Suppliers are very unhappy when they receive a demand from a bankruptcy estate to repay a preferential transfer. Here’s the scenario. A supplier sells to a customer who pays, but slowly. Then the customer files for Chapter 11 bankruptcy. The customer’s creditors’ committee is demanding that the supplier pay back the money it received from the customer during the 90 days before bankruptcy or else the committee is going to sue to get it back. How can this be when the supplier did nothing wrong and was paid for goods or services it supplied? This brief post won’t make the supplier happy, but it explains the rationale for the preference law.

We often think of bankruptcy as a debtor’s remedy, a way for insolvent companies to get protection from creditors. But the truth is that bankruptcy also protects creditors from each other. For example, once a company goes into bankruptcy all creditors are automatically stayed from taking collection action. One reason for the automatic stay of collection efforts is to prevent the piecemeal liquidation of the debtor, and to facilitate creditors’ sharing of the debtor’s assets and future income.

One purpose of the bankruptcy law is to treat creditors who are similarly situated the same in terms of the percentage that each recovers on its claims. So if there are $1 million dollars of unsecured nonpriority claims, and there are $100,000 of assets after paying secured and priority claims, each unsecured nonpriority creditor would get 10% of its claim paid.

The preference law is designed to answer the question, “As of what date should we look at what creditors are owed to determine how bankruptcy estate assets and future income are shared among the creditors?” One obvious choice is the date the debtor files for bankruptcy. For some purposes the bankruptcy filing date is precisely the choice Congress made. For example, claims are determined as of the bankruptcy petition date.

But choosing the petition date has some problems. If we use the bankruptcy petition date for all purposes, then creditors who are aggressive in the months leading up to the bankruptcy filing get rewarded, because they get more than those who were lenient and worked more cooperatively with the debtor. If you imagine 2 suppliers owed equal amounts of money, the aggressive creditor will be owed less on the bankruptcy petition date than the lenient creditor because the aggressive creditor collected more and maybe sold less to the debtor during the 90 days before bankruptcy.

Think of it this way: the aggressive creditor receives 100-cent dollars in the 90 days before bankruptcy, while the lenient creditor almost always is paid less than 100-cents on the dollar – often far less – and, as a result of the bankruptcy process, has to wait a long time to be paid.

To solve the problem of the disparity between the aggressive and lenient creditor, Congress created the preference statute (11 U.S.C. § 547). The purpose of the preference statute is to make it possible to determine the sharing of the debtor’s assets and future income as of 90 days before the bankruptcy petition date. The hope is that the preference law discourages suppliers from hounding a debtor into bankruptcy.

Under the preference law, a creditor who receives a preferential transfer must pay back what it received in the 90 days before bankruptcy, and then add that amount to the claim it files for what it is owed by the debtor. So, instead of collecting 100 cents on the dollar during the 90 days before bankruptcy, the supplier returns to the bankruptcy estate the 100-cent dollars it collected, and receives the same percentage on those dollars that all the other creditors receive.

Why make the determination as of 90 days before bankruptcy? Why not 100 days or 60 days? Under the Bankruptcy Act of 1898, the look-back period was 120 days. Congress shortened the preference period to 90 days when it passed the Bankruptcy Reform Act of 1978. The answer is that 90 days is arbitrary, but that is what the law has been since 1978.

There, didn’t that make you feel better? I thought not!

In August, the U. S. Court of Appeals for the 9th Circuit ruled that criminal restitution payments made during the preference period can be avoided and recovered under the Bankruptcy Code’s preference statute, 11 U.S. C. § 547. State Compensation Insurance Fund v. Zamora (In re Silverman), 616 F.3d 1001 (9th Cir. 2010).

Recall that a preference is a payment made by a bankruptcy debtor on or within the 90 days of the bankruptcy filing, to or for the benefit of a creditor, for or on account of an antecedent debt, that enabled the creditor to recover more than it would have recovered at liquidation, made while the debtor is insolvent. Preferential payments are avoidable in bankruptcy. 11 U.S.C. § 547(b). “Avoidable” is bankruptcy-speak for “Pay it back, and get in line with all the other creditors!”

