potential
liquidation scenario, to even find out what's going on with the case. The debtor's
lawyers and the bank's lawyers are generally not as communicative with general
unsecured trade creditors as they are with each other and with other secured
lenders, so the OCUC provides unsecured creditors with the information they
need, at least insofar as it's possible, and also offers unsecured creditors a chance
to work out problems that would be more difficult to solve outside of a committee
atmosphere.
* Language clarified in transcription process.
19
I served on the general unsecured creditors' committee for the 2005 Winn-Dixie
chapter 11. In that case, the company's corporate and capital structure made
arranging settlements very complex. Winn-Dixie had formed the company by
buying up regional grocery stores. Some of these stores were signatories on some
of the company's loans and their assets were pledged, but other stores were not
pledged, so there was a question around how to figure out which of these different
types of stores were owed money and were part of the different structures of the
debt.
As a committee, we got together and reorganized with different entities to come
up to an equitable agreement to divide the recovery up fairly, rather than by going
through a big litigation and discovery process. Without the unsecured creditors'
committee at the table, such a process would have driven up legal costs and
forced the case to drag on for much longer than was ultimately necessary.
The creditors' committee also gives the unsecured creditor's class the ability to
push back against bigger lenders, providing us with an important mechanism for
balancing out the divergent interests of multiple parties. Our work on the
unsecured creditors' committees in the Fleming case and the Bi-Lo case allowed
us to extract valuable concessions from the secured lenders, specifically in the
form of a carve-out for reclamation claims in Fleming and other concessions in
the Bi-Lo case that allowed unsecured creditors to receive payment in some form
while giving the secured lender what they needed to keep Bi-Lo operating. Bi-Lo
successfully reorganized even with these concessions made to the unsecured and
actually purchased Winn-Dixie last year.
I can't imagine why, with the history of successful creditor committee
contributions, anyone would want to consider eliminating this committee from the
Code. In my experience, they provide a necessary counterpoint to the influence of
secured creditors, one that provides unsecured creditors with better recoveries and
helps create going concern value for the debtor.
With that, I'd like to thank the Commission again in offering a chance for our
community to testify, and I would be happy to answer any questions. Thank you.
Berman:
Thank you very much. Questions from the Commissioners? Mr. Brandt?
Bill Brandt:
My name is Bill Brandt. In addition to serving at DSI, as many of my fellow
Commissioners know, I'm also the chair of the nation's largest state-sponsored
bond issuing agency, so I see this from the creditor side as well.
I speak only for myself and not for the Commission, certainly not for the ABI, but
I think all of you should know that since we began this process about a year ago
now or a little bit more, we have had a fair amount of secured lenders coming
before us to talk about the nature of the practice and how it's changed and that the
claims trading and the debt trading and the rest of it has become integral of U.S.
economy and that we are to take our measure of that before we change the Code.
* Language clarified in transcription process.
20
All of us at the Commission want to thank all of you for coming, this is one of the
best turnouts we've had. Again, speaking for myself, I have written sections of the
Bankruptcy Code, as some of you know, and I have been involved with political
side of this for a long time, I can assure you that there's probably likely no
possibility that the creditors' committee will see a sunset in any revisions we do. I
can also tell you that while all of us have struggled with the central mission of the
Bankruptcy Code, [we] go back and look at an equilibrium that was achieved in
the '80s and '90s, when there were reorganizations and restructures in the truest
sense, and many of us believe that the history of this perhaps will move on from
there to the way that the reorganizations are now done in the United States. Our
task is not to go back to the tides of history but to find a way to reset the
equilibrium so, as the lenders and witnesses have talked about, it will continue to
provide credit support to endeavors that need that in order to survive.
We thank you very much for that testimony. I think I want to leave all of you with
the message, more than a question, that we indeed are not inclined to mess with
section 503(b)(9). In fact, we may well find a way to strengthen it. We have
talked about, and some of the lenders, a few of you whom are here and this will
probably touch your hearts, but we talked about a surcharge. One of the issues
that's been debated among the Commission is the fact that secured lenders have
rights and revenues outside of bankruptcy court in foreclosure and state court that
common creditors don't have. If you're going to avail yourself of the bankruptcy
process, perhaps a way of resetting the equilibrium is to find some way to make
sure that the unsecured creditors are in for a piece of the reorganization no matter
how that's done now. We're not sure how we get there. We're not sure that will be
in the final recommendations to be made.
But I want to assure you that the transformation we see from reclamation [claims]
with administrative claims is important. We also wrestle with the issue of the
timing of the payment of those administrative claims. We understand that just to
be given an administrative claim and then to be told wait two or three years to see
how the case works out may not be what we had in mind. We don't have an
answer for that. But I think I speak for the Commission in general when I say that
none of us are predisposed one way or the other. We understand the equilibrium
needs to be reset. We've got some great scholars and great practitioners and great
political people on this Commission, and we will try and find a way and without
the input we have here today from the NACM, I suspect we'd be in far worse
shape trying to do so, so I thank you all for doing so.
May I ask one [*} question before I turn off my mic, and that is if the reclamation
[claims], as you suggest, and as I suspect, have become so worthless in actual
practicality, is there a way to strengthen [section] 503(b)(9) beyond just
administrative claim, if the witnesses would give us as an offering in a way that
might induce you to either extend further credit or to be more involved in the
process. Mr. Calahan [*]?
* Language clarified in transcription process.
21
Calahan:
Thank you. I think one of the ways to strengthen it would be that we could file our
[section] 503(b)(9) claims as part of our proof of claim form without having to
assert it in court. If we just had it automatically addressed in that manner, I think
it would just help a lot. I think it would save a great deal of cost to the court and
certainly appease our minds a little bit on how importantly lenders and others are
going to address our [section] 503(b)(9) claims.
Brandt:
Some of us, of course, are now moving to elect trying filing of claims, as with
regards to small cases, without a claims agent. But if you just file your proof of
claim [*], if it essentially sits there as an administrative claim, I'm trying to find a
trigger mechanism, and it may well be that it winds up being an administrative
claim, but if you actually want to get value accredited to your case or the filing of
a case, you'll need to do more for a trigger mechanism, it strikes me, than just to
file a proof of claim. You may need to actually be at court to pursue a revenue.
Calahan:
I think that would be one benefit of having a strong creditors’ committee that can
take out those claims and assert that in court. But if you're not certainly in the
committee or if you don't have committee, then you don't have a means to really
have your [section] 503(b)(9) claims acknowledged.
Berman:
Ms. Williamson?
Deborah Williamson: My name is Deborah Williamson. I'm one of the Commissioners. Two or
three questions and they are not necessarily related. Mr. Calahan and Mr.
McNamara, you both mentioned funding for creditors' committees. Where could
the money come from? The case that you mentioned had no DIP loan. I'm just
curious. I understand the importance of having a creditors' committee, but what
do you think the funding should come from?
Calahan:
I believe the funding should come from the estate. All of the committees I've
participated on, the professionals have been funded by the estate. In the examples
that I gave you, the other committee members, we looked at trying to backstop
counsel to represent the committee. Some of those other participants may very
well file bankruptcy themselves as a result of this proceeding. I don't know if that
has been a correct thing to do for Cargill to have jumped in there and paid all of
the attorney fees because I think there has to be some equitable distribution
among unsecured creditors related to those types of expenses. But that was one of
the barriers that we had because some of the unsecured were facing or would
possibly face bankruptcy as a result.
Williamson:
That's my first question, but in the facts that you gave, there was no DIP loan, and
it sounded like there was no excess property which the creditor or the committee
could take from. Are you suggesting that a statutory surcharge against the secured
creditor to always favor the creditors' committee? That's what I'm trying to
understand.
* Language clarified in transcription process.
22
Berman:
If I can, Mr. Calahan, where is the mechanism to put the funds in the favor of
professional?
Brandt:
If I could answer the question, something like a surcharge. If it is written in the
Bankruptcy Code that the committees that were needed to be formed were paid
regardless of the security structure, maybe that would suffice for a suggestion on
your part?
Calahan:
Surcharge sounds great.
Williamson:
Putting aside the constitutional aspects of something like that, that's the question
that I paint. Nine times out of 10, there is a committee. Nine times out of ten there
is a DIP and there is a Cargill. The situation you are talking about is when there
was no DIP and that, what I understood, you were relying on existing credit, an
existing secure credit. It's just I don't know where the source of the money would
come from under those facts, which I think are probably the exception not the
rule. Would you agree?
Calahan:
Most likely.
