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Publication Category: Creditors' Rights

Lessors and Bankruptcy: A New Look at Critical Vendor Payments in Chapter 11 Cases

Robert S. Bernstein, Esquire
Kirk B. Burkley
Bernstein-Burkley, P.C.

This article appeared in LJN’s Equipment Leasing Newsletter , June 2003.
An earlier version appeared in the July 2002 issue of Equipment Leasing Today.

Obtaining the authority to make Critical Vendor payments in Chapter 11 Bankruptcy is becoming more “critical” than ever in the early stages of a bankruptcy case. Bankruptcy proceedings are supposed to be fair and reasonably predictable. However, the fair and predictable system of who gets what and in what order is becoming a lot less clear due to recent high profile cases involving Critical Vendor payments in Chapter 11.

Critical Vendor payments fall under the Necessity of Payment Doctrine, also referred to as the Rule of Necessity, which basically says that because rehabilitating a struggling business is the fundamental purpose of Chapter 11, the courts can look first at which creditors are essential to the bankrupt’s business. These “Critical” creditors get paid first to avoid a disruption in service, while creditors with greater or equal priority interest just have to wait in line and hope that there is something left over after the Critical Vendors are paid.

Similarly, whether, and to what extent, a lessor will receive delinquent payments and/or will have the lease terminated by the debtor often depends on whether the lease arrangement is considered important to the reorganization process. An understanding of the bankruptcy process can make the difference between losing out completely in a bankruptcy or at least being treated fairly during the proceedings.

The rules governing bankruptcy can be complicated, especially business reorganizations under Chapter 11, but there are some easily understood basics. Among them is the Bankruptcy Code’s preference for grouping similar creditors together and paying the members of the group fairly as compared with each other. The general scheme of distribution under the Bankruptcy Code has secured creditors getting the value of their collateral, then the expenses of administering the case are paid, then unsecured claims with priority (like those for back taxes or wages, for example) must be paid. Next, if there is anything left over, the general, unsecured creditors share that amount on a pro rata basis until paid in full. Finally, and only after all other creditors have been paid do equity holders get paid.

The general scheme of distribution and the Critical Vendor payment scenario was played out recently in the well-publicized bankruptcy of the retail giant Kmart. On the very day Kmart’s Chapter 11 petition was filed, it sought and received, as part of its “first day orders,” authority to pay hundreds of millions of dollars to unsecured creditors which Kmart urged were critical to the company’s ability to reorganize. On appeal, the District Court reversed the ruling and ordered Kmart to recover the improper payments and the Seventh Circuit affirmed. In fact, the Kmart appeal resulted in the debtor was forced to seek the return of millions of dollars from the Fleming Companies, which ultimately caused Fleming to file its own bankruptcy!

Notwithstanding the Seventh Circuit’s Kmart decision, Critical Vendor payments are not uncommon. Chapter 11 debtors frequently must deal with situations where failure to make immediate payment could destroy their ability to reorganize. For example, it may be essential to maintain a workforce that is committed to a financially struggling business, or perhaps payment to consumers for returns or warranties is necessary to ensure continued customer confidence. The justifications for making payments to persons who would otherwise take last (or at least later) are unlimited, and they are all supported by the fundamental purpose of Chapter 11 – to rehabilitate a struggling business.

At first blush, this Doctrine might seem irrelevant to equipment lessors, because of the peculiar manner in which the Bankruptcy Code deals with leases. Lessors usually will not know how their claims will be classified until some time later in a bankruptcy case when the debtor makes its decision about whether it will assume or reject its leases. The Necessity of Payment Doctrine has very real consequences, however, because at the very beginning of the case it disrupts the balanced, orderly treatment of creditors set out in the Bankruptcy Code. If a Critical Vendor motion is granted, and the debtor is permitted to make substantial payments to unsecured creditors, lessor’s essentially lose the protections granted them by the Bankruptcy Code and must get in the back of the line.

The Doctrine is not completely without merit. Conceptually, most everyone agrees that successful reorganization is preferable to liquidation, and this often forms the basis for requests that Critical Vendors be paid. Furthermore, avoiding disruption of service in the beginning of the case may turn out to be beneficial to all creditors by allowing the debtor to jump-start its business and make a greater distribution at the end of the case.

But there are problems as well, including an inherent sense of unfairness and unwarranted dissipation of estate assets. Unsecured creditors, who have no rights in any property of the debtor, and who normally take last, can extort payment of their pre-petition claims by simply refusing to do business with the debtor unless they are paid. Lessors, on the other hand, must sit by for 60 days (or longer) while the debtor contemplates whether the lease is advantageous. If it is, the debtor can compel the lessor to perform through assumption (the debtor deciding to accept the lease as a post-bankruptcy obligation). Granted, if the debtor attempts to assume the lease, all defaults must be cured, but there is certainly a legitimate argument that unsecured creditors should not receive a similar benefit without the burdens the Bankruptcy Code imposes on lessors.

A more glaring problem stems from the Bankruptcy Code itself, which could easily be read to make no allowance for payments out of the ordinary, statutory scheme. After all, the Bankruptcy Code carefully sets out how creditors are classified as secured or unsecured. Then, with equal care, the Code singles out some of the latter group for priority treatment. Within any of these groups, the Bankruptcy Code expressly requires that they be treated similarly; unwarranted discrimination is simply not allowed.

To add to the uncertainty, the courts have found ways to interpret the Bankruptcy Code to allow these so-called critical vendor payments, with varying degrees of flexibility. One court recently authorized critical vendor payments so that the debtor could “realize the possibility” of successful reorganization, a view that apparently prefers the underlying concept of Chapter 11 to its substantive provisions. Others take a more hard line approach, as a Texas bankruptcy court did, requiring the debtor to specifically demonstrate the necessity of payment and a material benefit to the reorganization effort. That court also required that there be no legal or practical alternative to payment of pre-petition indebtedness. More recently, a Pittsburgh bankruptcy court found that brewing companies supplier met the standards of being a critical vendor because it was the only company that supplied the debtor’s unique aluminum bottles.

This strict approach certainly affords greater protection to the many parties to a bankruptcy case, including lessors, who have not been singled out as particularly important to the reorganization process in the early days after the bankruptcy is filed. These early decisions carry with them sometimes irrevocable consequences.

Obviously, if unsecured claims are paid early in the case and the attempt to reorganize nevertheless fails, necessitating liquidation, lessors and non-critical vendors will receive even less than they would have, had the Critical Vendor payments not been made. A recent study concluded that this is occurring at alarming rates in New York and Delaware, a favored venue for large, corporate bankruptcies. In Delaware, where reorganization plans are often negotiated before the bankruptcy is filed and move swiftly to confirmation, over half of the companies studied failed to thrive, necessitating a second bankruptcy, liquidation, or distress merger within five years of emerging from bankruptcy.

There are other, less obvious, ways that satisfaction of a Critical Vendor’s pre-petition claim could have a lasting effect on the bankruptcy. If the creditor demands, and the court approves, this “super-priority” payment to trade vendors, the debtor may have insufficient cash to satisfy other claims that must be paid, including the payment of §365(d)(5) payments (required post-petition lease payments) or the cure amounts on assumed leases. Trade creditors could also insist, in lieu of immediate payment, that their post-petition dealings with the debtor be secured by liens on the debtor’s property and, additionally, that those liens also cover pre-petition debts. By cross-collateralizing the pre-petition debts, an unsecured creditor in this scenario would not only get superior treatment in the bankruptcy case, but also the ability to foreclose on the debtor’s property – property that would have been available to unsecured creditors generally – if the bankruptcy fails.

In any bankruptcy case, the Necessity of Payment Doctrine is, at its core, a gamble. Assuming affected parties have the opportunity to make an informed decision about critical vendor payments (which Kmart and other cases demonstrate may not always be possible), those affected parties may acquiesce to the payments. Most likely, the acquiescence would be in the belief that the odds of greater payment later in the case are better than would be had under rigid adherence to the Bankruptcy Code’s payment scheme. The risks are even higher, however, when Critical Vendor issues are presented to the court along with other first day orders, when they may be decided even before other parties receive notice of the bankruptcy. Careful monitoring of the case from its inception, along with active participation, is imperative to ensure your ability to be paid is not jeopardized. Unfortunately, there are times even lessors with substantial relationships with a debtor are not treated among the largest unsecured creditors who generally receive notice of the presentation of first day orders. Where notice is available, lessors should consider whether opposing these critical vendor payments is in their interests.

In the end, whether notice is available or not, and whether these payments are opposed or not, lessors can take a lesson from those creditors who exert their influence in a bankruptcy case. Bankruptcies are risky enough that any leverage can add a few points to the probabilities that a lessor will be treated more fairly.

Robert S. Bernstein and Kirk B. Burkley of Bernstein-Burkley, P.C. in Pittsburgh, PA practice in the areas of Bankruptcy and Creditors’ Rights and can be reached at mail@bernsteinlaw.com.

Chapter 11 Cases for Chinese Vendors

As soon as you learn that your customer has filed bankruptcy in the U.S., you should do certain things in the first few days. Taking swift action will significantly improve your chances of collection. Seek legal counsel immediately to help you examine the issues raised below:

Reclamation is a process by which a credit-seller can “reclaim” goods sold on credit, not yet paid for but delivered to the customer within a certain time before bankruptcy. Reclamation may give you rights (or liens) regarding the goods you sold. Alternately, the Court may give your claim other priority rights instead of a lien. Generally, if you act within 20 days after the bankruptcy was filed, you can reclaim goods delivered within 45 days before the bankruptcy. But you must give proper notice of reclamation within that 20 days or the right will be lost. There are specific requirements attached to the reclamation notice for it to be effective (i.e., the deadlines must be met and the customer must still have the goods). Even if the goods are gone or there is other interference, the notice must be sent as soon as possible. Remember, the timing (20 days after the bankruptcy filing) is critically important.

A §503(b)(9) administrative priority is granted for the “value” of goods delivered to the customer within 20 days before the bankruptcy filing. There may not be a time limit for filing this claim, but the sooner it is filed, the sooner the Court can require the customer to pay it. This administrative priority raises the importance of the claim to one that must be paid by the customer as ordered by the Court or, at worst, at the time a Plan of Reorganization is approved. Bernstein-Burkley, P.C. attorneys can help to review your claim to see what invoices fall within this protection and help you make application to the Court for immediate payment.

Creditors’ Committee participation can significantly improve your understanding of the reorganization process and may allow you to influence the progress of the case. During the first few days of a Chapter 11 case, the Office of the United States Trustee (“U.S. Trustee”) will generally ask the largest unsecured creditors to serve on a Committee of Unsecured Creditors. The invited creditors come from a list filed by the debtor. That list may be inaccurate, so the U.S. Trustee also will invite creditors who file a sworn statement of claim (Proof of Claim) before the Committee is formed. This invitation and Committee formation usually occurs within a week or so of the case filing.

