Scrutinize your preference settlement: are you giving up your replacement claim?(Credit Column)

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

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

A. The Bankruptcy Preference Law

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

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

B. Replacement claim Under The Bankruptcy Code

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