In the Zamora case, a workers’ compensation insurer received payments of $101,531 in criminal restitution payments about 1 month before the debtors filed for bankruptcy. The debtors had pleaded guilty to a scheme that prevented workers from obtaining their workers’ compensation benefits (not nice!).

The insurer argued that there is a judicially created exception to treating the payment of a criminal restitution obligation as an avoidable preference, citing Kelly v. Robinson, 479 U.S. 36 (1986). In Kelly, the Supreme Court held that there is a clear, judicially created exception to discharge, which makes state court criminal restitution obligations nondischargeable. In the Zamora case, however, the 9th Circuit held that there is no clear, judicially created exception to applying the preference statute to criminal restitution payments.

Keep in mind what is really at stake in this type of case. If the insurer had prevailed, it would have walked away with $101,531, the debtors would have owed $101,531 less to the insurer, and the remaining creditors would have received none of the $101,531. Under the 9th Circuit’s holding, the insurer shares the $101,531 with the other creditors, and, because its claim is not dischargeable in the bankruptcy case, it is permitted to recover its remaining debt from assets acquired by the debtors after they file for bankruptcy.

The 9th Circuit got this case right. The debtors emerge with a large nondischargeable debt, so one has to wonder why they did not wait 91 days to file for bankruptcy. If they had waited, the payment would not have been avoidable as a preference. As they say, timing is everything.

When I was in law school, the late Professor Nathan Levy, who taught bankruptcy and secured transactions at UConn, said over and over again, in his Vicksburg, Mississippi Southern drawl, “Read on, Mr. Shaiken, read on.” A Third Circuit Court of Appeals decision illustrates the value of reading on.

In 1991, Exide Technologies sold its industrial battery business to what is now EnerSys for $135 million. The sale included an exclusive, perpetual, royalty-free license to use the name “Exide” in the industrial battery business. After the sale, EnerSys used the Exide name in the industrial battery business and Exide used it in other businesses. Almost 10 years later, when Exide wanted back into industrial batteries in North America, it bought GNB Industrial Battery Company. So Exide was selling batteries again, but could not call them Exide.

In 2002, Exide filed for Chapter 11 bankruptcy, and filed a motion under 11 U.S.C. § 365 to reject the licensing agreement. Under § 365, if a contract is “executory,” the Chapter 11 debtor-in-possession can move to reject the contract. Of course, EnerSys, having paid a lot of money in 1991 for the Exide name, and having spent 11 years building up the Exide brand, objected to the motion. The Bankruptcy Court granted the motion to reject the licensing agreement, and the District Court affirmed.

The Third Circuit Court of Appeals reversed, holding that Exide could not reject the agreement. The Court reasoned that EnerSys owed very little performance to Exide, and therefore the contract did not meet the definition of “executory.” The phrase “executory contract” is not defined in the Bankruptcy Code, so the Court relied on earlier cases that had adopted the Countryman definition: “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing performance of the other.”

The Court then applied New York law (because the parties had agreed that New York law would govern the contract) and held that because EnerSys had substantially performed all of its obligations under the contract, the contract was not executory, and therefore could not be rejected under § 365. In particular, the Court held that under New York law the Court must balance the performance rendered by EnerSys, i.e., the payment of $135 million and EnerSys’s compliance with the Licensing Agreement for more than 10 years, against any performance remaining due by EnerSys to Exide. The Third Circuit concluded that EnerSys’s performance already rendered outweighed any performance it owed under the agreement.

So the first lesson is don’t be too quick to concede that a contract is executory. The Exide case illustrates that not all contracts are subject to rejection under § 365.

Judge Ambro wrote a concurring opinion, and this is where reading on, in this case to the concurrence, really pays off. (Thanks to Nathan for a lifelong lesson in reading on). In Exide, the Bankruptcy and District Courts had written that Exide’s rejection of the Licensing Agreement meant that EnerSys could no longer use the Exide trademark. Judge Ambro wrote separately to express his disagreement with the lower courts’ ruling on the effect of rejecting a trademark license agreement.