The Committee has the right to hire legal counsel (paid for by the debtor, not the creditors) and you can have significant impact in this area. While many lawyers are capable of representing the Committee, Bernstein-Burkley, P.C., has experience representing Chinese creditors on Committees and has connections with various credit agents, and may therefore help assure that the interests of unsecured creditors will be represented to your liking.

When you contact a bankruptcy attorney immediately upon learning of a customer Chapter 11, he or she can discover the details of the filing and the timing of the Committee organization. Your attorney can then work to help you influence the progress of the Committee formation and activity.

It is critical to act on these three points—reclamation, §503(b)(9) administrative priority and Creditors’ Committee participation—in the first few days of a customer’s Chapter 11 case. Do not delay. If you miss the associated deadlines, you can lose valuable rights. Contact Bernstein-Burkley, P.C. as soon as you learn of a U.S. customer’s bankruptcy. 

Prepared by:
Robert S. Bernstein, Esq.
Bernstein-Burkley, P.C.
Suite 2200 Gulf Tower
Pittsburgh , PA 15219
Phone: 800-693-4013
Fax: 412-456-8135

Board-certified in Business Bankruptcy Law and Creditors’ Rights Law by the American Board of Certification

Lawsuit Danger Alert: Be Careful How You Dispose of Old Records

Changes in law that take effect this December will increase your chances of being sued for unmanaged attrition of records when litigation is likely. Protect yourself now!

I.  An Issue That’s Now Taking the Spotlight.

As if you didn’t have enough to worry about, litigation-wise, a threat is moving to the forefront. It’s called “spoliation of evidence,” and it’s been around for a while-but upcoming changes in the Federal Rules of Civil Procedure are making this risk even riskier.

Without any reference at all to the actual merits of a controversy, businesses have suffered the disaster of an adverse verdict of thousands, millions, or even billions of dollars, when a court determines in hindsight that “relevant” records were destroyed with “culpable intent” after the company had “reason to know” that it may be sued in a particular matter. Several recent, high-profile cases indicate that these kinds of claims are catching on. See: Glover v. Costco Wholesale Corp., 153 Fed. App. 774, 2005 U.S. App. Lexis 23943, CA. 2 (negligence is a sufficiently “culpable state of mind” to ground spoliation sanction); Coleman Holdings, Inc. v. Morgan Stanley & Co., Inc. , 2005 W.L. 679071, (Fla. Cir. Ct., March 1, 2005) (jury instruction on “adverse inference” grounding $1.45 billion verdict); Zubulake v. UBS Warburg, LLC, 229 FRD 422, 2004 U.S. Dist. Lexis 13574 (S.D.N.Y., 2004) ($20.2 million in punitive damages awarded in employment discrimination case following spoliation instruction).

As of December 1, 2006, the magnitude of this risk will increase dramatically for those businesses that ignore the legal requirements imposed upon them by amendments to the Federal Rules of Civil Procedure. In the works for over ten years, the rule amendments are intended to “catch up” with the dramatic and far-ranging effects of evolving information technology and the way businesses communicate and handle electronically stored information (ESI). In practice , these amendments will focus the attention of would-be plaintiffs and their attorneys on the possibility of raiding corporate larders-not based on the merits of an actual claim, but on shortcomings of the architecture and management of modern information systems. The resulting “feeding frenzy” is likely to splash over into litigation in the state courts as well. If you are ignorant of these developments, you and your business will likely become victims.

You can and should take steps to manage this risk.

II. The Importance of a Robust and Established “Hold” Procedure.

The courts have acknowledged that businesses have a right to purge information from their records, both paper and electronic. See proposed F.R.C.P. 37 (effective December 1, 2006):

Rule 37. Failure to Make Disclosures or Cooperate in Discovery; Sanctions

* * * * * * * * * *

(f)  Electronically stored information . Absent exceptional circumstances, a court may not impose sanctions under these rules on a party for failing to provide electronically stored information lost as a result of the routine, good-faith operation of an electronic information system.

Committee Note

Subdivision (f). Subdivision (f) is new. It focuses on a distinctive feature of computer operations, the routine alteration and deletion of information that attends ordinary use. Many steps essential to computer operation may alter or destroy information, for reasons that have nothing to do with how that information might relate to litigation. As a result, the ordinary operation of computer systems creates a risk that a party may lose potentially discoverable information without culpable conduct on its part. Under Rule 27(f), absent exceptional circumstances, sanctions cannot be imposed for loss of electronically stored information resulting from the routine, good-faith operation of an electronic information system.

III. Timing Is Critical.

However, deliberate destruction (or even “merely” negligent purging in some jurisdictions) of “relevant information” will not be tolerated once the business “has reason to know that litigation is likely.” This critical point does not just start upon the receipt of the suit papers, but can go back in time as far as the making of a claim or demand, or even the occurrence of an event indicating the “likelihood” of litigation.

IV. “Deemed Violations”-A Serious Matter.

Once this triggering threshold is deemed in retrospect to have been reached, a business, its in-house counsel, and its retained outside counsel all will be held to an affirmative duty to communicate a ” litigation hold ” on the destruction of relevant information to ” key witnesses, IT, and paper records managers, ” and to others who may possess information relevant to the litigation. Businesses and their lawyers have suffered reprimands, sanctions, and imposition of liability for failure to discharge this duty (notwithstanding even “automatic” rewriting over drives).

“Relevant information” can be broadly defined to include not just admissible evidence, but information that could “reasonably lead to discovery of admissible evidence.” It won’t be sufficient to produce static images on a CD. Today’s savvy litigators want to examine the “meta-data” that reveals the sources, evolution, and interconnectedness of data. (Imagine what a hostile lawyer can learn by retrieving “deleted” drafts of a sensitive document!) In the recent case of Cooper v. Schoffstall , Pa. 212 MAP 2004 (9-7-06), the Supreme Court of Pennsylvania interpreted the “for cause” discovery methodology as permitting a Court to authorize inquiry into an expert’s financial records, including tax returns, to discern the degree to which his past earnings as an expert witness may call his objectivity into question.

If you give your adversary’s imagination a “toe-hold” to argue that you are hiding something, you could be in for a bad time. Chillingly, even “attorney work product” and “attorney/client communication” privileges can be deemed set-aside by the “crime-fraud” exception, following in-camera review of information by the court. Mistakes, oversights and misstatements can easily be misconstrued, with disastrous consequences.

Following are some examples of criminal or disciplinary provisions that could take you unawares:

Bankruptcy/Insolvency

Bankruptcy Code – 11 U.S.C. §727(a)(3):

The court shall grant the debtor a discharge, unless the debtor has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor’s financial condition or business transactions might be ascertained, unless such act or failure to act was justified under all of the circumstances of the case.

Crimes Code (Bankruptcy Crimes) – 18 U.S.C. §152(8):

A person who after the filing of a case under title 11 or in contemplation thereof, knowingly and fraudulently conceals, destroys, mutilates, falsifies, or makes a false entry in any recorded information (including books, documents, records, and papers) relating to the property or financial affairs of a debtor shall be fined under this title, imprisoned not more than 5 years, or both.

Crimes Code (Bankruptcy Crimes) – 18 U.S.C. §152(9):

A person who after the filing of a case under title 11, knowingly and fraudulently withholds from a custodian, trustee, marshal, or other officer of the court or a United States Trustee entitled to its possession, any recorded information (including books, documents, records, and papers) relating to the property or financial affairs of a debtor shall be fined under this title, imprisoned not more than 5 years, or both.

“Normal” Business in a Post-Enron World

Sarbanes-Oxley was enacted by the Republican Congress in 2002, under pressure from the series of business scandals typified by Enron.

Sarbanes-Oxley is primarily focused upon publicly traded companies and companies in bankruptcy. However, by an insidious process of “incorporation” it affects many insurance and government contracts, as well as lenders’ covenants, and may also overlap with tax, environmental, labor/employment, or industry-specific requirements. Auditing accountants of public companies have direct document retention responsibilities under Sarbane’s-Oxley lasting five (5) years.

Crimes Code (Sarbanes-Oxley Act of 2002) – 18 U.S.C. §1519 (Destruction, alteration, or falsification of records in connection with Federal investigations or bankruptcy):

Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.

District of Columbia Code (Criminal Offenses) – DC ST §22-723 (Tampering with physical evidence; penalty):

(a) A person commits the offense of tampering with physical evidence if, knowing or having reason to believe an official proceeding has begun or knowing that an official proceeding is likely to be instituted, that person alters, destroys, mutilates, conceals, or removes a record, document, or other object, with intent to impair its integrity or its availability for use in the official proceeding.

(b) Any person convicted of tampering with physical evidence shall be fined not more than $5,000, imprisoned for not more than 3 years, or both.

District of Columbia Rules of Court (Rules of Professional Conduct) – DC R RPC Rule 3.4:

A Lawyer Shall Not:

(a) Obstruct another party’s access to evidence or alter, destroy or conceal evidence, or counsel or assist another person to do so, if the lawyer reasonably should know that the evidence is or may be the subject of discovery or subpoena in any pending or imminent proceeding. Unless prohibited by law, a lawyer may receive physical evidence of any kind from the client or from another person. If the evidence received by the lawyer belongs to anyone other than the client, the lawyer shall make a good faith effort to preserve it and to return it to the owner, subject to Rule 1.6.

Comment to DC R RPC Rule 3.4:

[2] Documents and other items of evidence are often essential to establish a claim or defense. Subject to evidentiary privileges, the right of an opposing party, including the government, to obtain evidence through discovery or subpoena is an important procedural right. The exercise of that right can be frustrated if relevant material is altered, concealed or destroyed. To the extent clients are involved in the effort to comply with discovery requests, the lawyer’s obligations are to pursue reasonable efforts to assure that documents and other information subject to proper discovery requests are produced. Applicable law in many jurisdictions makes it an offense to destroy material for purpose of impairing its availability in a pending proceeding or a proceeding whose commencement can be foreseen. Falsifying evidence is also generally a criminal offense. Paragraph (a) applies to evidentiary material generally, including computerized information.

[4] A lawyer should ascertain that the lawyer’s handling of documents or other physical objects does not violate any other law. * * * This Rule does not set forth the scope of a lawyer’s responsibilities under all applicable laws. It merely imposes on the lawyer an ethical duty to make reasonable efforts to comply fully with those laws. The provisions of paragraph (a) prohibit a lawyer from obstructing another party’s access to evidence, and from altering, destroying or concealing evidence. These prohibitions may overlap with criminal obstruction provisions and civil discovery rules, but they apply whether or not the prohibited conduct violates criminal provisions or court rules. Thus, the alteration of evidence by a lawyer, whether or not such conduct violates criminal law or court rules, constitutes a violation of paragraph (a).

