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Last RightsLiquidating a Company$

Ben S. Branch, Hugh M. Ray, and Robin Russell

Print publication date: 2007

Print ISBN-13: 9780195306989

Published to Oxford Scholarship Online: May 2007

DOI: 10.1093/acprof:oso/9780195306989.001.0001

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(p.223) Appendix 6 Evaluation of Preference Payment Claims

(p.223) Appendix 6 Evaluation of Preference Payment Claims

Source:
Last Rights
Publisher:
Oxford University Press

The bankruptcy liquidator's duties involve assessment of the debtor's preference claims. In general every payment made by the debtor during the 90‐day preference period prior to the bankruptcy filing is considered a preference payment that is subject to certain defenses. The three primary defenses include: (i) new value provided by the vendor to the debtor after the alleged preferential payments for which the vendor was not paid that offsets the amount of these payments; (ii) the payment was made in the ordinary course of business; and (iii) the transaction was a contemporaneous exchange or otherwise not a payment on account of antecedent debt. The liquidator and/or accounting staff must analyze each of these payments and determine whether suit should be brought. The initial assessment of potential preference claims should be approached systematically.

The first step is to identify all payments made by the debtor during the 90‐day preference period from the debtor's accounts payable disbursement records. Payees can be grouped into certain categories in order to exclude payments made to employees, bankruptcy‐related professionals, government agencies and taxing authorities, and vendors whose contracts were assumed in bankruptcy.

Second, calculate new‐value amounts and subtract these offset amounts against the preference‐period payments. This represents the maximum net preference recovery, (i.e., total payments minus new‐value offsets), before any payments are excluded for ordinary‐course‐of‐business defenses.

Third, perform an ordinary‐course‐of‐business analysis. Payments which were clearly made in the ordinary‐course‐of‐business should be completely eliminated from the maximum net preference value.

Where ordinary course status is less certain, potential recovery percentages should be assigned based on an estimate of the strength of the ordinary course of (p.224) business defense. For example, vendors with preference‐period payment patterns generally consistent with prepreference period patterns are estimated to have a stronger defense, thus yielding lower estimated recovery percentages. Vendors with less consistent patterns are estimated to have weaker defenses and thus higher estimated recovery percentages. These recovery percentages are then applied to the lesser of the maximum net preference value or high case ordinary‐course value to calculate an estimated range of preference payment recoveries.

This preliminary analysis reflects the impact of various potential defenses to a preference action, but it obviously does not predict the possible outcome of preference actions. Defenses in addition to those whose impacts are estimated above may be raised.

Data Gathering

Electronic data can be extracted from the debtor's information system and organized into four sets: (i) payment information, (ii) payment invoice detail, (iii) unpaid invoices, and (iv) vendor information.

The payment‐information data set includes the payment detail for payments made within the approximate 12‐month period prior to the petition date. This information is used in determining preference‐period payments as well as determining the trends and assumptions used in estimating potential new‐value and ordinary‐course‐of‐business defenses.

The payment‐invoice data specify exactly which invoices were paid with each payment. These data are used in the analysis to estimate new value and ordinary‐course‐of‐business defenses.

The unpaid‐invoices data set includes all of the invoices that remained unpaid as of the petition date. This data set is used to facilitate the compilation of the new‐value information required to estimate new‐value defenses. The invoice detail associated with the payment detail discussed above includes the invoice history of a vendor except for those invoices that were not paid. Therefore, this data set completes the invoice activity for each vendor during the approximate 12‐month period prior to the petition date.

Finally, the vendor information data set contains general information associated with each vendor such as vendor names, vendor numbers and types.

Analysis

Typically, the debtor's payment information contains the disbursement date (payment dates) regardless of the date such payments actually cleared the respective bank accounts (clearing dates). The clearing date is a key fact required to (p.225) establish which payments were made during the 90‐day preference period. Accordingly, payment‐information records must be updated to include clearing dates based on information obtained from bank accounts utilized by the debtor during the 12‐month period. Some disbursements may have never cleared a bank account. Unrecorded disbursements may be identified in bank statements. These differences result from several causes, including the existence of certain transactions that are processed directly to the general ledger rather than through the accounts payable and disbursements ledger. Investigation of these items with debtor's management is necessary, so that they can be updated to represent the actual disbursement history based on clearing dates.