Williamson:
Then my second question, which is unrelated to that of unsecured creditors, is
again talking about [section] 503(b)(9) and strengthening [section] 503(b)(9).
There is some tension between [section] 503(b)(9) in the statute and the courtmade remedy of creditors that are necessary, like in your case. How do you
believe that [section] 503(b)(9) is going to strengthen or address the tension that
other people, other commentators have pointed out regarding the every creditor
becomes a necessary creditor or it seems like every creditor has in some cases?
Schirmang:
In my experience, we have not had, at least in my industry, [*] we haven't had that
many instances. There have been few. Most recently, [a creditor in] the Bi-Lo case
down South was seen as wholesale business so was a critical vendor, I believe,
but they were supplying all of the groceries to the company, so it did make some
sense, and they had some very elaborate contractual arrangements that contribute
to it. I can see where there are situations where that makes sense, but by and large,
I would think they would be more the exception than the rule. I hope that helps.
Williamson:
I think it answers.
Berman:
Mr. Markus?
Jim Markus: I noticed one of the observations was that losing [section] 503(b)(9) could drive
more bankruptcies. I've actually experienced these at the opposite in two cases
where we had successful out-of-court restructurings that were rushed into
bankruptcies because some of the lenders wanted to avail themselves of their
[section] 503(b)(9) rights so they could leapfrog their unsecured constituents. I'm
wondering if any of you would have an issue if while we're going to preserve the
[section] 503(b)(9) status, if we would also preserve the notion that those
* Language clarified in transcription process.
23
creditors shouldn't have the rights to file involuntary bankruptcies so that they can
in fact leapfrog all the unsecured creditors.
Schirmang:
Not knowing more of the specifics around the case, it's hard to get my arms
around that. I think I understand the concept, but in most cases, I would think that
unsecured creditors would be [assured], if there is a way to make them feel
comfortable with an assignment for benefit of creditors or some kind of an out-ofcourt workout where their rights are still protected.
Berman:
I think the problem becomes if you're going to assert your [section] 503(b)(9)
rights, are you truly a general unsecured creditor? If that's the case, should you be
allowed to assert some right greater than a general unsecured creditor to affect the
greater recovery? Is that a fair?
Markus:
I think the way I try to phrase the issue is, outside of bankruptcy a special remedy
that's protecting the vendor within 20 days may not exist, so when you are
availing yourself of an involuntary [case], you're effectively trying to create
greater rights than you would have in an out-of-court workout. It seems that one
of the tradeoffs for giving these greater rights is to not allow those creditors to
leapfrog the other unsecured creditors who don't have a [section] 503(b)(9) right.
Schirmang:
Couldn't you incorporate that right into the court workout?
Markus:
It just doesn't exist though if you're viewing this through bankruptcy. Again, I'm
just trying to balance the tensions between the view of the trade vendor that's
providing services from the trade vendor that's providing goods.
Berman:
If you're, in fact, doing an out-of-court workout, a good old-fashioned meeting of
creditors and working out a program, you could define a class of the [section]
503(b)(9) creditor as of the date certain and give them the treatment. But that's a
consensual program versus what we're talking about here, which is outside the
bankruptcy, that right doesn't exist, and that's the concern.
Markus:
One other question. In all bankruptcies before BAPCPA, there was always a
notion of paying administrative claims as you go post-petition through projects
and DIP financing orders. I'm wondering if you've seen any kind of distinction
post-BAPCPAs to whether a [section] 503(b)(9) administrative claim gets treated
differently than the post-petition vendor has provided.
Schirmang:
I think sometimes those are the same parties. I think you could, working through
the committee, with the debtor, you can get [section] 503(b)(9) paid during the
pendency of the case and return for extension of current credit and then it just
rolls into credit confirmation, and the cycle keeps going. We've done that in the
food industry. We even did it before BAPCPA with reclamation claims where we
would negotiate with the debtor their agreement to honor reclamation claims and
pay it during the pendency of the case and return for ongoing credit. Basically
they were paying us out of our own money, if you will.
* Language clarified in transcription process.
24
Bruce Nathan: I also think in many chapter 11s with [section] 503(b)(9) claims paid earlier, it's
bristling to a critical vendor order not necessarily based on the creditor's [section]
503(b)(9) credits motion for using that claim.
Berman:
Mr. Hedberg?
Steve Hedberg: I guess I will further appeal on one of the questions. [*] It's a fascinating area.
Balancing each rights where a specific part of what's going to happen in this
entire process. I'm curious, you talked a little bit about extending rights, I think it's
arguing for extension of the rights for drop ships in this. I'm curious about the
scope of the right and who it should be available to generally. For example, why
wouldn't one extend [section] 503(b)(9) beyond goods to the folks that, by
contract, come and sweep the floors at night, service providers, really folks like
that? Do you have a view on where it should start and stop, or should we just lend
it to goods because it's always been goods? I realize this comes out of the credit
dip, a historical credit dip that has been trumped by secured creditors, and it
increases the [*] remedy of the administrative claims. Why should it be limited to
the sales of the goods?
Schirmang:
I think for one thing, when you're talking about the products that go into whether
or not a customer is selling, that's critical, if you will, to the business, whereas the
person who is sweeping the floors and so forth, you can get another entity in to
sweep the floors and to provide a lot of those services, but you can't get another
Cargill to provide you wheat [*]. Sorry, I always focus everything on Kraft.
Hedberg:
If that's the case, shouldn't we just limit the right to critical vendors then?
Schirmang:
I don't think so. I don't think so because that really favors the largest suppliers to
the detriment of everyone else, and the smallest suppliers could be actually treated
worse in some of those cases or be taken more advantage of by a dubious dip. I
did also want to add to Mr. Brandt's question around improving [section]
503(b)(9). I think delinking any connection between [section] 503(b)(9) claims
and preference assertions, as alluded to by my partner up here could be a problem
as well.
Brandt:
I was struggling with that because our next group of witnesses is going to talk
about preferences. But one of the cases that Mr. Calahan said, Sandra, the same as
you, I'm still struggling with it as well. I'm a great believer in creditors'
committees, but with creditors' committees who take up [section] 503(b)(9)
claims there is an inherent conflict that I'm still struggling with, and I think a lot
of the folks up here, in many ways, they're asking the same question, and that is if
you have a group of administrative claims essentially, is that the same thing with
your creditors' committee, and should that be the work of your creditors'
committee to see that those administrative claims are paid? [*]
Schirmang:
I would say clearly, if you have an administrative claim and a general unsecured
claim, you're wearing two hats, and if you're one of major suppliers to that
* Language clarified in transcription process.
25
company, you're probably on a creditors' committee as well. In order to do a
program that would get [section] 503(b)(9) paid early, let's say, or during the
pendency of a case, the [section] 503(b)(9) creditors need to work with the
unsecured creditors' committee to get their agreement to go on the program.
Brandt:
I guess I don't have a problem with that. The problem I have is if it is making the
creditors' committee a sort of a Trojan horse for the [section] 503(b)(9) creditors,
that's the concern because at some point, they're almost effectively administrative
creditors with a different category. We have no way of resolving that, but that's
the tension we see in this issue.
Williamson:
On a similar point, I do have to challenge you about people being harmed. Take
John's Janitorial Service, I'm not going to shop in the grocery store that's filthy,
and John is paying his people, and John is providing a service, but doesn't have
[section] 503(b)(9) protection. Again, the question is just because goods is a UCC
term, is that what we should be looking at? Should we be looking at the critical
vendors? Should we be looking at harm to the creditor as opposed or should we
just try to approach like everybody who provides anything is an admin player?
Which would certainly have an impact with management statements.
Schirmang:
And that's why I didn't go there because you're right, it does open up and how
much is too much?
Berman:
But it is a concern that the Commission is going to have to counterbalance. I'm
going to have to intercede with the chair's role and leave you with one other
thought, and I don't know if we have time for responses. It's nice to want
creditors' committees in the cases, but a number of the judges from around the
country have commented to many of us on the Commission on the others that they
don't see a willingness of the trade to serve on it. We have to be careful that we're
not just creating a remedy for large cases where there is a significant financial
dollar at risk. I don't know if there is an answer for that and certainly not one that
we have time to get into today. I know people in the audience and other people on
behalf of NACM have recommendations. I welcome those come to the
Commission via written statement.
At this point, I think we have run through the time for this panel. I want to thank
the witnesses for their testimony. We're going to take a very short break to set up
the second panel. Thank you very much.