V.  Who Pays? Shifting Expense Burdens (of Retrieval and Production of Information).

You can become subject to this “litigation hold” not only as a prospective party to a lawsuit, but also under amended F.R.C.P. 45, as a nonparty witness (including a business) when you receive a subpoena. You merely have to “be on notice” to preserve information. For nonparty witnesses, the opportunity to prevent disclosure on the basis of hardship, and/or keeping the (usually) expensive compliance costs on the seeker, is much greater. However, broad discretion resides in the court as far as “cost-shifting.”

Generally, you as responding party bear the cost of production of “accessible” information, while “inaccessible” information should be retrieved at the expense of the party seeking the information.

While “back-up tapes” and “disaster archives” of a party that are “not readily accessible” most often shift the burden of persuasion and expense of retrieval to the party seeking them, evidence of “suspicious” deletion of relevant information from operating systems or operating accessibility to those archival information pools has often been cited as sufficient reason to compel the production and/or shift the cost of retrieval to the respondent. “Sampling” (random searches) has also been allowed, which frequently permutates into a foot-in-the-door progression of retrieval and disclosure, increasingly at the responding party’s expense. Mistakes in IT architecture or management can have disastrous consequences.

Respondents to an “ESI” request are expected to act in a timely manner. Parties are expected to address known issues of privilege, or other bases of a protective order, as part of the Rule 26(f) disclosure process, very early-on in Federal Court litigation.

In the context of litigation, it is important for the respondent’s counsel to be “out in front of” the opposition, seeking a protective order and/or skillfully negotiating a “MAD” (mutually assured destruction) understanding with opposing counsel. (What’s good for the goose is good for the gander.)

So what can you as a businessperson do to protect yourself from this exposure?

VI.  Your Records Retention and Disposal Practices Must Pass the Test of Being Deemed “Reasonable” in Hindsight by an Unknown Judge.

First, have a disciplined, well-defined information storage, management and destruction policy. So long as the information is purged routinely, pursuant to such a system, and without “reason to know” litigation is likely, you are within your rights in purging information.

You may wish to designate an official “records-manager officer,” and routinely segregate information you know is important, while deleting information that is not.

There should be a clear-cut, established procedure for the regular retention and destruction of information pursuant to identified criteria and documented compliance with those company policies and procedures.

Second, have a documented and robust “litigation hold’ procedure in place. Make sure it’s broadly construed by your management and employees so that you can demonstrate to the court that an honest and energetic effort has been made, and nothing has intentionally been left outside of the “spotlight,” once you had “reason to know litigation was likely.” Make sure key witnesses, IT, and document storage personnel are officially noticed, and that the “hold” is in fact observed (issue memorializing “reminders” of the hold from time to time).

VII. So, How Do You Know When You Are “Safe”?

The bottom line? We do not want our clients to become victims of this tactical fad, nor do we want to become victims ourselves. We look forward to your successfully managing this risk and will assist in any way that we can. Unfortunately, the risk can only be managed, not eliminated.

In Brotech Corporation v. Delmarua Chemicals , 2003 Pa.Super. 281, 831 A.2d 613; 2003 Pa.Super. Lexis, 2327, two judges of the Pennsylvania Superior Court came to diametrically opposed conclusions, based upon the same record.

The majority, in reversing the Trial Court’s entry of a summary judgment as a sanction against the party for spoliation of evidence, noted that a discovery sanction must be procedurally supported by the existence of a motion for discovery sanctions. Further, the majority reasoned that the other party had ample opportunity to examine the evidence, albeit only a few days before trial, and was not in fact prejudiced in preparing its defense.

The dissent vigorously pointed out that the respondent failed to make discovery as requested for over two years, and produced the requested discovery only 11 days before the start of trial. The dissent further noted that there had never been a satisfactory explanation for the failure to make timely discovery, and that the court case below was characterized by contentious discovery behavior.

Broad discretion of the Trial Court is reviewed under a five-point test:

  • the nature and severity of the discovery violation;
  • the willfulness or the existence of bad faith in the failure to make discovery;
  • the prejudice to the opposing party;
  • the ability to cure the discovery violation with a lesser sanction; and
  • the relative importance of the precluded evidence in light of the failure to comply with the discovery.

The dissent conceded that the sanction for spoliation (in Pennsylvania State Court) is granted only in cases of willful failure to make discovery, and where the opposing party is actually prejudiced.

The dissent would have sustained the Trial Court’s entry of discovery sanctions in the form of summary judgment against the respondent!

Theoretically, the Supreme Court of Pennsylvania and the Third Circuit Court of Appeals have both adopted the same test for “spoliation.” See Schroeder v. Commonwealth of PA Dept. of Transp. , 551 PA 243, 710 A.2d 23, 1998 PA Lexis, 564; Tenaglia v. Procter and Gamble, Inc., 1999 Pa.Super. 220, 737 A.2d 306, 1999 Pa. Super. Lexis 2790 (the Pennsylvania Supreme Court has adopted the spoliation test adopted by the Third Circuit Court of Appeals in Schmid v. Milwaukee Electric Tool Corp., 13 F.3d 76 (3 rd Cir., 1994)).

The more recent federal case of Paramount Pictures Corp. v. John Davis , 234 F.R.D. 102, 2005 U.S. Dist. Lexis 31065, defines “spoliation” as the destruction or significant alteration of evidence, or failure to preserve property for another’s use as evidence in pending or reasonably foreseeable litigation.

Noting the Third Circuit Decision in a case out of New Jersey , Mosaid Xtechs v. Samsung Elecs, 348 F.Supp. 2d 332 (D.N.J., 2004), the Court noted the preconditions for a finding of spoliation:

  • that the evidence in question be within the party’s control;
  • that there has been an actual suppression or withholding of evidence;
  • that the evidence destroyed was relevant to claims or defenses; and
  • that it was reasonably foreseeable that the evidence would later be discoverable.

The Court noted that the range of sanctions for spoliation are on a continuum from dismissal of a claim or granting of judgment in favor of the prejudiced party, to the suppression of evidence, to adverse inference instruction, to fines and the imposition of attorneys’ fees and costs.

While there is no bright line rule, the Court’s discretion in granting or denying spoliation sanctions should generally consider (1) the degree of fault of the party who altered or destroyed the evidence, (2) the degree of prejudice suffered by the opposing party, and (3) whether there is a lesser sanction that will avoid substantial unfairness to the opposing party; and where the offending party is seriously at fault, will serve to deter such conduct by others in the future. The Court should choose the most appropriate sanction for spoliation that would be the least onerous corresponding to the degree of willfulness of the destructive act and the prejudice suffered by the victim.

The Court should consider the extent to which the responsible party acted deliberately to impair the ability of the other side to effectively litigate its case, as well as the degree of actual prejudice suffered by the party and whether that party had a meaningful opportunity to examine evidence before it was destroyed.

Yet, the fact remains that these are usually “judgment calls” about which reasonable minds can, and often do, differ. Don’t be caught unprepared, or it can really cost you. Get your information system in order. While there are no guarantees in this or any other legal area, at least you’ll be able to sleep at night knowing that you did everything possible to prevent litigation. That alone will make your efforts worthwhile.

Powerful Collection Tools for Unsecured Creditors in Bankruptcy

By: Kirk B. Burkley

This article appeared in the Pennsylvania Association of Credit Managers Newsletter, The Creditor

There are a couple of important statutes that should rest on the credenza of all trade vendors dealing with financially unstable customers, and unsecured creditors. These statutes are the Perishable Agricultural Commodities Act (“PACA”) and Section 503(b)(9) of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“Section 503(b)(9)”).

PACA was enacted in 1930, to promote fair trading practices in the produce industry. In particular, Congress intended PACA to protect farmers and growers who were vulnerable to the practices of financially irresponsible buyers. In 1984, Congress amended PACA to create a statutory trust in their favor. The term “perishable agricultural commodity” means fresh fruits and fresh vegetables, whether or not frozen or packed in ice, and includes cherries in brine. Any licensed vendor meeting this definition may have extremely powerful tools to use in collecting a debt.

PACA’s far-reaching powers give PACA claims priority ahead of all other creditors . A beneficiary of a PACA trust is entitled to priority as to all assets of debtor ahead of claims of creditors who have valid security interests, administrative costs and expenses incurred in Bankruptcy Court, and all other priority and general creditors. The trust protects the sellers against financing arrangements made by merchants, dealers, or brokers who encumber or give lenders a security interest in the commodities or the receivables or proceeds from the sale of commodities; thus giving the claims of these sellers precedence over those of secured creditors.

In order to pursue one’s rights under PACA, the creditor must meet very stringent notice requirements. Under all circumstances, the seller must give the buyer written notice of the seller’s intention to preserve its trust benefits. A seller eligible for the statutory trust benefit must preserve its rights by satisfying a notice requirement by either sending notice to the buyer within 30 days of a payment default or, as provided in the 1995 amendment to PACA, including a statutory statement referencing the trust on its invoices. Thirty days is the maximum allowable payment term under PACA regulation 7 C.F.R. § 46.46(e)(2), which provides as follows: “The maximum time for payment for a shipment to which a seller, supplier, or agent can agree and still qualify for coverage under the trust is 30 days after receipt and acceptance of the commodities…” This limitation exists because the statute is intended to protect only those produce sellers making short-term credit arrangements. PACA does not preclude a seller from agreeing in writing to a payment term beyond 30 days, but only disqualifies such a seller from participating in the trust.

In addition to PACA, trade vendors have a new tool for collecting debt in bankruptcy pursuant to Section 503(b)(9) of the bankruptcy code. Under Section 503(b)(9), creditors are granted an administrative priority claim for the “value” of goods delivered to the customer within 20 days before the bankruptcy filing. Typically, there is no deadline for filing a claim under Section 503(b)(9) other than prior to the deadline for voting on a Plan or Reorganization in chapter 11 or as set by the Court. That being said, the sooner it is filed, the sooner the Court can require the customer to pay the claim. Having an administrative priority claim raises the importance of the claim to one that must be paid by the customer as ordered by the Court or, at worst, at the time a Plan of Reorganization is approved. In order for a debtor to confirm a Plan of Reorganization the law requires that all administrative claims be paid in full.

As you can see, if you fall under the definition of a licensed PACA dealer or deliver goods to a bankruptcy customer within 20 days of the date the petition in bankruptcy is filed, you may have additional tools to use in collecting your debt. Any good credit policy should include knowledge of these areas of the law.