Often, open credit memos and invoices in a debtor's books and records are recorded as offsetting transactions, one a debit or series of debits, and the other a credit or a series of credits. This type of situation occurs when a debtor adjusts its accounts payable records to correct errors and record accounting adjustments. These open credit memos and invoices net to $0.00. Since, however, the credit memos and invoices have different dates in the system, they can affect the preference calculation. A systematic process of matching credit memos and invoices must be performed to eliminate from the preference calculation the open credit memos and invoices that net to $0.00. This adjustment is necessary in order to eliminate accounting adjustments and isolate the true economic substance of each transaction.

Vendors should be excluded from the preference analysis if the vendor's contract(s) were either already assumed or the debtor plans on assuming the contract(s) at confirmation. It is possible that these vendors received payments for goods and/or services not related to these contracts. However, unless the effort has been taken to match invoices and payments to specific contracts, all invoices and payments made to these vendors should be excluded from the preference analysis. Also, vendors holding cash collateral at the petition date, vendors holding letters of credit at the petition date, and vendors holding reclamation claims typically have additional defenses not considered in the new‐value or ordinary‐course calculations.

New‐Value Analysis Amount

The new‐value analysis is the maximum difference between the amounts paid and the amounts shipped per vendor within the preference period. This analysis is performed by developing a list of total payments by day (based on check clearing date) and the total amount invoiced per day (based on invoice date). The maximum positive difference between the amounts paid and the amounts invoiced is considered to be the maximum amount of the net preference claim, which is also subject to further reduction based on the ordinary‐course‐of‐business defenses.

(p.226)

Appendix Table 6.1

Days Prior to Petition Date

Payments ($)

Shipments

Pay to Ship Per Day Difference

Maximum Net Preference

90

100

(100)

75

100

100

100

70

100

100

200

60

100

100

300

45

200

(200)

100

40

300

(300)

30

500

500

500

20

500

100

400

900

1,300

700

600

*Number in thousands.

To serve as “new value,” new products or services must be delivered subsequent to a preference payment; otherwise it is not new value. In other words, if a vendor provided goods or services two days prior to a preference payment, this would not qualify as new value as it occurred prior to the payment. The date in which the maximum difference between the amounts paid and the amounts invoiced is identified for purposes of determining the preference payments net of new value offsets. Appendix table 6.1 is designed to illustrate this point.

The maximum net preference from the table is $900,000. Although the total difference between the amounts paid and amounts shipped during the entire preference period was only $600,000, some of these shipments did not qualify as subsequent new value. The maximum net preference amount of $900,000 results from $1,000,000 of payments and $100,000 of shipments in the last 30 days prior to the petition date. All other activity in the preceding 60 days is not considered, because new‐value shipments had offset payments prior to this point in time. To understand this new value concept fully, consider the following:

  1.  The shipment made 90 days prior to the petition date arrived before any payments were made during the preference period and, therefore, had no effect on the maximum net preference. This is value that was provided by the vendor, but it arose prior to any payments, and it was not subsequent new value.

  2.  The next three transactions are all payments within the preference period that increase the maximum net preference. Therefore, a $300,000 maximum net preference amount exists 60 days prior to the petition date.

  3.  The $200,000 shipment made 45 days prior to the petition date reduces the maximum net preference amount from $300,000 to $100,000 and qualifies entirely as a new‐value reduction.

  4.  The $300,000 shipment made 40 days prior to the petition date reduces the maximum net preference from $100,000 to $0. Therefore, only $100,000 (p.227) of this shipment qualifies as subsequent new value. The other $200,000 of shipments has no impact on the preference calculation.

  5.  The $500,000 payment made 30 days prior to the petition date increases the maximum net preference from $0 to $500,000.

  6.  The $400,000 difference between the $500,000 payment and the $100,000 shipment made 20 days prior to the petition date increases the maximum preference from $400,000 to $900,000.

As illustrated in the example, the maximum net preference amount for each vendor represents the largest dollar difference between the amounts paid and the amounts shipped between a certain date within the 90‐day preference period and the petition date.