Our second panel is dealing with the role of creditors' committees and
preferences, and I don't have the order of speaking, so I'll turn it over to you all in
a moment. We have Valerie Venable, Director of Credit Ascend Performance
Materials; Kathleen Tomlin, Regional Credit Manager from Central Concrete
Supply; Thomas Demovic, Senior Credit Manager from Sharp Electronics. The
attorney advisers are Wanda Borges and Lynette Warman. Who would we have
start? Ms. Tomlin, please.
* Language clarified in transcription process.
26
Kathy Tomlin: Good afternoon. I would like to begin by thanking the Commission for giving me
an opportunity to provide testimony about preference and creditors' committees
from the perspective of an experienced credit professional. My name is Kathy
Tomlin, and I have worked in the credit industry for more than 27 years, am a
long time member of and past national chair of NACM, and have dealt with more
than a few preference demands and cases.
I'm employed as Regional Credit Manager for Central Concrete Supply Co., Inc, a
prominent building materials supplier located in Northern California. Prior to
joining Central, I was also employed for 26 years by Hanson Permanente Cement
and Hanson Aggregates, serving as Regional Credit Manager before relocation of
the credit department out of the area.
I obtained an MBA from St. Mary's College and earned the designation of
Certified Credit Executive in 1998. I am also a graduate of NACM's Graduate
School of Credit & Financial Management, a recent recipient of one of highest
honors within the credit industry, NACM's O.D. Glaus Credit Executive of
Distinction Award, and have provided expert witness testimony for credit-related
issues in litigation.
My role as a credit manager is always to maximize recovery on collection matters,
including defending my company against preference claims. We have systems in
place internally to help us react quickly when customers begin to show signs of
financial distress, or a bankruptcy is filed. As part of my speaking and educational
activities for NACM, other credit organizations, and my own company, I often
teach credit managers at all experience levels about the perils of bankruptcy, its
short notice periods, and the various aspects of preference law.
Defending against preference demands is a very time-consuming and expensive
exercise. Many credit professionals are confused by the preference statute,
particularly the various defenses available to creditors. All of us, no matter what
level of experience we may have, are frustrated by the time and the cost required
to sort out the merits of a preference demand and evaluate our defenses.
The mechanics of putting together a preference defense are confusing to some
managers and exasperating to all of us. We must examine the books and records
which established the relationship, the payment history, any defaults in payment,
all notes regarding communications with the customer, and any notes, liens, or
security interests of any kind that may have been granted at the outset or during
the course of the relationship.
Unique to my situation, because my company is in the construction industry, I
must review and evaluate the benefits of mechanic's liens, determine whether
appropriate notices were given, and look to see if there were are any bonds in
place. Because most of my bankruptcy experience involves real property or bond
claims or deal with a bankrupt developer, I often have several defenses against a
* Language clarified in transcription process.
27
preference demand, but still have to endure the time and expense of proving that
defense to a trustee or debtor.
When there is no lien or bond in place, our defenses are generally the new value
or the ordinary course of business defense. To put together the information
needed to prove these defenses requires great time and effort on the part of my
staff, as well as employing one or more lawyers to advise us as to the standards
applicable to such defenses in the districts in which the demand is made or the
lawsuit is filed. Given the staff reductions and hiring freezes in effect in the credit
departments of many companies, it can be difficult to dedicate the resources
necessary to develop the information needed by counsel to adequately defend the
preference in any particular jurisdiction.
For my part, to help prepare our defense as to ordinary course, I depend upon my
industry credit groups to help determine a pattern of payments in the industry.
That information is helpful but not always definitive because every job is so
varied, depending upon whether it is a commercial, residential, or mixed-use
project. Often that information is not enough due to the requirements of the
district in which the case is filed, and we are forced to hire an outside expert to
review our books and records, evaluate the case, research the industry to the
extent possible, and testify on our behalf in court.
During this extended downturn in the economy, it seems to me that we have
received more preference demands than ever. Fortunately, because my company
is diligent about exercising lien and stop notice rights, we have been very
successful in asserting our defenses and managing the credit before a bankruptcy
is filed. As a consequence, we are frequently paid in full or at least on a current
basis before the filing. Often, it is prior to the start of the preference period.
Even though my company has had success in asserting lien rights and getting paid
outside of the preference period or defending preferences based on the liens, new
value, or the ordinary course defense, the fear of being sued always colors our
analysis of any given credit situation and adds to the cost of collecting from
financially distressed companies.
Due to the ever-present fear of preference liability, we are often reluctant to
extend additional credit or stretch out payments from a customer, even if we
believe a company's distress is temporary, simply because we want to avoid the
time and expense of a preference action. This uncertainty is not helpful to our
company or our customers, and I firmly believe it drives up the costs of credit by
a significant amount.
It is also distressing that we can be sued in locations like New York and
Delaware, which are generally far from our location as well as from the business
location of the customer. Defending preference demands in those locations often
require us to employ multiple lawyers in several areas just to appear in court and
take any action. As a result, some companies agree to pay all or a portion of a
* Language clarified in transcription process.
28
preference demand simply to avoid the high costs of defending against a
preference claim, which often exceeds the amount of preference liability in
controversy.
While this willingness to settle may seem to provide a greater gain for that
particular case, it is, at best, a short-term advantage. In the long term, the effect is
to reduce the availability of unsecured credit and the options available to
financially distressed customers.
As an experienced credit manager, I would like to see several changes in the
preference statute. First, there should be imposed an obligation upon the trustees
and debtors to evaluate preference claims and defenses before any demand is
made to creditors to repay an alleged preferential transfer. Also, there should be a
cost/benefit analysis required that shows that pursuing such preferences would
provide an actual benefit to the unsecured creditors of the estate above the cost to
pursue the actions, with none of the preference recoveries earmarked for secured
creditors. All too often, we discover the cost of preference recoveries earmarked
for secured creditors. Commencing the preference actions is inordinately large
when compared to the recoveries.
Third, the statute should be changed to afford more protections and defenses to
creditors, with the goal of reducing the expense of responding to preference
demands, and make the burden of proving those defenses consistent among
bankruptcy courts across the country. There should be no need to hire a thirdparty credit professional to testify about ordinary course. Instead, the testimony of
the credit manager familiar with the case and the industry should be able to testify
about industry norms and customs. If the debtor or trustee disagrees, the burden
should fall upon them to hire an expert to contest the testimony of the credit
manager. Additionally, trustees should not be able to sue just based on a review of
the check register.
Fourth, there should be further changes in the law to eliminate the need for credit
managers to travel to popular venues, often across the country, and hire several
sets of lawyers to deal with a preference demand or defend a lawsuit, especially
with regard to small demand amounts. Generally speaking, any preference claim
less than $100,000 filed in New York or Delaware is prohibitively expensive to
defend when the vendor is located in a jurisdiction like California. It is critical
that some protections be given to unsecured creditors to lower the cost of these
cases. These changes would reduce some of the uncertainty inherent in dealing
with distressed customers and perhaps reduce some of the costs of underwriting
unsecured credit, thereby assisting both unsecured vendors and their customers.
I would also like to address the concept of creditors' committees. Committees
provide a valuable service to unsecured creditors. They afford us an opportunity
to look under the tent, a way of participating in the case and obtaining
information, and a seat at the table otherwise denied to unsecured creditors. Like
anything, there will be some committees that are not as effective as others, but
* Language clarified in transcription process.
29
members generally try to look out for the greater good, and it would be a
significant loss for unsecured creditors should the role of committees be reduced
or eliminated.
I served on several creditors' committees. Because the committees were formed,
we were able to actively participate in the chapter 11 process and work to
maximize the recoveries of unsecured creditors. In one case, a liquidating chapter
11, due to the efforts of the committee, we were able to realize an 80% recovery.
There, the committee took over the marketing efforts of the property the debtor
had been unable to sell. The result was a substantial improvement over the initial
projections of payments to unsecured creditors. That experience is replayed in
courts throughout the country every single day.
Likewise, the committee is often charged with examining transactions between
the debtor and lender, the debtor and equity participants, and other related parties.
The committee frequently brings value to the case by pursuing available causes of
action against insiders. Similarly, the committee is able to review potential
preference issues and have a say on how such preference actions may be pursued
or preserved for later review.