Involuntary Bankruptcy – A Useful Tool for Lessors and Creditors

“Bankruptcy.” To many creditors, this term is understood to mean a lost cause, a write-off and the end of the collection process. To other creditors, including those that appropriately use the filing of an involuntary bankruptcy petition, bankruptcy can mean the beginning of a successful strategy. Many of the benefits leasing creditors and others derived from the filing of an involuntary bankruptcy petition against a delinquent customer under the former Bankruptcy Code are preserved in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), with some favorable additions. Used intelligently, and in the right situation, the filing of an involuntary bankruptcy petition can still be a useful tool.

One of the luxuries we have when discussing BAPCPA and filing involuntary petitions is that we don’t have to meticulously lay out the law under the former Bankruptcy Code, as anyone filing an involuntary petition after reading this article will certainly be operating under BAPCPA, which is now the law. Under the current Bankruptcy Code, an involuntary petition may only be filed by a minimum of three (3) creditors with debts totaling at least $12,300 in the aggregate. If the alleged debtor challenges the petition, the petitioning creditors will need to show that the debtor is unable to meets its obligations as they come due and that the creditors claims are not contingent as to liability or the subject of a bona fide dispute as to liability or amount. If the debtor has fewer than twelve (12) creditors, then a single creditor holding a claim of at least $12,300 can file an involuntary petition. Successfully prosecuting an involuntary petition generally means the fees and costs associated therewith are an expense to be borne by the debtor’s estate, provided it has sufficient assets to do so. This right is preserved in Section 503(b)(3)(A). Congress recognized that creditors should not bear the financial burden of declaring an already delinquent customer bankrupt. However, make sure to first seek the advice of experienced counsel before filing an involuntary petition, as the is court is empowered to grant judgment in favor of the debtor for its costs or attorneys’ fees if the involuntary petition is filed in bad faith and ultimately dismissed. Thus, before filing an involuntary petition against an account debtor, it is vitally important to make sure the creditor(s) joining in the petition meet the requirements of Section 303(b).

So when is it appropriate to use an involuntary bankruptcy petition? For starters, almost every company that leases equipment or sells on credit has either encountered or heard the story of the account debtor transfers its assets the week before the creditor executes on judgment, and many times the transfer is made to a related entity. In this situation, it may be critical to preserve the rights of creditors by filing an involuntary petition in bankruptcy. In this scenario, there are a couple important tools that can be utilized by the bankruptcy estate. Whether the action is prosecuted by the trustee in a chapter 7, the debtor-in-possession, trustee or committee of unsecured creditors in a chapter 11, grounds may exist for avoiding the sale under Sections 548 or 547 of the Code, relating to fraudulent transfers and preferences, respectively.

Under Section 548, fraudulent transfers, the trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within two (2) years before the filing of the petition, where the transfer was made for less than equivalent value while the debtor was or became insolvent or where the transfer was made with the actual intent to hinder, delay or defraud. Under the old Code, creditors enjoyed a look back period of one (1) year, but BAPCPA extended this period for an additional year. Even with the expanded reach back period, it is still important to file the involuntary petition to stop the running of the clock. This is often the case when a debtor quietly forms a new company for the sole purpose of acquiring the debtor’s assets for less than equivalent value, leaving creditors to chase a now-empty shell corporation with minimal or no assets. Through the prosecution of a fraudulent transfer claim the transferred assets can be recovered for the benefit of creditors.

Similarly, sometimes assets are transferred to another creditor or insider in exchange for the forgiveness of debt. While you are in process of collecting a debt you find out that the debtor just paid a substantial sum to another creditor, leaving the debtor with insufficient funds to pay your claim. Section 547 of the Code, relating to preferences, enables the trustee to avoid these transactions and recover assets for equal distribution to all creditors, not just the most aggressive or most favored creditor. In both scenarios, what otherwise would spell zero recovery may turn into partial or complete recovery. In collections the old adage “something is better than nothing” certainly rings true.

Sometimes, even though liability on your claim is established, it is more evident that the debtor will make it extremely expensive or inconvenient to collect. Perhaps this is because the debtor has enough resources to engage in delay tactics while it attempts to save its business or while it attempts to hide assets. To combat these tactics the filing of an involuntary petition may be the best route. In these situations, it may be better to force the debtor to disclosure its assets and manage its debts in bankruptcy at its expense, rather than yours. Whether a trustee makes a distribution in chapter 7 or the debtor successfully converts to chapter 11 and proposes a plan of reorganization, the debtor will bear the bulk of the expenses and creditors will have greater control in the direction of the case and the distribution of assets.

Particularly with regard to equipment leases, it is beneficial to get the clock started in bankruptcy. Under section 365(d)(1), if the trustee doesn’t assume the lease within 60 days after the order for relief, the lease is rejected from the bankruptcy estate. In addition, if the trustee or debtor decides that they want to keep the lease, the lease must be assumed an all defaults must be cured. Also, if the customer is not paying, having them under the Court microscope could be a good thing. Section 365(d)(10), the debtor is required to make payments starting with the 60 th day after the Order for Relief (adjudication of bankruptcy). If the debtor isn’t paying, having the power of the court behind your demands (after 60 days) should help. Again, be sure to seek the advice of counsel as Section 303(i)(2), preserves the right of the debtor to seek damages, including possibly punitive damages, for involuntary petitions filed in bad faith. If liability on your claim is not established or admitted, or you don’t have the requisite number of creditors joining in the petition, filing an involuntary petition may not be the best strategy and can get you into trouble.

Unsecured creditors may also have an incentive to file an involuntary petition in the face of an overly aggressive secured lender. Perhaps the debtor’s business has value as a going concern, which would be lost if the secured creditor liquidated its collateral. The filing of an involuntary petition may give a trustee a chance to briefly operate the debtor’s assets and sell them at fair market or going concern value, as opposed to liquidation. In other scenarios, the secured lender may have problems with its paper, particularly its UCC filings. Trying to navigate the world of state law remedies may prove time consuming and expensive, especially in cross-state (or transnational) transactions. Here, creditors are well served by focusing all of the issues in one forum and examining the security interests and collateral of the lender in front of the trustee and bankruptcy judge.

Finally, involuntary bankruptcy petitions can be useful in those situations where you simply don’t know what happened. One of your best customers suddenly goes belly up without notice. Typically, creditors suspect foul play, which may not always be the case. Rather than just letting the company dissolve and disappear, creditors often find an involuntary bankruptcy petition a useful tool in conducting an “autopsy” of the debtor’s business. While creditors may or may not ultimately see a distribution from the bankruptcy, it can be insightful to have an organized and open examination of the debtor’s business and financial demise. In these situations the collection benefits are not immediate, but can be extremely useful in future collection policy.

This article appeared in the Equipment Leasing Newsletter

Acceptance and Reclamation in PA

As a commercial seller, distributor, manufacturer or purchaser of goods you are certainly aware of an area of the law known as the Uniform Commercial Code (U.C.C). In fact you have most likely read articles dealing with contract formation and the “Battle of the Forms” under the U.C.C., but what happens in this area of the law after this “battle” has been waged and a contract has been formed?

What happens when an agreement has been reached and the goods have been packaged and shipped? Surely, all that the law requires is the Buyer to take possession of the goods and then make payment to the Seller on the accompanying invoice. Not quite. This article will briefly outline and discuss the rights and duties of both a Seller and Buyer with respect to the performance of a contract for the sale of goods. In addition, we will look at how certain actions taken by the Seller and Buyer affect those rights and duties. When reading the following sections, it may be helpful to imagine a timeline with each topic representing a point in time where certain rights, duties, choices or remedies available to a party are either triggered or lost.

REJECTION – Can the Buyer refuse the goods?

Once a Seller has presented the goods to the Buyer, an act known as “tender”1 under the law, it is up to the Buyer to act next. The Buyer must react to the Seller’s tender of the goods whether or not the goods or delivery conform to that which was agreed upon. In other words, the goods are now at the Buyer’s doorstep and the Buyer has one of two options, the Buyer may reject or accept the goods.

If tender of the goods conforms in every respect to the contract, i.e. type of goods, time of delivery, method of delivery, etc., then typically the Buyer must accept the goods.2 However, if there is any defect in the tender of the goods the Buyer has the right to reject the whole lot, accept the whole lot, or accept any commercial unit or units and reject the rest. This ability of the Buyer to reject the goods in light of any defect, no matter how slight, is known as the “perfect tender rule.”3

In order to exercise the right of rejection, a Buyer must seasonably notify the Seller that the Buyer is rejecting the goods. This notice must state with sufficient particularity the grounds for the rejection, i.e. the problem with the goods. As discussed below, failure to provide this notification may result in the Buyer being stuck with goods it neither wants nor needs. Additionally, the Buyer must exercise this right of rejection in “good faith” and not for the sole purpose of escaping from an unwise bargain that had previously been entered into.

Of course in certain circumstances the Buyer may want to accept goods that do not conform to the parties’ contract. The Buyer may do so and often will when the Buyer has made plans in reliance upon the delivery of the goods by the Seller. As you will see below, it is important for a Buyer to carefully analyze how much these goods are needed because certain rights are lost the moment that the Buyer decides to accept the goods.

To better illustrate the concept of rejection, we look to the following hypothetical. A Seller and a Buyer enter into an agreement whereby the Seller will provide the Buyer with 50 blue widgets for the price of $5.00 per widget, to be delivered on November 1. On November 1 the Seller tenders 50 red widgets at a price of $5.00 per widget. In this situation the goods are nonconforming because the contract provided for blue rather than red widgets. As a result of this nonconformity, the Buyer has the absolute right to reject the widgets. It is important to note that at this point of the transaction it does not matter whether or not the Buyer could have used red widgets rather than blue widgets, the “perfect tender rule” allows the Buyer to reject the widgets.

What are the consequences of this rejection? Once a Buyer has properly exercised a rightful rejection, it is the Seller who must now act.4 The Seller is going to have to arrange to get the goods back. Meanwhile, the Buyer has a duty to hold the goods in safekeeping for a reasonable period of time to ensure that the goods are not damaged while awaiting pick up by the Seller.5

As a practical businessperson you are probably asking, how is this possible? Surely, the law does not expect that every contract for the sale of goods begins with a perfect tender by the Seller. Once the Buyer exercises a rightful rejection, is the deal over? As we will see in our next section, the deal is not always dead after a rightful rejection. The Seller’s right to cure is one way that the Seller can mitigate the harsh results of the “perfect tender rule” and keep a deal alive.

CURE – Is there anything the Seller can do to salvage the deal?

Suppose the Seller has delivered the goods. Now suppose further that the Buyer has a right to and does reject those goods, citing particular nonconformities in justification of this response to the Seller’s delivery.

Is the deal lost? As a practical matter, the answer is most often no. This is because the Buyer often concludes that this particular Seller is still either the only potential supplier of just what is wanted or if not the only one then at least the supplier best positioned to quickly and effectively fill the Buyer’s order. As a result, the Buyer’s notification of rejection will be accompanied by a request for the Seller to come back soon and “make right” on the deal. In this situation any damages incurred by the Buyer may be worked out informally between the Seller and Buyer through various non-legal remedies such as a price rebate or free shipping.