Ordinary‐Course Analysis Value

Three primary analyses can be performed as ordinary‐course‐of‐business tests: (i) scattergrams, (ii) a weighted average comparison, and (iii) standard deviation. A scattergram analysis compares the number of days between the invoice date and payment date for the historical period and the preference period (see Appendix table 6.2). As can be seen from this example, the historical payments were made anywhere from 19 to 41 days after the invoice date, while all of the payments during the preference period were made more than 41 days after the invoice date. Note that this example depicts a clear difference between historic‐period and preference‐period payments. Data indicates the payments made during the preference period were made outside of the ordinary course of business, as the payment timing was different from historical patterns. Payment patterns related to a debtor's vendors are generally wider and more sporadic, thus making an ordinary course of business more difficult.

Appendix Table 6.2

Preference

Preference Period

Days to Clear

Paid Inv Count

Paid Inv ($)

Paid Inv Count

Paid Inv ($)

19

16

1,440

21

1

1,305

24

21

1,800

26

1

1,350

27

1

1,215

30

1

2,430

36

1

720

41

2

4,230

49

1

2,025

52

1

945

69

1

95,990

>90

1

1,350

44

14,490

4

100,310

(p.228) The weighted average number of days to pay during the historical nine‐month period should be calculated based on the number of days between invoice date and payment date, with the average weighted by the invoice amounts. For example, if it took 100 days to pay an invoice in the amount of $100,000 and 50 days to pay an invoice in the amount of $10, the weighted average would approximate 100 days, as the $100,000 invoice would impact the weighted average substantially (10,000 times) more than the $10 invoice.

Based on the weighted average days to pay comparison, a standard deviation calculation can be performed to identify those historical weighted averages that have a large deviation. A large standard deviation indicates that the historical‐payment timing was sporadic. Therefore, no ordinary‐course‐of‐business pattern exists.

A specified range of days can then be identified as ordinary‐course payment timing for each vendor, based on a review of the results of these analyses, particularly the scattergrams. Payments made within the specified range should be considered payments made in the ordinary course of business. Payments outside this range less new value represent the estimate of the high end of the recoverable amounts. Payments that were made prior to invoice date (prepayments) or on the same date as the invoice date (cash on delivery) should also be excluded. These payments are not payments made on account of antecedent debt, which is a necessary condition for establishing a preference payment claim.

A review of the payment history is necessary in order to determine how to treat wire payments made to vendors. Vendors should be separated into two groups: (i) vendors with wire payments treated as the normal method of payment and (ii) vendors with wire payments treated as preference payments. Vendors with wire payments treated as the normal method of payment have a consistent history of wire payments before and during the preference period. Wire payments (and invoices paid by these payments) for these vendors should be eliminated from the estimated recoverable amount, if the wire payment was made in the ordinary course of business, based on the payment history for that vendor. A wire payment to be classified as preference will exhibit a change in the method of payment from checks to wires just preceding or during the preference period.

Appendix Table 6.3

Estimated Recovery Percentages

Grade Criteria

Grade

Low %

High %

A

40%

60%

Completely different timing differences

B

20%

40%

Significant timing differences

C

5%

20%

Slight to moderate timing differences

D

0%

5%

No to slight timing differences

(p.229) Such wire payments for these vendors should be considered a preference payment, regardless of whether the wire payment was made in the ordinary course of business.

Conclusion

In summary, the high case ordinary‐course analysis results in a total potential preference payment amount calculated as follows: amount of total payments less new value and less payments that have been treated as payments made in the ordinary course of business or were contemporaneous exchange payments. Recovery estimates can be based on a grading system used in connection with reviewing the ordinary‐course patterns for each vendor. Grades can be assigned to each vendor based on a manual review of the vendors. Appendix table 6.3 presents a possible grading system, the percentage recovery range per grade, and general criteria used for assigning each grade.

Obviously, these recovery percentages must be assigned without the benefit of testimony and documents that might be gathered in a more in‐depth analysis. Such an analysis might yield a more meaningful estimate the value of preference claims. Upon assigning a grade to each vendor, the recovery percentages can be applied to calculate the low and high case preference recovery estimates for each vendor. Questions as to collectibility can further reduce these estimates.