In one particular instance, the debtor had been a member of our Industry Credit
Group, as well as a customer of my company. As a result, the unsecured creditors'
committee knew what their pattern of payments had been to other creditors during
the preference period, and for a significant period of time before the case was
even filed. The debtor's pattern of payments to vendors wavered by only a day or
two over the course of the two or three years prior to the case being filed, and
virtually all vendors were paid on the same time schedule. Due to this intimate
knowledge of the debtor's payment history, the creditors' committee was not
required to spend a great deal of time, efforts, and funds to perform an allencompassing preference claim review. In addition, because we were able to
show this pattern to the debtor, none of the vendors were sued for preference
recovery.
In contrast, however, payments made to reduce obligations incurred by the debtor
in the form of personal loans made to the debtor corporation by its principals
showed a vastly different set of circumstances. The payments made to reduce
obligations incurred by the debtor in that preference period was due to the fact
that the principals were informed by their bank that the bank no longer wanted to
be in the construction industry and lines of credit would not be renewed.
Subsequent to that comment, the debtor began to make regular substantial
payments to the principals on the insider loans. After a demand was made by the
creditors' committee, the funds were returned to the debtor's estate because the
principals were not able to prevail on any defense, including payments in the
ordinary course.
I've been involved in many discussions about participating on creditors'
committee by professionals in various industries. Each one believed that the
* Language clarified in transcription process.
30
experience was an invaluable learning tool which afforded them a deeper
understanding of the chapter 11 process and a better understanding of how to
maximize their recoveries, as well as generally providing a better outcome for
unsecured creditors in the case at hand. Unsecured creditors provide goods and
services on an unsecured basis to companies all across all industry types
throughout the United States. The importance of our contribution to the continued
improvement in the economy cannot be overstated.
In conclusion, we strongly believe that the Commission should include preference
recommendations designed to reduce the costs of underwriting unsecured credit
by changing the law applicable to preferences by making the defenses uniform,
easier, and less expensive to prove, to eliminate the need to respond to preference
demands in courts far from our primary location, and to require debtors and
trustees to review potential preference defenses and conduct a cost/benefit
analysis before making such demands. Such measures would greatly reduce the
cost and uncertainty that now exists in underwriting unsecured credit.
Thank you for your time this afternoon. I'd be happy to answer any questions the
esteemed members of the Commission may have.
Berman:
Thank you, Ms. Tomlin. As we did with the other panel, we'll go through all the
testimony before we go to questions. Who's next? Mr. Demovic?
Tom Demovic: Yes. Thank you.[*] My name is Thomas Demovic. Thank you for giving me the
opportunity to speak on this issue today. I'm currently the senior manager of the
Corporate Credit Department for Sharp Electronics Corporation. I previously held
corporate credit positions with several other consumer product companies. My
total experience in the credit sphere is 42 years. I obtained a Bachelor's degree
from Wilkes College, an MBA from Fairleigh Dickinson University. I also have
earned the designation of Certified Credit Executive, which is the highest
accreditation by NACM. I've also achieved the designation of International
Certified Credit Executive from the FCIB and graduated from the NACM's
Graduate School for Credit and Financial Management at Dartmouth College.
Sharp Electronics has been involved with numerous preference matters over the
years, and I, as part of the credit department, have worked on many of those
matters. I just want to preface that any remarks I'm making today are my own
opinions based on my years of experience and in no way do they represent an
official statement from Sharp Electronics. With that said, I'd like to focus my
remarks today on the ordinary course of business defense.
Sharp does not merely manufacture goods and sell them to the end-user. To the
contrary, most of our customers are distributors of Sharp products. This creates a
unique relationship between Sharp and its customer.
In my prior experience in industries, companies sold products usually on 30-day
terms, and if a customer didn't pay on time, it was easy to place that customer on
* Language clarified in transcription process.
31
hold or stop shipping to that customer entirely. You can't do this in a business
with distributors for a number of reasons. First, there are often distributor
agreements that require Sharp to supply specific products and to also designate a
particular customer to be an authorized dealer of Sharp merchandise. Even where
there is no formal distributor agreement, there are dealers that Sharp recognizes as
authorized through various programs which affect the way that dealer pays its
bills.
Some of these programs include rebates and discounts. More importantly, some of
the programs involve how and when merchandise can be returned to Sharp and
when a bill's payment will be delayed because of returns, claims for discounts,
charge backs, et cetera.
It is not uncommon for an invoice with 45-day terms to be paid much later
because of these types of issues. When preparing an ordinary course of business
analysis and needing to defend against a preference action, I have often had to
deal with an outsider who really has no knowledge of, and frankly, doesn't care
about, how the industry works. That outsider is merely trying to collect as much
money as possible.
Personally, I have been involved with numerous preference actions. They are not
straightforward. Our industry is unique in that there are numerous terms of sale
that are used with any one customer. In one specific case, our customer was given
30-, 45-, 60-, and 75-day terms, depending on what type of product was being
purchased and where the product was coming from. A subsequent preference
lawsuit totaled $35 million. The liquidating trustee conceded that $20 million was
for product purchased on a cash advance basis and agreed that the $20 million
would not be sought as a preference. However, the trustee believed that it has a
solid complaint for the remainder. Additionally, the lawsuit contained a demand
for $3 million in alleged receivables from Sharp due to rebates, discounts, and so
on.
I worked with our law firm and a preference analyst, and the spreadsheet that was
created showed that payments made during the year prior to the chapter 11
proceeding generally ranged from 60 to 90 days, and there were a few anomalies
of substantially later payments due to disputes or shortages. The preference period
payments really didn't change, yet there was a serious spread in the payments.
Even using not a percentage but a flat amount of days as a spread, the payments
were disparate enough that a settlement could not be reached. Therefore, using a
simple 10-day spread did not accurately portray how business was conducted.
Fortunately, separating out the invoices paid according to the invoice terms
created an interesting result. It turned out that the 30-day invoices were paid the
slowest, and we believed that to be due to the type of product which was sold
under those terms. However, the 45-day terms were paid on average within 53
days. The 60-day term invoices, which were the majority of the invoices involved,
* Language clarified in transcription process.
32
were paid on average in 83 days. The 75-day term invoices were paid on average
within 91 days.
A different calculation had to be used for each different set of terms. Effectively,
the invoices and payments were broken down into four separate categories, so
four separate sets of analyses had to be prepared in order to prove that the
hypothesis would work showing that there was a different yet ordinary average
paid dates for each different set of terms.
Ultimately, the entire lawsuit was settled by a much, much lower than initially
sought amount after about a year. An expert witness brought in by Sharp to help
defend this lawsuit cost the company thousands of dollars in fees. It had to have
cost the debtor an equal amount of money. The real question is how much, if
anything, of that sum would ever go to the unsecured creditors? It is this kind of
example that makes the current preference statute so troubling.
The debtor absolutely knew that its payments to Sharp were different because of
different terms. An accurate and complete analysis, not just of the new value, but
of the ordinary course of business should have been done before the lawsuit was
commenced. I believe, however, that the debtor was guided by counsel who saw a
$35 million opportunity and decided to move forward without determining what
the actual net realizable amount could be.
In another quite different case, Sharp was sued to recover the sum of $27,700 in
alleged preferences. It barely made any sense to pay a large legal bill to deal with
this preference. However, it could not be ignored. This debtor assumed Sharp's
executory contract upon confirmation of its plan. As such, all pre-petition
payments owed to Sharp had to be paid in full. Therefore, any pre-petition
invoices that were paid by the debtor would have to have been paid anyway due
to the assumption of the executory contract.
The litigation trustee insisted that the payments made before the executory
contract was assumed were recoverable as preferences. It was economically
unfeasible to spend a lot of money on legal fees to prove or disprove the litigation
trustee's hypothesis, and I would have spent more money running an ordinary
course of business analysis. The matter for nuisance value was settled for less
than $2,000 and was paid to the litigation trustee to do so.
Sharp had to pay thousands of dollars to defend these preference actions. I believe
it is a common occurrence for an adversary proceeding to be commenced merely
because it's believed that preference defendants will settle rather than spend time
and money defending such an action.
In my opinion, a change to the preference statute is logical. I believe it could save
bankruptcy estates and trade creditors an enormous amount of money. Before a
trustee or debtor or creditors' committee wastes time and energy in pursuing a
* Language clarified in transcription process.
33
preference from a trade creditor, that trustee, debtor, or creditors' committee
should do its homework.
A true preference analysis should be prepared to determine if, in fact, those
payments made during the preference period were not ordinary. Rather than the
onus being put on the trade credit grantor to defend against a preference, the
burden should be on the debtor or creditors' committee or trustee to determine that
the payments made were not in the ordinary course of business.