What if the relationship between the Seller and Buyer has soured to the point that the Buyer no longer wants anything to do with the Seller? In this situation the Buyer either doesn’t want the goods or wants to look elsewhere for them. Does the Seller have any say in this? In other words, does the Seller get a second chance or is the deal lost?

The legal question becomes whether or not the Seller has a right to cure or remedy the situation. The answer, as with any legal question, is that it depends on the timing and circumstances surrounding the Buyer’s rejection. Generally, the Seller has a right to remedy the situation if such remedy can be completed before the time for performance of the contract has expired.

With regard to our hypothetical, suppose that instead of delivering 50 red widgets at $5.00 per widget to the Buyer on November 1 that the Seller delivered the same 50 red widgets on October 25. The Buyer rightfully rejects the red widgets. The price of widgets has dropped to $4.00 since the time the parties entered into the contract, and the Buyer is unwilling to allow the Seller to make good by sending 50 blue widgets. The Buyer wants to purchase widgets from another supplier in order to take advantage of the drop in market price of widgets. However, in this situation the law allows the Seller to claim the right to cure if the Seller immediately notifies the Buyer of his intention to cure the defect and does so within the time for performance under the parties’ contract. Accordingly, the Seller can “save the deal” by notifying the Buyer that he will send 50 blue widgets, and actually doing so before November 1, the time for performance under the parties contract.

There is another situation in which the Seller may be afforded time to cure or remedy a defect in the goods or delivery of the goods. When a Seller has reasonable grounds to believe that the Buyer would accept nonconforming goods and the Buyer subsequently rejects such nonconforming goods. Then the Seller may, after immediate notification to the Buyer of his intention to do so, have a reasonable time to substitute conforming goods.

To that end, suppose that the Seller and Buyer in our hypothetical have a previous business relationship and that several times in the past the Seller has been short on blue widgets and sent the Buyer red widgets instead. The Buyer had always accepted and used these red widgets. Therefore, based on the parties’ previous dealings, the Seller had reason to believe that 50 red widgets would suffice in place of the 50 blue widgets that were required under the contract. However, the Buyer rightfully rejects the 50 red widgets utilizing the “perfect tender rule.” Under these circumstances, the law affords the Seller a reasonable time, without regard to the time of performance, to cure or remedy the defect by presenting 50 blue widgets to the Buyer.6

The Seller’s right to cure operates to allow the Seller time to repair and revive the parties’ contract if the circumstances permit. Any interference by the Buyer with the Seller’s right to cure may operate as a breach of contract on the part of the Buyer. On the other hand, a Buyer is not forced to deal with an incompetent Seller by affording unlimited opportunities to cure any defect. This protection is given to the Buyer in the form of temporal requirements on the Seller’s right to claim cure.

As you can tell from the preceding sections the law provides great flexibility to both parties at the earliest stages of the performance of a contract for the sale of goods. This is done both to protect the rights of each party and to preserve the original agreement that the parties entered into.

ACCEPTANCE – When has the Buyer accepted the goods?

What if the Buyer doesn’t reject the goods, but instead chooses to keep them? In this situation the Buyer has “accepted” the goods. It must be understood that a Buyer need not expressly accept the goods for the law to find that an “acceptance” has occurred. Under the law, “acceptance” occurs when: 1) after a reasonable opportunity to inspect the goods the Buyer signifies to the Seller that the goods are conforming or that the goods will be retained in spite of any non-conformity; or 2) after a reasonable opportunity to inspect the goods the Buyer fails to make an effective rejection of the goods; or 3) the Buyer does any act inconsistent with the Seller’s ownership in the goods.7

It is important to recognize that in all three situations the Buyer must have been afforded a “reasonable opportunity” to inspect the goods before he is deemed to have accepted them.8 This requirement prevents a Buyer from being deemed to have accepted goods that it could not have chosen to reject. Thus, the Buyer can avoid the deadly game of “Russian Roulette” that would result if he were forced to choose whether or not to reject or accept goods without prior inspection because a wrongful rejection would result in a breach by the Buyer. Not only is the Buyer given this opportunity to inspect the goods before acceptance, the Buyer has an affirmative duty to perform this inspection. This duty cannot be ignored and the Buyer need not actually have inspected the goods in order for the law to find that the Buyer had a “reasonable opportunity” to do so.

Turning to our hypothetical, the Buyer will be deemed to have accepted the 50 widgets, red or blue, if upon receipt of the widgets from the Seller the Buyer inspects the goods and signifies that the goods will be accepted. This could be done through something as simple as signing an invoice. Suppose the Buyer receives delivery of the 50 red widgets and upon inspection decides that the he will reject the widgets as nonconforming, but the Buyer never informs the Seller of his intention to reject and the goods remain in the Buyer’s warehouse. The Buyer has “accepted” the goods despite his desire not to. Lastly, suppose that the Buyer, upon delivery of the 50 red widgets, uses the widgets in the manufacture its product, but later decides that the red widgets will not work due to aesthetic reasons. However, the Buyer cannot reject the 50 red widgets because the Buyer has accepted the widgets by utilizing them, an act that is certainly inconsistent with any ownership interest the Seller has in the widgets. Now that we have outlined the various acts and situation that may constitute acceptance of goods under the law, we must turn to the next question.

What effect does the “acceptance” of goods have on both the rights and obligations of the Seller and Buyer? First and foremost, “acceptance” imposes upon the Buyer the duty to pay the contract rate for any accepted goods. In the situation of acceptance of nonconforming goods the Buyer may be entitled to offset the contract price with a claim for damages, but for purposes of this article it is important to remember that at the moment of acceptance the Buyer is on the hook for and the Seller is entitled to the contract price of the accepted goods.

Second, upon acceptance the Buyer loses the opportunity to reject the goods, meaning that the Buyer can no longer take advantage of the buyer-friendly “perfect tender rule.” As we will discuss below, the Buyer still may be able to revoke acceptance of the goods. However, the ability to revoke acceptance is not as clear-cut and unfettered as the Buyer’s initial right of rejection.

Acceptance also shifts the burden to establish breach of contract from the Seller to the Buyer. While a “burden” is something that you typically would allow your lawyer to be concerned with, it may be helpful to include a brief explanation at this juncture. A “burden” may be viewed as establishing who must first “speak to the court” when there has been a dispute between the parties. For example, when the Seller provides 50 red widgets at a price of $5.00 per widget to the Buyer on November 1 and the Buyer rejects the goods, as discussed above, it is the Seller who must prove to the court that on November 1 the 50 widgets that the Seller provided to the Buyer conformed in every respect to the contract. Now suppose that the Buyer had accepted the 50 red widgets on November 1 and the parties later went to court, the Buyer must prove that what the Buyer accepted did not conform to the parties’ contract. Admittedly, this example may not drive home the importance of a “burden” in the courtroom because of the ease of showing that the widgets provided were red and the contract required blue. However, in more complex situations the burden to prove breach of contract can be very costly and time consuming, especially when the evidence necessary to show breach is in the hands of a third party such as a shipper or distributor.

Perhaps the most important consequence of the Buyer’s “acceptance” of the goods is that once the goods have been accepted the Buyer must within a reasonable time after he discovers or should have discovered any breach notify the seller of the breach or be barred from any remedy. Thus, once a Buyer has accepted the goods not only is the onus upon the Buyer to provide notice of any non-conformity that the Buyer discovers, but also any non-conformity that the Buyer should have discovered. Think about the harsh results this could impose upon a Buyer who is not attentive and prompt in dealing with newly acquired goods.

Suppose our Buyer, upon acceptance of the 50 red widgets from the Seller and their subsequent use in the manufacturing of Buyer’s product, finds out that every one of his products in which he used the red widget is catching fire and causing harm to the Buyer’s customers. Moreover, suppose that Buyer knows that the reason his product is catching fire and harming customers is due to the use of the 50 red widgets and it is determined that the red paint used on the widget spontaneously combusts when exposed to sunlight for more than four hours at a time. At this time, due to the fact that acceptance has already occurred, the Buyer must notify the Seller of this defect or else risk being barred from any recourse he may have against the Seller.

So we have concluded that acceptance requires notification of any breach and/or non-conformity in the goods. Also, we just stated that once the Buyer accepts the goods he can no longer reject them. What then is the purpose of this notification?

REVOCATION OF ACCEPTANCE – Can the Buyer send the goods back after acceptance?

What occurs when a reasonable inspection of the goods does not disclose a defect or non-conformity in the goods that later comes to light? Or, when the Seller assures the Buyer that he will remedy any known defect or non-conformity in the goods?

After a Buyer has accepted the goods, the Buyer still may have the ability to deal with situations such as those set forth above. Under certain circumstances, the Buyer may have the ability to revoke acceptance.

However, before discussing the Buyer’s ability to revoke acceptance it must be noted that the Buyer can certainly choose to seek monetary relief. In doing so, the Buyer keeps the goods and must pay the contract price for the goods that were accepted, but the Buyer may be able to subtract from what is owed a significant amount for damages due to the defect or non-conformity in the goods.9 This option leaves the Buyer owning and in possession of the goods, albeit having paid less than what was originally was called for under the contract. For many Buyers this remedy will suffice.

On the other hand, due to the defects or non-conformities now apparent in the goods after acceptance, the Buyer may have no use or desire for the goods whatsoever and may wish that he or she never accepted them at all. It is in this situation that the Buyer will want to revoke acceptance of the goods and return them to the Seller.

There are certain requirements that the Buyer must meet before gaining the right to revoke acceptance. The non-conformity or defect in the goods must “substantially impair” the value of the goods as to the Buyer. In addition to “substantial impairment,” the prior acceptance of the goods must have been made: 1) based on a reasonable assumption that any known non-conformity or defect would be cured; or 2) without discovery of such non-conformity or defect if the Buyer’s acceptance was reasonably induced either by the difficulty of discovery or by the Seller’s assurances.

Once it is determined that the Buyer has the right to revoke acceptance, the Buyer must also follow additional steps in order to exercise this right. The most important being notice to the Seller within a reasonable time after the Buyer discovers or should have discovered the grounds for revocation of acceptance. In addition, this notice must be given before there is any substantial change in the condition of the goods, which is not caused by their own defects.

As you can see, whether or not the Buyer has a right to revoke acceptance is an almost entirely fact based inquiry, which would be too exhaustive for our hypothetical. There are many factual issues including: whether or not there is a “substantial impairment;” whether or not the acceptance was “reasonable” in light of the circumstances;10; whether or not the Buyer should have discovered the defect or non-conformity sooner; and whether or not notice was timely. To engage in a discussion of the intricacies of each of these questions would require volumes rather than the paragraphs that are available in this article. To that end, we turn to the result that revocation of acceptance can have on the dealings between the parties.

