Creditors Must All Be Sung The Same Tune

Earlier this year, we did a blog on the Gibson Guitar bankruptcy. It’s a case we’ve been following closely because it is a high-profile version of a type of case we frequently work on ourselves – a Chapter 11, business reorganization bankruptcy. A recent article in the Wall Street Journal provides yet another peek into the case with a focus on an issue that comes up in almost every business bankruptcy – the pre-filing treatment of creditors.

The guitar company’s creditors are reportedly investigating whether certain lenders were favored in the months leading up to the bankruptcy filing. For example, a loan from Elavon Financial Services DAC, U.K. Branch was swiftly paid down from $60 million to $24 million in the months leading up to the bankruptcy filing.

Businesses that are struggling to stay out of bankruptcy, and those that suspect they will soon be forced to file, often think it is a good idea to pay off small debts so it looks like they have fewer creditors, or to focus on paying down larger debts to keep those lenders happy. But treating some creditors better than others in the months before filing for bankruptcy is a no-no.

If a filer prefers one creditor to others, that creditor might have to give back the money they were paid by the debtor and see it instead distributed to all the creditors.   

The Bankruptcy Code defines a preferential payment as:

  1. Any transfer by the debtor;
  2. Made to or for the benefit of a creditor;
  3. To pay back a debt which was owed by the debtor before the transfer was made;
  4. Made while the debtor is insolvent;
  5. Within 90 days prior to the date the bankruptcy case was filed, or within 1 year for “insiders”;
  6. That enables the creditor to receive more than it would have received in a Chapter 7 liquidation.

This is a very broad definition, so it is common for all of a bankruptcy filer’s creditors to receive a letter alerting them that funds they have been paid are being clawed back. Creditors should not hesitate to fight these demands.

Creditors can often keep the money they were paid or at least reach a settlement allowing them to keep a portion of the payment if they can show that they have a valid defense to a claim of preferential treatment.

The most common defense is that the payment was made for a contemporaneous exchange of goods. Prime examples of contemporaneous exchanges involve cash-on-delivery (COD) payments for equipment or inventory the debtor is using to run their business.

It may also be possible to show that the payment was made in the ordinary course of business, and was therefore not preferential but typical. This is a heavily litigated defense, but one that should not be dismissed just because there are few bright lines rules governing what is done in the ordinary course of business.

Our firm regularly helps creditors defend against all sorts of preference claims.