Trade creditors have suffered enough loss in bankruptcy proceedings without
having to pay back money which was paid in the normal course of business. In
my opinion, it is unfair to make the creditor prove what is ordinary. I think the
trustee, debtor, or creditors' committee bringing the action should prove that the
payments made during the 90 days prior to the bankruptcy are not ordinary.
Thank you.
Berman:
Thank you, Mr. Demovic. [*] Thank you for your patience, Ms. Venable.
Val Venable: My name is Val Venable. First off, I'd like to thank the Commission and the ABI
for this opportunity to testify on this issue of critical importance to trade creditors.
I've spent my entire professional career in credit. I am Director of Credit with
Ascend Performance Materials for over two years. Prior to that, I was with GE
Plastics and SABIC Innovative Plastics from 2000 to 2011. I received my degree
in business from Charter Oak College in Connecticut.
I am a past national chairman of NACM, and I've co-chaired the Unsecured Trade
Creditors Committee of ABI and was a member of the ABI Ethics Committee. I
also hold the Certified Credit Executive designation, and I'm a Certified Expert
Witness for Preference Matters. As such, I have been retained by or freely offered
my services to various trade creditors to assist them in defending preference
claims. I have defended over 40 preference matters for my employers. Among
those cases, there have been times when my company has had to pay nothing as a
result of my ability to prove the preference defenses, but my company has also
had to pay as much as $2.9 million to settle a preference. None of the preference
matters with which I have been involved have gone to trial.
In addition to those preference demands or lawsuits with which I had been
personally involved, I have served on more than two dozen creditors' committees,
many of which I chaired.
I strongly feel that section 547 of the Bankruptcy Code needs reform. One of the
major underlying issues is that the preference defense defined in the Code are
open to interpretation and quite frankly not even interpreted and applied the same
way within the same jurisdiction, let alone federally. Consequently, this has given
birth to an entire industry focused on extracting additional funds from the
creditors who supported the debtor while they struggled and tried to survive.
* Language clarified in transcription process.
34
The recovered funds for the most part do not benefit the debtor, or even the
creditors. The funds instead are primarily paid to those seeking the recovery. A
study by the National Bankruptcy Review Commission found that over 90% of all
preference recoveries go to pay for recovery cost. ABI's own study in the late '90s
showed that credit providers felt 75% of the time they never or rarely saw an
increase in distribution as a result of recovery preferences, and only 22% felt they
did sometimes.
Credit managers, by nature, are very analytical and we like to make calculated
decisions. The preference statute, as it stands now, is very unpredictable, and as
such, it's difficult for a credit manager to gauge if their decision to help a
distressed customer will ultimately result in a preference action against them. The
sheer magnitude of the way that credit preferences can be interpreted and applied
can make it very expensive to defend a preference. There's no fixed firm
guideline. What is permissible in one jurisdiction is not allowed in another. Even
two different bankruptcy practitioners within the same jurisdiction can have
opposing views and both be right. How then can a typical creditor defend against
a preference recovery if the rules are cloudy and inconsistent? The reality is this
actually serves to discourage a creditor from working with a debtor that might
otherwise been able to help.
The original intent of the preference recovery, equality of distribution, has been
lost. The concept of leveling the playing field, requiring those few creditors who
seemingly receive preferential payments over other like creditors should surrender
those funds back to the pool of same creditors, just isn't the reality. Instead,
generally speaking, the only parties who benefit from preference recoveries are
those professionals handling the matter.
In all of the cases I have been involved in, or any of those where I've closely
watched through the filings, I have never seen any of the trade creditor preference
recoveries going to unsecured creditors' pool for distribution. I donated my share
to that fund. Of the nearly $3 million I returned in one case, I didn't even see $3.
I sell raw material used in manufacturing, little plastic pellets that go into
anything, from underwear to carpet to tires. When a customer of mine has
financial difficulties, it's not uncommon for me to work with them to allow
additional time to pay, either as it sells my goods or on an extended repayment
plan that allows the debtor to run their business through a period of temporary
cash flow constraints. This not only helps the debtor stay alive and keep the lights
on but also allows my company to continue to build a strong business
relationship.
In all honesty, sometimes this strategy pays off, but sometimes, I just end up with
a higher balance due and opening myself up to potential preference exposure
should the debtor ultimately fail. Because of fear that payment will have to be
given back, some creditors, in order to preserve their own company's assets, will
make a business decision not to continue to sell to a troubled business rather than
* Language clarified in transcription process.
35
try and find a way to get them enough product to keep them in business. This lack
of willingness to work with the debtor may protect the creditor but also may serve
as a catalyst to eventual business failure to the debtor.
Yet, the whole time I'm working with the debtor, allowing slower payments in
order to keep the debtor in business, I have to keep weighing the potential impact
of a subsequent chapter 11 or chapter 7, where a demand for repayment will be
made to me because those payments were not ordinary. Even a formal adjustment
of terms for quantifiable valid business reasons has worked against me. When I
receive the letter asking for recovery of preference, or worse, a notice of a
complaint being filed, I'm presumed guilty until proven innocent, and to prove my
innocence is going to be costly and time-consuming, and in some cases, more
risky and more uncertain outcome than selling to the distressed debtor in the
beginning.
Trying to define "ordinary" is like trying to define "blue." There are many
different shades and interpretations. The law should be looking at intent. I totally
understand it's not black and white, but there has to be reasonableness. We have
product that takes up to a month to get cross-country by rail car. In order to
protect myself from a potential preference attack, it would require me to demand
cash in advance from a troubled customer. However, common sense tells me that
my customer can't and shouldn't have to pay us and then wait for weeks to get
their product. If they had those extra weeks of cash flow, we probably wouldn't be
discussing them being distressed in the first place.
So I ship my goods to the customer to keep them operating, I get paid as soon as
they can, and, then, up to 27 months later, I receive a preference demand to give
the money back. There is nothing in the statute that enables the concept of
intention to come into play. There is nothing in the statute that even allows the
customer to pay to their own cash flow improvements without putting those
payments at risk of being classified as potential preference. For example, if they
slow pay me during the summer months but have improved cash flow in the fall, I
have to hope they don't file chapter 11 in the winter, or those improved cash flow
and better payments opens me up for increased preference exposure.
In my experience, a big disconnect in preparing an ordinary course defense is
trying to present my data so it can be understood by a non-business-oriented
interpreter or someone not familiar with the peculiarities of my industry or billing
cycles in general. For example, not all terms are net 30 days. In some instances,
we work on something called "prox terms." Proximal means "next," so this means
that I am paid on a specific day of the next month. I could have invoices paid on
terms that are up to 30 days apart in days outstanding. If I am paid on the fifth of
the second month, I'm paid on invoices 35- to 65-days-old. In this case, for
ordinary, I evaluate the number of days beyond terms. Payment terms also
frequently are used at the end of the month as a measure, meaning payments are
due at a particular month or X days from the end of the month. Again, a simple
days-to-pay calculation will not work in an ordinary course defense.
* Language clarified in transcription process.
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Also, to add complexity to an already complex environment, if a company like
mine sells different products, it is quite possible that each product is sold at a
different term because of industry competition. I have some customers to whom I
sell three or four different products, and each product is a different term. One
definition of "ordinary" does not work in this situation. Industries that offer
seasonal data have an entirely different definition and profile of "ordinary."
I have to prove that the fluctuations, which appear out of the ordinary to the
trustee, are, in fact, ordinary in my business and in my industry. Yet, despite the
change to the statute in 2005, eliminating the three-pronged defense, I still have to
convince the trustee that my payments were ordinary and there appears to be a
fluctuation. I will ultimately need an expert to analyze the types of terms and
payments in my industry.
Alternately, if I don't immediately retain an expert to try and cause the trustee to
understand my ordinary course of business analysis, I'm barraged with requests
for more and more documentation. I've had a couple of people tell me it is in the
recovery professional's best interest to ask for all this data. Many get paid based
on a percentage of what they collect, and if they make it difficult enough for me, I
will give up the fight and accept their assessment. I view this as harassment.
So if I don't succeed in convincing the trustee to withdraw the preference demand
or action, what happens then? I have to weigh the cost of hiring an expert to prove
that my ordinary course analysis is correct, or I have to pay what amounts to
ransom, and that expert will base their opinion not just on my company history
but will attempt to analyze the industry.
Here is the rub: what industry am I in? Are you going to compare the use of
plastic pellets in the tire industry or the use of in the lingerie industry? It's all
extremely subjective and very costly trying to defend if you have to bring in an
expert witness and accountants to support your position. The trustee knows it's
going to get expensive to me to continue to defend and is counting on a monetary
settlement just to get rid of them.