The effect of a successful revocation of acceptance is the same as if the Buyer had successfully exercised a rightful rejection of the goods. In other words, the Buyer has a duty to hold the goods for a reasonable time until the Seller arranges to have them picked up. Also, the Buyer has the right to claim any damages that he has incurred as a result of the Seller’s failure to provide conforming goods in accordance with the contract.

As you can see once the Buyer has successfully revoked acceptance the goods are sent back to the Seller and the parties are essentially back at square one with respect to the performance of the contract. However, in this situation the Seller will most likely have to pay damages to the Buyer for failing to perform the contract as required.

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1 “Tender” entails certain acts and imposes certain duties upon the parties to a contract depending on the subject matter and terms of the contract. In general, tender encompasses the time, place, and manner in which the Seller must present the goods to the Buyer.

2 It is important to note that nothing under the law prevents the Buyer from rejecting goods that are perfectly fine, however this is known as a “wrongful” rejection and is in fact a breach of the parties underlying contract.

3 The “perfect tender rule” does not exist when the parties have entered into an installment contract. An installment contract is best described as a contract, which requires or authorizes the delivery of goods in separate lots to be separately accepted. The right of rejection with respect to an installment contract is available only when the defect “substantially impairs” the value of the contract as a whole. The “perfect tender rule” is not available under an installment contract because the parties have agreed to subsequent deliveries, which the Seller can use to cure any technical defects.

4 As previously mentioned, a wrongful rejection would result in a breach of contract by the Buyer and the Seller would be able to resort to legal action including filing suit.

5 Of course the costs of storing rejected goods is recoverable from the Seller.

6 Recognize that under these circumstances the Seller is given the ability to perform the contract after the time for performance set forth by the parties has passed.

7 The U.C.C. provides that if such an act is wrongful as against the Seller then it is only deemed to constitute an acceptance if the Seller ratifies the acceptance.

8 In the event that a contract of sale requires that payment be made for the goods before the buyer inspects the goods, a payment so made will not constitute an acceptance of the goods. That is not to say that such payment is to be ignored when analyzing whether the Buyer has accepted the goods, but rather that acceptance cannot be deemed to have occurred based solely on the fact that such pre-payment has been made.

9 These damages would be recovered under a breach of warranty theory, which is a topic far too complex to even be briefly discussed in this short article.

10 The law does not protect the Buyer who blindly accepts goods and then subsequently attempts to utilize revocation of acceptance to compensate for his lack of care.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

Enforceability of Various Contract Clauses Found in Commercial Credit Applications

Nicholas D. Krawec, Esq.
Partner, Bernstein-Burkley, P.C.

Commercial credit applications are contracts which will govern the credit account transactions between the credit grantor and its customer, and therefore are subject to the same rules of interpretation and enforceability as other contracts. The goal of contractual interpretation is to ascertain and to effectuate the intent of the contracting parties. In determining the intent of parties to a written contract, the court looks to what the parties have clearly expressed, because the law does not assume that the language of the contract was chosen carelessly. Thus, the terms and conditions of a commercial credit application are to be construed according to the intent of the parties as determined by a reasonable interpretation of the language used in the light of the attendant facts and circumstances. Furthermore, the parties have the right to make their own contract, and it is not the function of a court to rewrite it or to give it a construction in conflict with the accepted and plain meaning of the language used.

As with all contracts, a commercial credit application must be construed as a whole. One part of a contract cannot be interpreted so as to nullify another part, and a contract must be construed, if possible, to give effect to all of its terms. Proper construction of a contract may involve a consideration of its subject matter, the circumstances surrounding its execution, the purpose, and the legal effect of the contract as a whole. Neither the form of a contract nor the name given to it by the contracting parties controls the interpretation of the contract.

The meaning of a clear and unambiguous written contract and the intent of the contracting parties must be determined from the contents of the contract document itself. If the written contract is ambiguous, a court may look to extrinsic evidence to resolve the ambiguity and determine the intent of the parties. Additionally, ambiguous contract terms will be construed against the drafter of the contract, because that person controlled the wording that is used.

Needless to say, disputes often arise between a creditor and its customer, particularly if the customer (who has now become a debtor), seeks to avoid some terms of the credit application which he considers to be particularly onerous or, in his perception, unconscionable.  Under Article 2-302 of the Uniform Commercial Code, if, in the course of adjudicating such a dispute, the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made, the court may: (1) refuse to enforce the contract; (2) enforce the remainder of the contract without the unconscionable clause; or (3) so limit the application of any unconscionable clause as to avoid any unconscionable result. When it is claimed or appears to the court that the contract or any clause thereof may be unconscionable, the parties must be afforded a reasonable opportunity to present evidence as to its commercial setting, purpose, and effect to aid the court in making the determination. A contract or a clause in a contract is to be considered unconscionable if there is an absence of meaningful choice on the part of one of the parties together with contract terms which are unreasonably favorable to the other.  However, a finding of unconscionability of a contract or a contract term, is very rare when the contracting parties are commercial enterprises, who have meaningful choices at their disposal when entering into the credit agreement.

The rights and obligations of the parties to a contract, which the words of the contract clearly express, must be recognized and enforced. The following provides a brief discussion of the enforceability of various contract clauses found in commercial credit applications.

Personal Guaranty Clause

A personal guaranty is a separate agreement by one person to pay some debt or perform some contract or duty upon the default of another person who was initially liable for that payment or performance. Generally, a personal guaranty is prospective and not retrospective in operation. Liability continues as long as is expressly or impliedly provided for in the personal guaranty. The determination of whether a personal guaranty is continuing or noncontinuing depends on the language of the contract, or from the course of dealings between the parties or from both.

As with other contracts, a personal guaranty is not enforceable unless based on sufficient legal consideration. A mere promise to pay the existing debt of another without any consideration is void, however, it is not necessary that consideration pass directly to the guarantor; the extension of credit to the principal obligor is sufficient consideration to support the promise of the guarantor.

Where a personal guaranty is conditional, the guarantee must make diligent effort to collect from the principal before he can resort to the guarantor. On the other hand, where the personal guaranty is absolute, the guarantor is bound immediately on the failure of the principal to perform his contract without further legal proceedings. Statutory law has codified the distinction at common law between a surety, who became immediately liable upon default, and a guarantor, who did not become liable until efforts to collect from the defaulting principal proved unavailing. Pursuant to 8 P.S. §1, all agreements to answer for the debt of another will be regarded as a suretyship, unless the agreement shall contain words in substance stating that “this is not intended to be a contract of suretyship.”  The surety and principal obligor for debt are both primarily liable for obligation upon default, meaning the surety’s liability is direct and immediate, and liability to obligee is coextensive with the primary liability of principal.

The nature and extent of the liability of a guarantor or surety depend on the terms of the personal guaranty. A guarantor is liable for all consequences of the failure of his principal to perform under the principal contract, and, if the terms and conditions of the contract so state, he may assume greater liability than that of his principal.

Disclaimer of Warranties Clause

A warranty is an assurance by one party to a contract of the existence of a fact upon which the other party may rely, thus relieving the promisee of any duty to ascertain the fact. Warranties applicable to the sale of goods may be express or implied. The scope of the warranty may vary, depending on the circumstances, such as the terms of the seller’s actual promise, express or implied in fact, the seller’s express or tacit representations of facts serving as inducements to the bargain, and broader considerations of policy. A warranty is ordinarily a matter of contract, but if a warranty is part of the contract or transaction of sale, no separate consideration to support it is necessary.

In general, implied warranties may be expressly excluded or waived by the terms of the contract of sale, and such terms are valid unless, as related to the particular subject matter of the sale, they are violative of statutes or against public policy.

The Uniform Commercial Code provides for contractual modification or limitation of the remedies of the buyer for breach of warranty. In general, a buyer is protected from unexpected and unbargained language of the disclaimer, since general language disclaiming warranties is insufficient, must be in specific language, and the preclusion of implied warranties is accomplished only by appropriate, conspicuous language of disclaimer. A provision in a contract of sale that the contract contains all of the agreements between the parties does not preclude an implied warranty of merchantability.

Pursuant to Article 2-316 of the Uniform Commercial Code, to exclude or modify the implied warranty of merchantability or any part of it, the language of exclusion must mention “merchantability,” and, if the disclaimer is in a writing, must be conspicuous. To exclude or modify any implied warranty of fitness for a particular purpose, the exclusion must be in writing and conspicuous. Language to exclude all implied warranties of fitness for a particular purpose is sufficient if it states that “There are no warranties which extend beyond the description on the face hereof.”

Unless the circumstances indicate otherwise, all implied warranties are excluded by expressions like “as is,” “with all faults” or other language which in common understanding calls the buyer’s attention to the exclusion of warranties and makes plain that there is no implied warranty.

Words or conduct relating to the creation of an express warranty and words or conduct tending to exclude or limit warranties are construed, wherever reasonable, as consistent with each other, but, subject to the provisions of the Uniform Commercial Code with reference to sales of goods, on parol or extrinsic evidence, exclusion or limitation of warranties is inoperative to the extent that such construction is unreasonable.

Confession of Judgment Clause

A confession of judgment is a voluntary submission by a debtor, to the jurisdiction of the court, given by consent and without the service of process.  Thus, a confession of judgment clause permits a creditor or its attorney simply to apply to the court for judgment against a debtor in default without requiring or permitting the debtor, or its guarantors if a confession of judgment clause is included in a guaranty, to respond at that juncture. Generally, a confession of judgment may be made by the defendant himself or herself, or by some person duly authorized to act for him or her in their behalf, as by a warrant of attorney.

In general, the law does not favor confession of judgment provisions. Confession of judgment is a powerful tool because it effectively prevents the debtor from having his or her day in court prior to the entry of judgment. Such power must be exercised fairly and with exacting precision. The use of confessed judgment in all “consumer credit transactions” has been abolished. Confessed judgments are still permissible in commercial transactions, but must be exercised fairly and in strict accordance with the requirements of the law and the rules of civil procedure.

In analyzing a confession of judgment clause in a commercial credit application, the court is guided by rules that apply to other written contracts. The right to enter a judgment on a confession of judgment clause is a question governed by the intent of the parties.  Depending on the circumstances, a confession of judgment clause contained in a commercial credit application may be invalid on the ground of unconscionability.  For example, if the confession of judgment clause is not in conspicuous print on the credit application, or the debtor’s signature on the credit application does not relate directly to the confession of judgment clause, a confession of judgment debtor might successfully challenge a confession of judgment, and have the judgment stricken by the court, on the basis that enforcing the confession of judgment clause under the foregoing circumstances would be unconscionable.

