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Journal

The (Bankruptcy) Trustee Cometh

January 04, 2011 BY Gary Beelen

     The primary function of a bankruptcy Trustee is to marshal the assets of a bankrupt debtor’s estate to pay the creditors of the bankrupt debtor.  This function is generally accomplished by identifying assets of the estate, negating debts, and/or by avoiding prior transfers improperly made to creditors via lawsuits within the bankruptcy known as Adversary Proceedings.  In such proceedings, the Trustee may initiate suit against a person or entity to recover payments made to such person or company up to two (2) years prior to the debtor/customer’s bankruptcy filing.  Pursuant to 11 U.S.C. §547,  a Trustee may “reach back” to “Preferential Transfers” made 90 days before the filing of the bankruptcy petition, and pursuant to 11 U.S.C. §548, the Trustee may reach back up to two (2) years prior to the filing of the petition for “Fraudulent Conveyances.” 

            Though the fundamental goal of recovering assets improperly paid to one creditor to the detriment of other creditors is laudable, the process also engenders certain abuses.  Bankruptcy laws and rules are structured to afford the Trustee substantial flexibility in the performance of his/her duties, and provide few obstacles to prevent the Trustee from initiating Adversary Proceedings against all persons or entities who received payments from the bankrupt debtor, regardless of legitimacy of such payments, in the two (2) years immediately preceding the filing without even alleging, let alone proving, that such person of entity did anything wrong.   Since Trustees are, at least in part, usually compensated by a percentage of assets recovered in such actions, there is substantial incentive to recover assets by what some may consider legitimized extortion, i.e. filing “shot gun” Adversary Proceedings for the sole purpose of leveraging settlement through the threat of prolonged and expensive litigation. 

            Simply put, any money you receive from a failing customer in the two (2) years prior to the date your customer files for bankruptcy is subject to avoidance, i.e. disgorgement, for up to one (1) year after a Trustee is appointed or two (2) years after the customer files its bankruptcy petition. (11 U.S.C. §546). 

            Generally, a defendant must be sued in the jurisdiction where he/she resides or where the business entity is registered.  In an Adversary Proceeding, however, the Trustee may initiate the lawsuit in the state where the bankruptcy petition was filed.  Therefore, if your customer is a Delaware corporation, you may very well find yourself as a defendant in the U.S. Bankruptcy Court for the District of Delaware.

            Under the normal rules of civil procedure, both state and federal, service of process must be made via the sheriff or a process server upon an officer or registered agent of a company.  As such, it is fairly difficult to not know that you have been named in a lawsuit.  Under the bankruptcy rules, however, service of process may be made by simply mailing a copy of the Complaint to any officer, agent or other person authorized to receive service at your place of business by first class mail postage prepaid. (Fed. R. Bankrp. P. 7004).  In light of the foregoing, it is possible that you have been named as a defendant in an adversary proceeding in the U.S. Bankruptcy Court for the District of Delaware  and don’t even know it. 

            Rule 8 of the Fed. R. Civ. P. requires that a Complaint provide a “short and plain statement of the claim showing that the pleader is entitled to relief.”  The United State Supreme Court has determined this to mean that a formulaic recitation of the elements of a cause of action will not do, and a complaint must set out ‘sufficient factual matter’ to show that the claim is facially plausible in order to avoid being dismissed. Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007); Ashcroft v. Iqbal, 2009 U.S. Lexis 3472 (2009).  In the bankruptcy arena, however, even the rulings of the U. S. Supreme Court may be liberally construed in favor of the Trustee.  In many states, most notably Delaware, there are a limited number of persons authorized to act as Trustees, and even fewer to handle complex/major bankruptcies.  Accordingly, there is a certain familiarity that may develop over the years between a Court and the Trustees regularly appointed in that jurisdiction, where the defendant/creditor is the “visiting team” and the Trustee, who has established a reputation with the Court, receives professional deference with respect to the sufficiency of his/her pleadings.  As a practical matter, this means that even though the Trustee files a formulaic recitation of the elements of a §547 Preferential Transfer claim or a §548 Fraudulent Conveyance claim without any, or minimal, factual support 365 days after being appointed, it will be an uphill battle to convince the Court that the pleadings are so deficient as to require prompt dismissal.

            To add insult to injury, many insurance policies exclude coverage for defense costs/claims where there is no allegation of wrong doing against the insured.  In Adversary Proceedings alleging §547 Preferential Transfer or §548 Fraudulent Conveyance claims, the allegation of wrongdoing is against the debtor/customer, not the creditor, i.e. since the debtor/customer impermissibly elected to pay you ahead of its other creditors, the Trustee is authorized to recover those funds from you to satisfy the other creditors in order of priority. Furthermore, depending upon whether a policy of insurance is a “coverage” or “claims made” policy, it is possible that any coverage that may have at one time existed no longer exists because the policy of insurance lapsed between the time of the customer’s payment to you and the date you receive notice of the claims. 

            Once you receive notice that you have been named as a defendant (possibly in an out-of-state bankruptcy court) without having been accused of any wrongdoing, and without insurance coverage to fund your defense costs, the looming issue becomes how to most promptly and economically extricate yourself from this morass.  One strategy is to “come out swinging,” file a motion to dismiss, and press discovery to expose the Trustee’s lack of factual support for the claims alleged.  Though such a strategy may take the wind out of an under-funded Trustee’s sails, it can also be quite expensive and/or motivate the Trustee to focus more on this proceeding than it otherwise intended.  The flip-side of the foregoing strategy is the “rope-a-dope,” i.e. simply wait for the Trustee to have to “make its case” and expend the finite resources of the bankrupt estate.  This strategy is certainly more economical than the foregoing, but it also permits the Trustee more time to fully evaluate a severely flawed case that may have been haphazardly prepared immediately prior to the expiration of the statute of limitations.  It is important to consider, in either case, that the Trustee, though initially holding all the cards, operates on a finite and limited budget, and ultimately has the burden of proving the claims alleged in the Complaint.  Because the Trustee’s compensation is in part based upon the amount recovered, he/she has an incentive to maintain the action for as long as possible with the least expenditure of resources as possible while simultaneously forcing you to incur substantial defense costs.  In doing so, you will be compelled to consider prolonged and expensive litigation to defend your right to retain legitimate payments made by the debtor/customer, or alternatively, to enter into a monetary settlement with the Trustee for cents on the dollar to promptly (relatively speaking) dispose of the case. 

            Though it is virtually impossible to insulate yourself from avoidance claims initiated by a Trustee in an Adversary Proceeding associated with a customer’s bankruptcy, multiple defenses are available to defeat such claims.  The Trustee cannot prevail on such claims if the customer was not insolvent at the time of the payments, the customer’s debts arose in the ordinary course of business, new value was contemporaneously exchanged for payments received, or payments were made in exchange for reasonably equivalent value. Therefore, it is important to keep detailed and accurate records of your financial dealings with, and closely monitor the financial condition of, those with whom you conduct business, especially when they appear to be in financial distress. 

The Journal is a publication for the clients of Drew Eckl & Farnham, LLP. It is written in a general format and is not intended to be legal advice to any specific circumstance. Legal Opinions may vary when based upon subtle factual differences. All rights reserved. 

Editorial Board:

H. Michael Bagley
(Editor-in-chief)