Even the calculation of new value defense can be problematic. We can spend
hours arguing the paid/unpaid argument, let alone shipments that may or may not
qualify for [section] 503(b)(9). Suffice to say there is no consistency in the
interpretation or enforcement of the rule.
While a new value defense on paper looks like the easiest thing to prove, I've had
attorneys or firms for recovery go so far as to ask me to provide the time stamp of
the exact time truck left the facility versus the exact time the check hit the bank,
totally abusive requests. Was this really new value if they left at 9 AM with the
truck and the check wasn't deposited until 10 AM? I'm told this is not new value.
The truck would never have been allowed to leave our facility if we did not have a
check in hand. Yet, I've lost on that one. Nine times out of 10, the personnel at the
loading dock doesn't time stamp it immediately or even have time stamps right
* Language clarified in transcription process.
37
there. To be more efficient, they often process shipping tickets in batches at
various times of the day, or potentially even once a day. Is it fair for me to give up
my preference defense because of this?
This stringent interpretation would require us to give up the efficiencies of batch
processing or hire additional resources to process each shipment one at a time. Do
I have to go to the dock and interview people who stamped the check to determine
what time the process in the receipt was really made?
A customer, in order to maintain cash flow, needs to get product that goes directly
into a machine that's ready to process it. Although it started with some of the
larger manufacturers in the automotive and aerospace industries, now, more and
more of the smaller manufacturers are using just-in-time inventory processes. To
wait until their check is in the bank to release their shipment could cause their
material to be delayed to the point their lines are shut down or machines sit idle.
Neither condition is beneficial, especially to an already distressed debtor.
This customer may always pay me on Friday but now needs the product by
Thursday. If I refuse to deliver until payment comes in, the customer could lose
time, perhaps a whole production week, or worse, lose their customer.
On top of all of this is the timing for bringing a preference action. The Code
stipulates that the action would be brought within two years of the date of filing
with certain exceptions. Within that two years, some companies change
computers or accounting systems, lose records, see people who have first-hand
knowledge of the collection practices, leave the company, or their memories fade.
In a case like Delphi, where the preference actions were filed under seal and only
disclosed to the creditors a year or more later, the ability to recreate accurate data
becomes even more difficult and expensive. This, coupled with the backwards,
guilty-until-proven-innocent approach, puts an undue burden on the creditor.
I am a firm believer that an active creditors' committee brings value to the estate
and is helpful in bringing a more efficient resolution to the case. I see a strong
correlation between the lack of an active creditors' committee and an increase in
unjustifiable attempts at recovery of purported potential preferences. By having a
debtor's business practices vetted by the committee, they can usually work with
their finance professionals to help identify the truly extraordinary payments to
insiders or creditors. This is far more cost effective than the shotgun approach that
targets everyone in the 90-day ledger and requires extra work and cost to all.
I can only speak from my experience, but in the many cases where there has not
been due diligence on the part of the recovery agent or proper regard for ordinary,
they have typically been cases without an active creditors' committee. The
business professionals who voluntarily serve on creditors' committee bring the
voice of reason and reasonableness to the process. They help direct the recovery
effort in areas where there truly may be potential preferential payments because
* Language clarified in transcription process.
38
they are more likely to understand the debtors' business and industries. Without
the creditors' committee pursing the right decisions, we have businesses out there
shotgunning it and trying to collect money.
I have served on at least one committee where the committee, upon a thorough
analysis, decided not to pursue those preferences, essentially deciding not to beat
up on the creditors. In one case, the committee looked at a data dump of payments
sent out in 90 days and found approximately 200 different recipients. Upon
examining the information, everything looked pretty normal. Perhaps one or two
guys got paid slightly different from the rest, but those payments were
insignificant and could have been due to negotiated terms. The committee was
quickly able to determine that the cost to investigate would have been exceeded
by any potential recovery. To hire a preference recovery firm to go through the
debtor's records and attempt to recover all 200 payments, the estate would have
spent far more than it could have ever hoped to recover.
Because the committee is made up of business professionals who had a working
knowledge of the debtor's business, they are frequently able to spot some
abnormalities with respect to related entities that warrant a second look. This has
resulted in a fairly substantial recovery from insider transfers, in my experience.
I believe the creditors' committee brings strong business sense and the realization
when the costs are not going to be recovered based on what you're going to find.
Simply put, those on a good committee are more likely to truly understand the
debtor's business. In that instance, the creditors' committee becomes an asset, and
the unsecured creditors who've already lost their money don't have to spend more
to defend against any additional unnecessary claw back and have the assets at the
debtor's estate wasted on unnecessary fishing expeditions.
In one case with an active committee, we were able to market some of the debtor's
patents and intellectual property to bring a sizable recovery to the estate. I served
on another where, in our review of the secured lender's documents, we were able
to determine they were not properly filed, resulting in millions that would have
gone directly to the secured lender instead divided up amongst the entire
unsecured creditor body. Had we not found that error, there would have been no
distribution to the unsecured creditors' committee. Committees do add significant
benefit to the process.
The tremendous amount of expense involved in pursuing and fighting preference
actions, attorneys, temporary workers to go through bills of lading pulling time
stamp times, getting an expert to testify, writing checks for nuisance value, are
among the many factors that drain an already deficient pot during a bankruptcy.
The preference statute should be changed so that the pursuer of the preference
recovery, be it the trustee, the committee, or the debtor, should first prove that the
payments were not in the ordinary course of business and new value was not
given by the creditor. Shift the paradigm from guilty until proven innocent to
* Language clarified in transcription process.
39
putting the burden of proof on the party bringing the action in the preference
recovery. This would limit the amount of needless and baseless preference actions
that are commenced. Preference recoveries would be sought only after a true and
realistic analysis has been performed. Most importantly, the trade creditors who
already lost money to the debtor will not be compelled to spend more time and
more money on these claims.
Again, I thank you for your time and consideration, and I look forward to
answering any questions you have for me today.
Berman:
Thank you, Ms. Venable, and thank you for all the witnesses' testimony. Before I
open it up to questions from the other commissioners, I want to make sure that
there's precaution in all of this because there are a lot of people, many up here,
who have served as trustees. I've served as a post-confirmation trustee. Not
everybody is taking a check register and filing a lawsuit. I realize that that appears
to be an abuse to the system, but you need to be careful, I think, that we don't
create or suggest that a remedy be created for that abuse.
There are rules. Bankruptcy sits in federal court. Rule 9011 of the Bankruptcy
Rules applies to lawyers who sign pleadings that aren't justified. But saying that a
trustee is just taking a check register and filing lawsuits is not typically accurate.
Yes, there are firms and people who do that, I understand, and those may be the
exceptions and cause of this whole reaction, but that's not how everybody does it.
I had served in a case years ago where there were 125,000 lines of activity in the
90-day period before the bankruptcy was filed. The post-confirmation estate was
unaffected five weeks before the deadline to file the claims. There was almost no
ability to analyze that information and make any decision, and so lawsuits were
filed because there was no way to tow the statute of limitations. That doesn't mean
it's right, but those are the facts.
I can tell you, in that case, with over 700 lawsuits filed, none, zero went to trial.
Two were out on summary judgment. Everything else was settled or dismissed.
Again, I want to make the caution here that while there are people that create the
havoc that you all are concerned about, it's not everybody.
With that, let me open up to question, if I can, to any of you on the testifying
panel. Mr. Demovic, you talked about it, Ms. Venable, you talked about it, selling
on different terms within the same claim. Where that's the case, how do you
expect a debtor or a trustee to know what is in fact ordinary within your own
sales? You want to shift the burden of proof to the trustee to know what's ordinary
when you've got four or five different sets of terms. Now how is that doing
anything other than trying to be a bar to bringing a claim?
Venable:
Like I said in my testimony, some of it is changing how we look at things. Instead
of looking at the number of days outstanding from the invoice date, looking at the
number of days past due. If I sell to one customer three different terms, 30 days,
* Language clarified in transcription process.
40
60 days, and 90 days, even though my payments may reflect 35, 65, and 95,
they're paying me consistently five days past terms, I think that's a good substitute
versus looking at average days of pay.
To your point, for somebody who isn't in industry, that's not the first way they
look at it, but that's part of what we try and explain when we do an ordinary
course, is have them look at it through a new light.
Berman:
So the recommendation really is to change the basis of the defense to the days
past due, not the days from invoice?