A “warrant of attorney” is a means of giving a creditor security by his or her debtor authorizing an attorney to confess judgment against the debtor for an agreed upon amount.  It constitutes a grant of authority by one contracting party to the other, upon the happening of a certain event, specifically, a breach of the terms of the agreement wherein the warrant of attorney is contained, to enter a judgment.

When a party to a contract seeks to bind the other party with a warrant of attorney authorizing the confession of judgment, the warrant of attorney must appear in the body of the contract, and cannot be incorporated by casual reference to a separate document, with a designation not its own. The grant of authority to confess judgment must be clear and explicit. However, no particular phraseology in confessing judgment is required, it being substance rather than form which is important. The warrant of attorney to confess judgment need not contain any form of the word “confess,” nor any other specific words, provided that proper intention to confess judgment is displayed.

Because a warrant of attorney authorizing confession of judgment can be an oppressive weapon, a judgment entered pursuant to a warrant of attorney can be accomplished only by strict adherence to the provisions of the warrant.  Justification for the entry of a judgment by confession must be found in the terms of the instrument itself, and may not be extended beyond the definite power which the law confers. Thus, the validity of such a confessed judgment rests upon a strict construction of the language of the warrant of attorney, which should be strictly construed against the party favored thereby. Any ambiguity or doubt as to the validity of a judgment by confession upon the authority of a warrant of attorney must be resolved against the party entering the judgment. If the confessed judgment includes an item not authorized in the warrant, the judgment is void in its entirety and must be stricken.

Forum Selection Clause

As a general rule, private parties cannot, by contract, change the rules of jurisdiction or venue embodied in the various laws of the states. However, an agreement between the parties, purporting to determine the forum where future disputes between them should be litigated is not per se invalid or without legal effect. Where the parties have freely agreed that litigation shall be conducted in a specified forum, and where such agreement is not unreasonable at the time of the litigation, the court in which venue is proper and which has jurisdiction should decline to proceed with the cause.

In view of the vast growth of interstate (and international) transactions, forum selection clauses have been increasingly enforced by federal and state courts, at least in interstate transactions, Forum-selection clauses in commercial credit applications are prima facie valid and should be enforced in the absence of fraud, undue influence and overbearing bargaining power, or if the clause is not shown by the resisting party to be unreasonable under the circumstances. Such a clause would be unreasonable only where its enforcement would, under all circumstances existing at the time of litigation, seriously impair a party’s ability to pursue or defend a cause of action.  Mere inconvenience or additional expense is not the test of unreasonableness, since it may be assumed that a party received under the contract consideration for these things. A forum selection clause in a commercial credit application, mandating that suit be brought in a jurisdiction where the defendant does not reside or does not have its principal place of business, will be found unenforceable where: (1) absent the contractual provision, venue would properly lie in another jurisdiction; and (2) all the essential contacts, witnesses, and circumstances of the case exist in that other jurisdiction, and it would cause the objecting party unjustifiable and onerous expense to litigate the matter in a contractually created forum.

In summary, these contractual clauses – personal guaranty, disclaimer of warranties, confession of judgment and forum selection clauses – are enhancements to the creditor’s position which should be incorporated into commercial credit applications to the maximum extent possible.  If the credit applicant resists, at the very least the exclusion of one or more of these clauses can be used as negotiating points to extract a quid pro quo, in terms of other concessions from the credit applicant.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

New Bankruptcy Code Forces Consumer Debtors to Pay More to Unsecured Creditors

Bernstein-Burkley, P.C.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 is over two years old now. By now, most people are familiar with its terms and have adjusted to the changes. Much of the new law, however, is still subject to different interpretations and litigation is heating up on a number of fronts.

One such front should be of interest to our clients that often find themselves with large unsecured debts in consumer Chapter 13 bankruptcies. The new Bankruptcy Code requires debtors whose income exceeds the state median income in which they live to apply all of their “projected disposable income” towards making payments to unsecured creditors. See, 11 U.S.C. § 1325(b)(1)(B). The point of this provision was to curtail the practice of debtors paying their secured creditors in their Chapter 13 plan, but only making a small or sometimes non-existent percent distribution to unsecured creditors.

The point of dispute has been on how to calculate “projected disposable income.” However, using all different calculation approaches, the result of this provision in practice has been, in many circumstances, a dramatic increase in the monthly plan payments or dismissal of cases for failing to pay all “projected disposable income” to unsecured creditors.

The Means Test and Form B22C

The first hurdle is to determine whether the debtor is an above-median income debtor, which is a comparison of the debtor’s income over the prior six months before bankruptcy against the state median income. The prior six months of income is known as the “Current Monthly Income” or “CMI.”

If the debtor has above-median income, the Bankruptcy Code then provides a calculation, known as the “Means Test,” to determine if the debtor has enough available income to be forced into a Chapter 13 bankruptcy. Debtor’s expenses are determined by reference to IRS National Standards and Local Standards for certain categories and Debtor’s actual expenses for other categories. See, 11 U.S.C. § 707(b). The Means Test is the CMI minus the debtor’s standardized expenses.

A standardized form, known as Official Form B22C and titled Chapter 13 Statement of Current Monthly Income and Calculation of Commitment Period and Disposable Income, was created to facilitate this calculation. A filled out Form B22C can normally be found in all bankruptcy filings attached to the Schedules filed by the Debtor at the beginning of a bankruptcy.

A Practical Application of the Projected Disposable Income Rule

Line 58 of Form B22C, titled Monthly Disposable Income Under § 1325(b)(2), shows the result of the Means Test calculation. Holders of unsecured claims can use this number as a starting point in determining if the Chapter 13 plan is proposing to pay as much as it should to unsecureds.

As an example from a recent case in which this law firm was involved, the result of Line 58 was $799. This means that, over a sixty month plan, the debtor should propose to distribute at least $47,940 (60 * $799) solely to unsecured creditors. If the unsecured creditor pool was $100,000, that would be a 48% distribution. In that recent case, the debtor proposed a 0% distribution to unsecureds.

This law firm filed an Objection to Plan Confirmation based on Section 1325(b)(1) of the Bankruptcy Code which provides that, upon the filing of an objection by “the trustee or the holder of an unsecured claim” the court “may not approve” the plan unless plan provides that all “projected disposable income” be paid to unsecureds. This is important because the onus is on the unsecured creditor to determine that the plan is underfunded and make the objection. If the claimant does not make the objection, an underfunded plan will be approved and become the law of the case.

In the above example case, the Bankruptcy Court agreed that the debtor was not applying all “projected disposable income” to pay unsecureds and dismissed the case because the plan was not confirmable.

The Dispute Over How to Calculate Projected Disposable Income
The previous example was very simple in that it only used the Form B22C Means Test result. However, the Means Test result officially shows “disposable income” and not “projected disposable income” as that term is set forth in Section 1325(b) of the Code.

Bankruptcy practitioners throughout the United States have argued that “projected” requires a forward looking approach to the debtor’s income and should not be reliant on the backward looking six month average of the CMI discussed above. A growing number of bankruptcy courts have agreed that the most accurate reflection of projected income is set forth in debtor’s Schedule I (the Schedule in each debtor’s Voluntary Petition that shows the debtor’s monthly income as of the bankruptcy filing). See, e.g., In re Bossie, 2006 Bankr. LEXIS 3956 *5 (Bankr. D. Alaska 2006); In re Edmonson, 363 B.R. 212, 217 (Bank. D. N.M. 2007).

This is because the CMI looks back at the last six months, which may be distorted by periods of unemployment or seasonal employment, while Schedule I shows income as it is on the bankruptcy filing date.

On many occasions, such as in the one used as the example in this paper, the CMI of Form B22C and Schedule I are the same number. However, in situations where Schedule I exceeds the CMI, creditors may argue that the correct “projected disposable income” example is debtor’s income reflected in Schedule I minus the Form B22C standardized expenses. The result will be in many cases an even greater distribution to unsecured creditors.

Even though parties are still litigating its exact meaning, the requirement in the new Bankruptcy Code that above-median income debtor’s pay all of their “projected disposable income” to unsecured creditors is a very powerful tool that is dramatically increasing percentage payouts to unsecureds. Unsecured creditors can easily make a rough determination if the plan is fully funded or not by referencing Line 58 of Form B22C. If it is not paying enough to unsecureds, a timely plan objection can force a higher plan payment or result in the dismissal of the bankruptcy case.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

Understanding Preference Actions Under the Bankruptcy Code

There is perhaps nothing more frustrating than when one of your customers files bankruptcy and avoids paying money that they owe your company. However, anyone that has dealt with a “preference action” knows that merely writing off a debt as uncollectible is not the worst thing that can happen when a customer enters bankruptcy. A preference action has the potential to be much worse, because it is a lawsuit by the debtor or the bankruptcy trustee against your company, seeking to recover payments that were made by the debtor to your company before the bankruptcy. Fortunately, the Bankruptcy Code provides creditors with certain defenses that can be used to defeat a preference action.

The Preference Action:
The Bankruptcy Code permits the trustee to avoid and recover from creditors payments made within the 90-day period before the bankruptcy filing. The policy behind this provision is to prevent aggressive collection activities that often force the debtor into bankruptcy.

A “preference” is defined by Section 547 of the Bankruptcy Code as:

  1. Payment on an “antecedent” (meaning a previously incurred as opposed to current) debt;
  2. Made while the debtor was insolvent (meaning its assets are less than its liabilities);
  3. To a non-insider creditor, within 90 days of the filing of the bankruptcy;
  4. That allows the creditor to receive more on its claim than it would have, had the payment not been made and the claim paid through the bankruptcy proceeding.

Section 550 of the Bankruptcy Code allows the trustee to avoid and recover any preference payments by filing a lawsuit against the creditor.

Typically, a preference action is often preceded by a “demand letter” from the debtor or the trustee. The demand letter sets forth the trustee’s claims and demands immediate payment. Often times the trustee is willing to settle the preference action for an extremely reduced amount if the settlement is reached before the lawsuit is filed. Consequently, when the creditor receives a “preference demand letter,” the creditor should always have experienced bankruptcy counsel review the case to determine whether the creditor has valid defenses. Bankruptcy counsel can often negotiate a favorable settlement and allow the creditor to avoid having to expend large sums of money in litigation.

If the parties do not reach a settlement, the preference action is initiated with a complaint filed with the bankruptcy court. The preference complaint is similar to any other lawsuit with the exception that its filed in bankruptcy court, rather than federal district or state court.

Defending a Preference Action:

The Bankruptcy Code also provides defenses to preference actions. The three most common are: 1) the “ordinary course of business defense”; 2) the “contemporaneous exchange for new goods or services” defense; and, 3) the “new value” defense. All three of these defenses are “affirmative defenses,” meaning that the creditor has the ultimate burden of proof on the issue.

