Recent Changes to Bankruptcy Code Give Trade Creditors Some Important Rights

Recent Changes to Bankruptcy Code Give Trade Creditors Some Important Rights

By Shannon Raye Martinez

No creditor likes to hear the word “bankruptcy.” It is likewise disheartening to hear that a customer filed bankruptcy when you have been supplying goods to that customer for years and the customer has not paid for several large recent shipments. If you have ever delivered goods or inventory to another business on credit (meaning the payment was not due upon receipt of the goods), then you are a trade creditor. Most creditors equate bankruptcy with immediate headache and a slim chance of recovering any money. In addition, in some unfortunate cases, bankruptcy can mean you actually end up paying back some money you already received. Fortunately, some recent changes to the bankruptcy code may help change your feelings about bankruptcy.

President Bush recently signed into law the extensive Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“Bankruptcy Act”), which dramatically changes bankruptcy law for businesses, including trade creditors. This article highlights some of the major changes affecting trade creditor’s rights to preferential transfer defenses and reclamation rights.

The Bankruptcy Act becomes law on October 17, 2005, and applies to all cases pending or commenced on or after that date. However, a few sections of the Bankruptcy Act are effective as of April 20, 2005. As the effective date of the Bankruptcy Act approaches, look for future articles discussing other critical changes contained in the Bankruptcy Act.


A preferential transfer lawsuit (“Adversary Proceeding”) is an unwelcome and potentially devastating claim after a customer has partially or fully paid a large account payable and then filed bankruptcy. Section 547(b) of the existing Bankruptcy Code allows a trustee or debtor in possession to file an adversary proceeding and recover “preferential” payments made to creditors. A payment is considered a “preferential” payment if it was made: (1) to or for the benefit of a creditor, (2) for or on account of an antecedent debt owed by the debtor before such transfer was made, (3) made while the debtor was insolvent, (4) made on or within 90 days before the date of the filing of the bankruptcy petition, and (5) that enables such creditor to receive more than such creditor would receive in bankruptcy if the transfer had not been made. Each of these requirements has been litigated extensively and there are steps a trade creditor can take now to protect themselves from these claims.

For example, under the prior bankruptcy code, one of several defenses known as the “ordinary course of business” defense helped to limit a trustee or debtor in possession’s powers to avoid potential preferential transfers. The defense provides that a trustee is not allowed to avoid the transfer if the payment was (1) the payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, (2) made in the ordinary course of business or financial affairs of the debtor and the transferee, and (3) made according to ordinary business terms. While the ordinary course of business defense is helpful, it is difficult for a trade creditor to affirmatively satisfy all three elements of the defense.

The new Bankruptcy Act broadens the scope of the ordinary course of business defense, and now requires that the creditor prove just one of the three requirements explained above. Say, for example, a creditor supplies inventory to a debtor on credit. The inventory is shipped on the 1st of every month, with an invoice stating that payment is due in 30 days. The creditor has been supplying this inventory to the debtor for several years, and the debtor has faithfully paid each invoice in 30 days. Assume that this scenario is customary in the creditor and debtor’s business. The debtor then finds that it does not have enough money to pay its bills, and has fallen behind on its payments to creditor. Debtor’s bill is now 120 days past due, but the creditor continues to ship the goods. In the following month, Debtor gets enough money to pay creditor and pays off the entire bill. However, debtor hasn’t paid any of his other creditors and his business is doing worse. Debtor decides to file bankruptcy just one month after he paid the trade creditor in full.

Under the prior bankruptcy code, the creditor would not be able to meet the requirements of the ordinary course of business defense and retain the full payment. The creditor would only be able to retain the most recent payment received for goods shipped in the last 30 days. The creditor would not qualify for the defense because the debtor always paid within 30 days, and a majority of the payment was made well after the 30 days. The creditor would, therefore, not be able to prove all three requirements of the defense for the entire payment.

However, under the new law, there is the possibility that the creditor may prove the first requirement that the payment was on account of “debt incurred in the ordinary course of business.” In our scenario, if the creditor continued to ship the goods and bill the debtor despite the outstanding account, as he had done before, then he may be able to argue that the debt was incurred in the ordinary course of business, and the defense would apply. This is a simple example and the outcome will ultimately depend on how the courts interpret and apply the new statute and other relevant law.

This change may prove to have considerable advantages to trade creditors who extend credit to its customers and will require trade creditors to evaluate prior credit practices adopted to combat preferential transfer concerns.


In addition, the Bankruptcy Act significantly strengthens a trade creditor’s reclamation rights. A reclamation right allows a trade creditor to reclaim goods, under state law, shipped to the debtor while it was insolvent. Under the prior bankruptcy code, a creditor could only reclaim the goods if he or she made written demand in writing before 10 days after receipt by the debtor (or 20 days if the 10-day deadline expired after the date of the debtor’s filing of bankruptcy).

Additionally, the court has discretion to deny reclamation to a creditor, and instead grant the creditor an administrative expense claim or grant a security interest to the creditor to secure its claim for payment of the goods.

The Bankruptcy Act extends the time period for a creditor to reclaim the goods to no later than 45 days after receipt of the goods by the debtor (or 20 days if the 45-day period expires after the date that the debtor filed for bankruptcy). Consequently, if a customer receives a large shipment within 45 days of filing bankruptcy and is still in possession of the goods, the Bankruptcy Act will allow a trade creditor to “reclaim” those goods from the bankrupt customer.

The old bankruptcy code also allowed the court to deny a reclamation claim by a trade creditor and instead provide that creditor with a priority administrative expense claim against the bankruptcy estate. In essence, the court could allow the bankrupt customer to sell the trade creditor’s goods and offer them the future potential of getting paid out of the bankrupt customers assets. While an administrative expense claim is entitled to priority over other unsecured creditors there is never a guarantee of payment, and a significant delay could occur before payment is received by the trade creditor.

Fortunately, the Bankruptcy Act offers new protections. First, the Bankruptcy Act will allow a trade creditor who fails to provide notice within the required time to file an administrative expense claim for the value of the goods. The Bankruptcy Act may also affect the courts power to substitute goods for an administrative expense claim; however, changes to the courts’ substitution power under the Bankruptcy Act are not entirely clear. It will be interesting to see how the courts resolve the conflicting language in the Bankruptcy Act.

These few changes are but a small portion of the significant changes that the Bankruptcy Act will have for businesses. As the effective date of the legislation approaches, changes to past practices designed to address insolvency and payment concerns should be evaluated to guarantee that the additional benefits provided for in the Bankruptcy Act are fully taken advantage of by creditors.

If you have any questions about this article, or the new Bankruptcy Act, please call either Shannon Raye Martinez or Erich Paetsch.