Venable:
Absolutely. That would be very helpful.
Nathan:
Can I follow up with Geoff's question? If we were to do that and we were to
create some sort of presumption the transaction is ordinary, do you have any
thoughts, for any of you, as to whether a number of days past due would be, say,
par?
Tomlin:
I think you have to look at what the industry terms are. For the food industry, it's
extremely short terms because it's perishable commodity, so if they have 10-day
terms, is five days past due a lot or not? If it's the construction industry where
maybe they're getting progress payments in 60 days, five days is miniscule.
What some credit practitioners have discussed is perhaps using a benchmark of
twice whatever terms are. If you have 10-day terms, 20 would be ordinary. If you
had 30-day terms, 60 might be ordinary. I'm not saying that twice should be the
actual number. Maybe it's one and a half times, but they would be standard, and
you could apply that metric against all industries.
Berman:
Remember that years prior to the enactment of the Code, the concept was x
number of days past invoice statement. It was automatically deemed the
preference. California, it was a 45-day rule, and the dating didn't matter. I think
you have to be very careful even with the number of days past due concept that
any safe harbor is going to run into the same problem. How do you define what is
or isn't appropriate? Then you're going to get into the subjective of, "our industry
is x number of days" and who has that information?
Venable:
I can tell you that in some of the defense analyses I've done in looking at just
exactly that, I've looked at a whole section of a portfolio, for example, in the auto
sector or whatever, and come up with a standard deviation for that and set it,
whether it's seven days, 10 days, 30 days, whatever, and apply that standard
deviation and see anything that falls outside of it, just like the bell curve, is not
ordinary.
Berman:
OK. But how do you codify that into a statute versus having that be a defense that
you can prove that this industry has a standard deviation of 10 days? Ninety
percent of the payments fall within the standard deviation. Those should therefore
be ordinary. Ms. Williamson?
* Language clarified in transcription process.
41
Williamson:
My question was more two-pronged again. [*] The first question is I've heard
several of you say recovery should not go to secured creditors, and I'm looking for
clarification. Are you saying that recovery should not go to the pre-petition
secured creditors or recovery should not go to the dip providers, or does it make a
difference?
Venable:
I've been in cases where before the unsecured creditors' committee was even
formed, all preferences had already been assigned to the pre-petition secured
lender in order to get dip financing, so they had vested interest in breaking the
unsecured to get more money, and there was nothing back to it. My understanding
was the intent of the original Code would be to put it back in the same class from
which it came from. Again, if we go after the unsecured creditors, let it go back
into that pool and be divided equally. That goes back to the equity of distribution.
Tomlin:
What we find is that a credit manager, a company, is penalized for doing their job,
and they may have been very diligent and are penalized by the preference action
when they've really done a good job all along. Then what happens is if it's given
back to the estate, it goes to the secured creditors rather than the pool of everyone
sitting there who has nothing. So we'd like to see it go back to the unsecured
creditors, at least share pro rate our own class of credit.
Williamson:
As a follow up, my second part of that is what about the section 503(b)(9) factors?
Are you saying that it should go to truly the general unsecured creditors or should
it go to unsecured creditors that then hold administrative claims?
Venable:
In my experience, generally, [section] 503(b)(9) creditors also have an unsecured
debt also, so they too would benefit. But looking at [section] 503(b)(9) as an [*]
administrative claim, I would think it would go back into distribution, and so at
the end of the day, when we're dividing up the pool, the class of unsecured
[creditors] should go to recovery of unsecured [claims].
Williamson:
Thank you. In case we forget, because we're asking some questions that maybe
were not included in your statements, we reiterate what Geoff said earlier, we
welcome written statements. If you want to provide, or if anyone wants to
provides additional written statements particularly to the questions that we've
raised, we welcome them, and so keep that also in mind.
Nathan:
But just to clarify, Ms. Venable, if payments go back into the estate, are you
saying it should go to all administrative creditors of [section] 503(b)(9) class?
Venable:
No, I'm saying they should go to class. If they're recoveries from the unsecured
class, they should go back to any distribution to the unsecured class.
Berman:
Again, but which unsecured? Are you including 503(b)(9) creditors as unsecured?
Are we including priority wage and tax claims, or are we talking general
unsecured creditor?
* Language clarified in transcription process.
42
Venable:
If [demands are] recovered from general unsecured creditors, then they would go
back to general unsecured creditors. That's my opinion.
Hedberg:
Can I ask one extra question on the premise of what you're suggesting? Especially
if a dip lender post-petition is extending credit post-petition that’s allowing the
debtor to operate post-petition and presumably funding goods and services
delivered post-petition, and that position deteriorates, as post-petition it often does
empirically, they would just get in worse condition over time maybe results in
liquidation or something like that. They've been setting credit post-petition. Under
your theory, it would not participate in any preference recovery at all even though
they funded the debtor post-petition because they happened to extend credit at the
wrong time, wrong place?
Venable:
In my experience, a lot of times, the secured lender also has a portion of
unsecured debt, so they would recover from it that way. But for post-petition debt
they extend, again, this is my own personal opinion, they're going into it with
their eyes wide open. They're extending new debt to an already distressed debtor.
Hedberg:
But the protections for that as they're taking post-petition lien on preference
recovery and taking a super priority claim in administrative case, so they'd get
those recoveries, is you're carving that out. You're basically saying you're going in
with your eyes open. You don't get access to any of those recoveries. A secondary
benefit may be less incentive to pursue certain claims [*] that may result from it.
[*] There may be fallouts from it, but I'm just trying to balance the relative rights
of certain involuntary post-petition conduct versus the pre-petition conduct that
arise in a potential recovery.
Venable:
Like I said, unfortunately, sometimes all of this is decided before the committee is
formed. What I'd like to propose is if there is going to be an assignment
preferences, it be done after committees form so that the committee can have a
voice and perhaps negotiate some sort of carve-outs.
Berman:
Mr. Markus?
Markus:
Thanks. I have a couple of follow-up … by the way, thanks for your very
insightful views on these issues. I really want to focus on this notion of, that there
seems to be this idea of Geoff as a liquidating trustee or I as a Chapter 11 trustee
somehow need to make this subjective evaluation. Good trustees try to use the
hand that they have available, but sometimes, there is not a lot. What type of
evaluation are you proposing do you want to see being made before a trustee files
an action? Is it just a letter that says, "We've identified these payments that seem
extraordinary. Please explain why," or do you want more than that?
Venable:
First of all, some of my comments are directed more at some of the preference
recovery firms that are little more than bill collectors [*]. I've seen letters, demand
letters for recovery preference made out for petty cash, so that tells me that
somebody didn't quite look thoroughly. Is it possible to look at inventory record
* Language clarified in transcription process.
43
and say, "Gee, I got brought into this company about the same time I'm paying"
and use some of that? I don't know if it's more for work by the trustee, but
essentially, especially some of these recovery firms that are incentivized on
payments for the pound of flesh they can extract. [*]
An example, I had one that, in addition to the time the check was received, I'm
trying to prove ordinary course, and their stance was I've harassed the debtor into
paying me because I have an automated system that, four days past due, would
contact the debtor. Every four days, we contact the debtor. Their stance was that
other customers in some industry I wasn't contacting at four days past due every
four days. This was when they went past due, so why would I contact them if they
weren't past due, and I lost on that because I wasn't contacting a non-delinquent
debtor every four days like I was with delinquent debtor.
I think there has to be some reasonable method. Again, I think a lot of my
comments are directed more towards some of these for-profit recovery firms than
the trustees who, to your point, have limited resources, but certainly, there are
firms that can run some of these numbers through checking inventory records and
payments record and see if there's some sort of correlation.
Markus:
One thing I have not seen anybody make comment on, which was surprising, is
the notion of a prevailing party standard on fee shifting. That is, a hold-up firm,
you're not using your words but I use it, you called it being the target of a hold-up.
Wouldn't that be a disincentive for a hold-up to take me to trials if there was a
shift in fees for those truly egregious hold-ups, not Rule 11, but they sued you for
$30 million and recovered one?
Venable:
That's a double-edged sword. I've already gambled on the debtor. I don't need to
gamble again on should I lose the preference and have to pay my preference and
their fees as well or a portion of their fees. It shifts a lot of the legal system as far
as recovering. I do think though, in my own personal opinion, there should be
some governing body or some supervision over some sort of sanction if they do
bring frivolous and not necessarily suits to the point of filing a suit, possibly a
complaint, or some of these demands. There should be somewhere where we can
go to appeal possibly to a trustee or something and say, "This is unreasonable.
