AMPAD Decision Affects Trustee’s Ability to Avoid Preferences

October 09, 2007 Commercial Lending Review

A distressed company can find itself in a Chapter 7 bankruptcy liquidation in one of three ways. First, the company can file a Chapter 7 bankruptcy petition, which is very rare. Second, the company may file for Chapter 11 but the reorganization fails and is then converted to a Chapter 7 liquidation. Third, the company may file for Chapter 11 and sell substantially all of its assets. Then, the Chapter 11 is converted to a Chapter 7 case. Recently, the third way has been the most prevalent in corporate bankruptcies. After a case is converted to Chapter 7, a trustee is appointed and has the duty to liquidate any remaining assets for the benefit of the company’s creditors and distribute the proceeds to the company’s creditors, according to the priorities set forth in the U.S. Bankruptcy Code (“Code”).

By and large, the most valuable asset of a company in Chapter 7 consists of certain causes of action provided by the Code. These causes of action include avoidance and recovery of preferential transfers, which are typically payments made by the company to creditors preceding bankruptcy that “prefer” these creditors in some way, such as being out of the ordinary course of business. The policy behind such actions is to promote equality of distribution among creditors and to dissuade creditors from pressuring a company to pay outstanding debts when the company is in a distressed situation. However, as with most statutory causes of action, Section 546 of the Code provides a two-year statute of limitations period under which a debtor-in-possession (DIP) or Chapter 7 trustee is restricted as to pursuit of avoidance actions. This time period can be extended by one year if certain requirements are met, which are particularly applicable in cases that are converted from Chapter 11 to Chapter 7.

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