What do Preference Complaints, Claw Backs and Fishing Nets in Bankruptcy Have in Common?

By John J. Scura II

Let's take a look at an issue that frightens creditors: preference claims!

Assume that during the 90-day period prior to filing for bankruptcy, a debtor made payments to certain creditors. The trustee or the debtor's representative can review those transfers of funds to determine whether those transfers were preferential payments to the creditors. The question is whether the debtor doled out money to preferred creditors just before going broke. If so, the trustee or the debtor's representative can file an adversary complaint in the bankruptcy court to recover any such preference. Lately, that effort has become known as a "claw back" because the plaintiff bringing the action, i.e. the trustee or the debtor's representative, is attempting to force the return of those payments to the bankruptcy estate. Recently, I heard a bankruptcy judge analogize those actions by a trustee to throwing out fishing nets to see what the trustee can land - maybe not a fair description of the trustee's efforts, but like the claw back, it certainly is descriptive.

For example, a company in financial difficulty wants to keep the business operating and in the process has made payments to certain creditors to keep them happy and keep them supplying goods. But, things didn't work out and the company had no choice but to file for bankruptcy. The trustee or the debtor's representative then reviews the history of the company's payments made during the 90 days prior to the filing, determines the identity of the creditors paid during that period, and sends letters to those creditors threatening to sue them, thus, throwing out the fishing nets. Some creditors receiving those letters assume that they have no defense because why would the trustee threaten them if there were no valid claim? Many creditors decide not to pay attorneys' fees and instead settle with the trustee. I know this to be true because during the past 35 years of my bankruptcy practice, I have appeared on both sides of the argument. What creditors don't realize is that the Bankruptcy Code contains several very effective and valid defenses that can be used to stop the trustee's action.

What are those defenses to a claw back? A common defense is that the suspect payments were made in the ordinary course of the dealings between the debtor and the creditor who was paid as a vendor of supplies or services. If the parties had a history, which is not uncommon, with the creditor receiving payment on outstanding invoices on a 30-day basis, this history neatly fits into the category of being a payment in the ordinary course of business, and a valid defense under the preference statute 11 U.S.C. Section 547 (c).

Another defense to a claw back is called "new value", which means that after the payment was made, the creditor sold the debtor more materials on credit or performed more services. The net result would be that if the trustee was to pursue that payment because it was in the 90 days, the creditor could defeat the trustee. There are several other defenses provided for under the Bankruptcy Code and, in addition, there are legal procedural issues that can be successfully raised.

A procedural defense to a claw back action has its roots in a 2007 decision by the United States Supreme Court regarding the sufficiency of complaints filed by plaintiffs. Federal Civil Procedure requires a plaintiff in his complaint to allege facts with particularity, and a plaintiff's obligation to provide the grounds for his entitlement to relief "requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do". See Bell Atlantic Corp. v.Twombly, 550 U. S. 544, 555 (2007). The elements of a valid recognized cause of action (like a preference action) must be detailed in the complaint. In the words of the Supreme Court, civil complaints must contain "more than an unadorned, the-defendant-unlawfully-harmed-me accusation". Ashcroft v. Iqbal, 556 U.S. 662, 1295 S.Ct. 1934, 1949 (2009).

The Court of Appeals for the Third Circuit has taken the pleading issue one step further and instructed federal courts to determine whether the plaintiff's factual allegations in the complaint nudge the plaintiff's claims "across the line from conceivable to plausible". See Fowler v.UPMC Shadyside, 578 F.3d 203, 210-11 (3rd. Cir. 2009).

In applying the Third Circuit's analysis, in the United States Bankruptcy Court for the District of Delaware, judges are examining the sufficiency of claw back complaints in preference actions to determine whether the complaints satisfy the Third Circuit's standard and, where appropriate, are dismissing the complaints. The Hon. Mary F. Walrath dismissed a complaint because "it set forth only conclusory allegations parroting the statutory language of section 547". See Geller v. Lenick Co., 2011 WL 2669113, at *1(Bankr. Del. July 6, 2011). In Claybrooks v. Beer Growth Capital Partners LLC, 2011 WL 2607090, at *1 (Bankr. D. Del. June30, 2011), the same judge dismissed the complaint against one of the defendants because the plaintiff trustee did not identify who had received the preferential payment. In another action, the Hon. Brendan Shannon dismissed a complaint on the grounds that plaintiffs did not allege the facts showing that there was an antecedent debt. See Charys Liquidating Trust v. Hades Advisors LLC (In re Charys Holding Company Inc., 2010 WL 2788152, at *5 (Bankr. D.Del. July 14, 2010).

In summary, creditors should not be intimidated by the trustee's claw backs and instead should consider hiring an attorney to advise them on bankruptcy code defenses that may be raised as well as any procedural defenses to the complaint.

Finally, many bankruptcy cases are filed in the State of Delaware. The distance and unfamiliarity with Delaware courts can also scare creditors into settling rather than hiring unknown Delaware counsel. For years, my firm has had a relationship with Delaware local counsel and we are able to negotiate fair settlements with trustees because we have a representation system in place. If we think there is a valid defense, we will fight for the client, and go to trial if necessary. We can go to the wall fighting because our relationship with Delaware local counsel permits us to prepare the legal work necessary right from our New Jersey offices. If the case has to be tried, we are appointed by special order of the court in Delaware to try the case in Delaware. What the public doesn't realize is that trustees in bigger cases hire essentially glorified collection agencies on a contingency basis to pursue creditors and lean on them to settle. Over the years, our firm has had a lot of success in dealing with these kind of agencies. We understand the issues. We can be a tremendous help in stopping fishing nets and claw backs.