They need to stop." But I don't think saying that now we have to roll the dice and
gamble and have to pay additional not only my preference recovery but then also
additional fees.
Tomlin:
I'd like to add to your question as to which party, where do you go to determine
what ordinary course is. If that is brought to the creditors' committee, assuming
that one is formed, and the preference demands are not made prior to creation of a
creditors' committee that oftentimes, it can go to that committee who is very
familiar with the industry and/or the debtor who can determine and give a basis to
the trustee of the creditors makes you determine what ordinary course might be,
and then they are the ones who would perform that due diligence to look at the
cost/benefit analysis.
* Language clarified in transcription process.
44
Williamson:
A question, and maybe this might be an appropriate venue, I'm told, with how we
struggle with burdens coming forward. I'd ask you to consider what it were if the
trustee or the claims have had the burden to come forward with a lack of ordinary
course, a lack of value or burden of proof that all the time is on the recipient of
the payment. Just like we do with solvency, with the burden to come forward, and
lack solvency, lies with the recipient, but the burden of proof is all the time on
claim. It's just an idea.
Demovic:
One point I'd like to bring up deals with Mr. Markus' point about communicating.
Let me just go back because I've been doing this a while. Maybe a number of
years ago, you could contact and you could take the chance of talking to
somebody, and then you resolve these issues. Now, with the scope of the size of
all these claims involved, I can't put my company at risk by taking the burden on
myself and making a wrong decision or making some technical error in dealing
with a suit or an action by the trustee. I have got to take action by using an
attorney, a professional in that field, an expert to protect the company. It just puts
me at risk personally and puts my company at risk as well. It would be nice if you
could just talk to somebody, and maybe it's pie in the sky, and say, "Yeah, let's
just work this out and let's just move on."
Berman:
Again, I can't state it often enough, it's who you're dealing with. I understand
when you're dealing with the firms that specialize in this and you're trying to get
through to somebody and you get to some first-year person who hasn’t got a clue
what you're talking about. That's not true for everybody who does this. There is
still something to be said about the old-fashioned way of reaching out and talking
to people. It's understood. But if they're not doing it, then you got to do what you
got to do.
I started many, many years ago, as Robin Schauseil knows, I started at the NACM
system in 1980 at the largest affiliate out in southern California. This hasn't
changed any. U.S. credit managers have a greater opportunity to gather the
information as soon as you get the notice of a bankruptcy than anybody is going
to have this, that you get the notice of a bankruptcy, go pool your records so that
if and when you get that preference demand, you're not going back and recreating
your record sheet. I've been on that soapbox for over 30 years, and most people
look at me like I'm talking Greek when I say it.
Tomlin:
I'd like to speak a little bit of a different language, not quite agree, but it's true that
as soon as a bankruptcy is filed, we do have the immediate records, but we only
have our immediate records, and we don't have the debtor's records, and we don't
know how they're paying other creditors.
Berman:
But the Code changed with BAPCPA so that the ordinary course defense didn't go
from having to prove both as between the debtor and the creditor and in the
industry. If all you have to prove is that it was ordinary between you and the
debtor, you've got that.
* Language clarified in transcription process.
45
Tomlin:
That's true.
Berman:
Mr. Brandt?
Tomlin:
But the debtor does as well. They know how they paid you. They know what the
invoice terms were and how they conducted their business.
Demovic:
To your point, we do that. As soon as something happens, we have to start
gathering all information specifically to protect ourselves down the road. It's not
just in looking at our payment records altogether. It's all the other documentation
as well. It goes to the point where we have to do it every time, and as a point was
mentioned from other people, you only have limited resources within the
company to be able to do these things, so unfortunately, you have to do it when
you have to do it. But my point being that if there is some way, and I don't know
exactly how we would do it, but a system for some of this work upfront, it would
be helpful.
Brandt:
Picking up from my comments, my thought about this hasn't changed any. One of
the things that I've been dealing with is the search for an equilibrium. I'm not
stuck in the Code anymore. When we began talking about preferences, we began
talking about the '80s and '90s. But unsecured credit was the novelty, if you will,
that got most of this into the bankruptcy arena. Now, I will agree, preferences
seem to be an anachronism largely done now for the benefit of secured lenders
and to fund their cases. I start from the premise that I'm not sure that preferences,
at least to non-insiders, should exist anymore, which is a rather striking position
to take from the outside. But in spending my time in the Senate and House staff
side, I would tell you that there are two courts that Americans see more than any
other courts. First, there's traffic court, and the second is bankruptcy court. In
terms of bankruptcy court in the parlance of traffic court, preferences of "see the
movie" motion that we always see, for those of you who haven't been to traffic
court, that got out, "see the movie" is a term of art for one of the punishments that
may be meted out by one of the judges. [*]
I'm not sure that preferences that run for the benefit of secured lenders make any
sense anymore. I think the preferences run for the benefit in equal steering of
unsecured creditors 20 years ago did make sense, but like everything else, the
equilibrium needs to be reset. I am troubled immeasurably by the issue of the cost
to defend. One of the thoughts I had in doing this was with tribunals spread
around the country perhaps run by the U.S. Trustees Office or even the NACM on
an administrative basis where if you were sued in Delaware and you're in
California, the matter is heard as an administrative matter by the NACM in
California, and the trustee has to come out and do it, if we're still talking about
keeping some kind of preferences. If you had that kind of tribunal system, where
you no longer had it in bankruptcy court so have no need to hire a lawyer but have
them focus on some kind of legal tribunal system, would that be something at
least that might preserve, in your mind, the ability to have preferences in the
Code?
* Language clarified in transcription process.
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Williamson:
And on a related issue, because we do have newcomers, we said at the very
beginning that there is an integrated system, if indeed, taking Bill's idea, that there
was no preferences for non-insiders or non-non-insider preferences for 90 days,
what would that do to the dip market? We don't know. But certainly, we may have
the ability, the resources to actually do an analysis of that or gather some data
because some courts will not even do an analysis and some do. How does that
impact the ability of dip financing because no one wants to take away the
potential benefit and kill the customer. But when we're looking at solutions, we
also need to see, if we can, gather information that would help us see how it fits.
Brandt:
It does trouble us that collateral for a dip loan is preferences. I'm at the position
where maybe they shouldn't be either assignable or assailable. As others have
suggested, that if there is a distribution, a rising of preferences, should they stay in
the Code, maybe we go with the unsecured credits not for the benefit of both the
secured and unsecured. But your position on some of that? I'm moving yes
Berman:
Unequivocal yes?
Venable:
Like I've said, I strongly feel that the recovery should go back to the class from
which they came.
Brandt:
Will the NACM be willing to establish a series of tribunals or work with a group
that did where these matters were heard locally? So if it's a Delaware case and
you’re in in San Bernardino, it’s heard in San Bernardino?
[*]
Hedberg:
Just really to follow up on the law of unintended consequences here on a couple
of fronts, I'm just curious and wondering back to the option of eliminating
preferences altogether for non-insider claims. There is a prophylactic purpose for
the preference statute outside of bankruptcy that gets lost in that. It stops a run on
the debtor that puts the debtor out of business prematurely and kills with it the
trade creditor as well as the debtor. That's a little disconcerting. A lot of
compositions with creditors, you deliberately make lump-sum payments to the
entire creditor class the best you can so that as you work the thing out, you got a
minimum 90-day preference where normal people are going to sit on their hands
and enter discussions with you on a longer term workout, which again preserves
the benefit for the body. I just want to make sure that …
Brandt:
When was the last time you did a composition?
Hedberg:
I did a composi- … well, let's see. Back when I was practicing all those months
ago, I did a composition of creditors probably four years ago, five years ago
inside of a case.
Brandt:
And they are now where because of the nature of secured lending.
* Language clarified in transcription process.
47
Hedberg:
Though I would submit that they and receiverships are coming back especially
because of [section] 503(b)(9). You're seeing more and more receiverships
because people try to avoid the [section] 503(b)(9) indications. I think you're
seeing more potential compositions and more receiverships out there as a result.
But yeah, they're still fairly rare.
Berman:
With that, I'm going to have to intercede because I'm being told we're up against
the deadline. On behalf of the ABI, of which I serve as a chair this year, and the
Commission to Study the Reform of Chapter 11, I want to thank everyone who
testified today. I want to thank everyone who sat in the audience and participated
here. This had been very helpful and very enlightening. With that, this field
hearing is adjourned.
* Language clarified in transcription process.
48