In 1985, the Fourth Circuit Court of Appeals held that a debtor-licensor’s rejection in bankruptcy of a technology license meant that the licensee could no longer use the licensed technology. Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F. 2d 1043 (4th Cir. 1985), cert. denied, 475 U.S. 1057 (1986). This is exactly the conclusion reached by the Bankruptcy and District Courts in Exide. In response to Lubrizol, Congress added a new subsection (n) to § 365, which provides that, upon rejection of an “intellectual property” license, the licensee has the option of (a) treating the contract as terminated, or (b) retaining its rights under the contract (including the right to exclusivity if the contract is exclusive) through the end of the term of the contract. Under § 365(n), the licensee may retain its use of the “intellectual property,” but cannot enforce any obligations other than exclusivity that are owed to it by the debtor-licensor. Why have I put “intellectual property” in quotes? Read on.

The problem is that Congress defined “intellectual property” in Bankruptcy Code § 101 as a trade secret; invention, process, design, or plant protected by patent law; patent application; plant variety; copyrighted work; and mask work protected under copyright law as a semiconductor chip product. Trademark is conspicuously missing from this definition. If a trademark is not “intellectual property,” then the protections of § 365(n) do not apply, and therefore, upon rejection, a trademark licensee would have no right to continue to use the trademark, just as one would expect under Lubrizol.

This is where reading on to concurring opinions gets really interesting. Judge Ambro noted that in the legislative history to § 365(n), Congress stated that dealing with trademarks and service marks is complicated and would require further study. Instead of delaying the passage of § 365(n) in order to determine what the rule should be for trademarks, Congress decided to “allow the development of equitable treatment of this situation by bankruptcy courts.” S. Rep. No. 100-505.

Judge Ambro cited the legislative history and held that the omission of trademarks from the Bankruptcy Code definition of intellectual property did not mean that Congress intended that upon rejection of a trademark license agreement the licensee automatically loses its rights. Instead, Judge Ambro wrote, Congress punted this issue to the courts.

On the receiving end of this punt, Judge Ambro cited a number of authorities that argue that rejection does not terminate a contract. Indeed, the Bankruptcy Code does not say that rejection equals termination. Rather, Judge Ambro argued, rejection is simply an abandonment of the bankruptcy estate’s rights in the contract, so that the estate is no longer burdened by it. The abandonment idea does not necessarily imply that the non-debtor party has lost its benefits under the contract, other than those benefits that would burden the bankruptcy estate, such as payment by the debtor. So, Judge Ambro concluded, courts should use their equitable powers to relieve debtor-licensors of the burdensome aspects of trademark licensing agreements, short of permitting the debtor-licensor to “take back trademark rights it bargained away.”

In the absence of a convincing argument why trademark licensees should get a worse deal than other intellectual property licensees, I think Judge Ambro has it right. Here are my questions for discussion:

1. What makes trademark and service mark licenses more complicated than those licenses, such as patent licenses, already protected by § 365(n)?
2. What obligations would a trademark licensor typically have to a licensee that would be burdensome, beyond exclusivity? (Recall that exclusivity is protected under § 365(n).)
3. Should Congress make amendments to § 365(n) to deal with trademarks and service marks, to make clear what a licensee’s rights are following rejection of a license agreement?

Certiorari is pending so the Supreme Court might have a say on this important issue.

See In re Exide Technologies, 607 F.3d 957 (3rd Cir. 2010), cert. pending.

In June, the U.S. Supreme Court ruled that bankruptcy judges have discretion to adjust a debtor’s projected disposable income (“PDI”) based on known or virtually certain changes in his income and expenses at the time of the plan confirmation hearing. The Court rejected a mechanical approach to determining PDI. Hamilton v. Lanning, 78 USLW 4518 (June 7, 2010).

When Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, it sought in various respects to curtail bankruptcy judges’ discretion in consumer bankruptcy cases. The Hamilton decision restores some of that discretion, and that is good news for debtors and creditors alike.

In some cases Hamilton gives creditors an opportunity to litigate the PDI calculation at the confirmation hearing with a view to increasing a debtor’s plan payments. This hand is to be played carefully, however, because unless the debtor fails the means test, the law permits the debtor to dismiss a chapter 13 case or convert it to chapter 7 liquidation at any time. So, if creditors are going to get more than liquidation value through the plan, they may not wish to push so hard that the debtor converts to chapter 7, where creditors are limited to liquidation value of assets and future income is sheltered from creditors’ claims. If the chapter 7 option is unavailable because the debtor fails the means test, then creditors may wish to be more aggressive about the PDI calculation.