To prove the “ordinary course of business defense” the creditor must show that the preference payments were made in the “ordinary course of business” between the creditor and the debtor. Typically, this is done by showing that the preference payments were: 1) not the result of any overt collection activity on the part of the creditor; and, 2) were made in a similar amount of time and under similar terms and conditions as previous, non-preference period payments made by the debtor to the creditor. Assuming that the payments were in fact made “in the ordinary course of business” of the parties, proving the defense is relatively simple and can usually be done with past invoices and payment dates, and testimony regarding the lack of collection activities. Alternatively, if the payments were not in fact made in the ordinary course of business between the parties, the creditor can show that the preference payments were made on terms and conditions prevalent in the respective industry. This is a harder form of the ordinary course defense to prove and should only be used as a fall-back position. All payments that are shown to have been made in the ordinary course of business are not avoidable as preferences and need not be repaid.

To prove the “new value defense,” the creditor only needs to show that goods or services were sold/provided to the debtor after one or more of the preference payments were made. The value of any “new” goods or services can be offset dollar-for-dollar against any preference payments made by the debtor.

The creditor proves the “contemporaneous exchange” defense by showing that the creditor provided new goods or services contemporaneously with (i.e., at or near the same time) a payment that was of equal value to the goods or services provided and that the parties intended the transaction to be a “contemporaneous exchange.” For example, if the creditor receives a $100 payment on June 1 and delivers goods worth $100, if the parties intended the $100 payment to be for the $100 in new goods, then the contemporaneous exchange defense applies. If the parties intended for the $100 to pay a previous invoice, then the contemporaneous exchange defense is not applicable.

Sometimes Bankruptcy Counsel can raise these defenses with the trustee before the complaint is filed and actually avoid the lawsuit altogether. Other times, the defenses can be used to significantly reduce the amount that the trustee will accept as full settlement of the claim. No matter how the preference defenses are used, the defenses are designed to ensure that viable, ordinary, good faith business transactions are not ultimately reversed by the bankruptcy court.

Attorneys at Bernstein-Burkley, P.C. will often have clients ask the following question: “I have a customer that is offering to make a large payment on their account. I know that they are about to go bankrupt. The payment will probably be a preference—should I take it?” The answer, of course, is “YES! TAKE THE PAYMENT!” At worst, you can almost always negotiate with the trustee and pay a reduced amount in full settlement of the preference claim. Perhaps the defenses illustrated above can be used to reduce your preference exposure. At best, the trustee will decide not to pursue the preference action and you will get to keep the entire payment. Preference actions are a natural part of bankruptcy law but with knowledge, the right circumstances, and experienced counsel, a creditor can often avoid having to return the payments.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

Confession of Judgment under Pennsylvania Law

Bernstein-Burkley, P.C.

As a creditor, there is perhaps no greater tool than a valid confession of judgment clause within your written agreement with a customer.

Imagine a customer fails to make payment on its commercial credit account. Now you must decide whether or not to hire an attorney and initiate a lawsuit. However, the last time a lawsuit was filed on one of your accounts it was months, maybe longer, before you received payment. At the very least, the customer, now former customer, had to be served with a Complaint. Then your attorney informed you that your former customer had to be given the opportunity to file an Answer. Next, there was discovery and a hearing where you had to prove they were in default. All of this time to obtain a judgment. Additional time and money will be spent executing on the judgment if the former customer decides not to voluntarily pay. At this point, you are astonished; this was the simplest of transactions. The customer purchased and used the goods without objection and failed to pay you for them. Yet it has taken you significant amounts of time and money to obtain a judgment against him or her.

Aside from refusing to deal with this customer on a credit basis, you ask yourself whether there was anything else you could have done to protect your business. The short answer is yes. You could have negotiated a confession of judgment clause into your agreement with this customer.

A confession of judgment clause provides that one party agrees to allow the other party to the contract to enter judgment against him or her. The clause permits a creditor, or their attorney, to apply to the court for judgment against a debtor in default without requiring or permitting the debtor to respond or contest the judgment at that point in time. More importantly, there can be an immediate judgment entered without having to follow the timely process set forth above. The customer has voluntarily submitted to the jurisdiction of the court and for the entry of judgment without service of process in the event of a default.

As stated above, a confessed judgment is entered without notice or a hearing. Depending on your personality, you are probably wondering how this is possible, or why is this not done more often. In fact, such a concept seems counterintuitive to one of the basic principles upon which our nation was founded, due process of law. The Constitution provides that no person shall be deprived of life, liberty or property without due process of the law. Typically, due process of the law requires notice and a hearing whereby one can defend themselves against the actions of others. Therefore, confessions of judgment clauses are generally disfavored under the law because such a contractual provision essentially deprives a person from having his or her day in court. Courts will strictly scrutinize confession of judgment clauses because of the constitutional due process concerns associated with enforcing such clauses. However, in certain situations, and if certain procedures are followed, two parties can effectively contract away one’s right to notice and a hearing.

First, it is important to determine whether or not you are the type of creditor that can utilize a confession of judgment clause. Under Pennsylvania law, judgment cannot be confessed against any natural person in connection with a consumer credit transaction. A consumer credit transaction is defined as any credit transaction in which the party to whom credit is extended is a natural person and the money, property or services which are the subject of the transaction are primarily for personal, family or household purposes. For example, judgment may not be confessed against an individual who purchases new furniture on a credit account for use in their home. However, if that same person purchases new furniture on credit for use in one of many apartment units that he or she owns and manages, then it may be possible to confess judgment against that person for non-payment on this credit account.

Next, the language of the confession of judgment clause itself must be sufficient to withstand court scrutiny. This includes not only the text of the language, but also the location of the confession of judgment clause itself. For the actual text of a confession of judgment it is best to consult an attorney to determine what language must be included to ensure validity of your confession of judgment clause. Generally, a valid of confession of judgment clause must be CONSPICUOUS, and the signature of the party who is authorizing judgment to be confessed against them must bear a direct relation to the clause itself. These strict linguistic requirements are because it is this executed instrument that the court will review if the confessed judgment were to be challenged. If properly drafted, a valid confession of judgment clause will convey to the court that there is no doubt that the signor was conscious of the fact that he or she was authorizing the other party to enter judgment against them without notice or a hearing.

Lastly, there are special procedural requirements that must be followed when enforcing a confession of judgment clause. The most common method of enforcing a confession of judgment clause is to file a complaint in confession of judgment. Generally, the complaint in confession of judgment must include: 1) the names and addresses of the parties; 2) the original or a reproduction of the instrument showing the defendant’s signature; 3) a statement regarding any assignment of the instrument; 4) a statement that judgment has not been entered in any other jurisdiction; 5) an averment of default or condition precedent, if required by the instrument before the entry of judgment; 6) an itemized computation of the amount due based on matters outside the instrument, including interest and attorneys fees if authorized; 7) a demand for judgment as authorized by the instrument; and 8) signature and verification as required by the rules of civil procedure. It is this filing that instructs the Prothonotary to enter judgment in the amount stated and against the named defendant.

As you can see, a confession of judgment clause is an effective, but complicated tool that requires both careful planning and implementation. It is critical to make sure that the confession of judgment clause is properly drafted, and that the proper steps are taken in its enforcement, in order to take full advantage of this powerful collection tool. For more information regarding confession of judgment clauses, contact Bernstein-Burkley, P.C. for an in-depth look into your business, and how a confession of judgment clause may specifically benefit your business.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

Forum Selection Provisions in Credit Agreements

Be Careful What You Wish For:

Nicholas D. Krawec, Esq.

Bernstein-Burkley, P.C.

In the modern business world, where interstate and international transactions are commonplace, many commercial contracts include a clause commonly referred to as a “Forum Selection Clause”. This clause specifies the geographic location, and often the specific court or tribunal (such as the American Arbitration Association, or National Arbitration Forum), in which any lawsuit to adjudicate a dispute between the parties to the contract, regarding the contract’s terms, must be brought. This is done primarily by businesses to protect themselves from having to retain counsel and litigate cases far from their home office or nearest satellite office, but also may be included to take advantage of certain favorable laws, regulations or procedural rules within a particular jurisdiction.

In the context of commercial credit agreements and collection actions, the concerns of the creditor are slightly different, since it is the creditor who is usually the Plaintiff and thus has the initial choice of forum for adjudication of contract disputes. Moreover, rather than institute suit in the jurisdiction closest to the creditor’s home office, many creditors seek to locate and sue debtors wherever they can be found, since any attachable property belonging to the debtor is likely to be located there as well, and also because it avoids the delay and expense associated with transferring a judgment from the creditor’s jurisdiction to the debtor’s jurisdiction. However, if a creditor has inserted a forum selection clause in its credit agreements which vests exclusive jurisdiction in the court where the creditor’s home office is located, if the creditor and debtor are located within the same state, a judgment obtained in the creditor’s jurisdiction (county) can relatively easily be transferred to a local court in the debtor’s jurisdiction (county).  If the creditor and debtor are located in different states, the creditor can domesticate the judgment obtained in the creditor’s jurisdiction (state) in the court of the debtor’s jurisdiction (state) pursuant to the Uniform Enforcement of Foreign Judgments Act (UEFJA).  However, some states’ version of the UEFJA have a 30 day waiting period after domestication of the judgment, before a creditor can take action to execute upon (enforce) the domesticated, out of state judgment.  This allows time for the debtor to take action to attempt to challenge the out of state judgment on jurisdictional grounds.  If the courts of the debtor’s jurisdiction disfavor forum selection clauses, the debtor may succeed in getting the judgment which was domesticated in his state stricken, in which case the creditor must re-file the lawsuit in the debtor’s jurisdiction (and hope that the statute of limitations has not run on the cause of action).  The creditor must therefore take these factors into consideration when drafting a forum selection clause.

The most important consideration in drafting an effective forum selection clause which favors the interests of the creditor is examining the applicable law of the jurisdiction selected as the forum. This is particularly true in the case of consumer credit agreements, since many States have strong consumer protection laws which may hamper, delay, or increase the cost of collection. Additionally, under the terms of the Federal Fair Debt Collections Practices Act (FDCPA), which governs third party debt collectors collecting consumer debts, an action to recover a consumer debt must be brought either in the jurisdiction where the debtor resides, or in the jurisdiction in which the contract was signed (which can be the creditor’s place of business).  Moreover, most states consumer protection statutory framework includes a state version of the FDCPA, which may mirror the provisions of the FDCPA, and may apply to creditors collecting their own debts.  Thus, simply choosing the jurisdiction of the creditor’s home office or state of incorporation, as is common in many form contracts, may not be the best option, if for example, the creditor is located in California or Massachusetts. At the same time however, the creditor, in drafting a forum selection clause for its contracts, cannot simply choose, from among the fifty states, the one whose law is most favorable if neither creditor nor debtor conduct any business in that state, or if the transaction has no relation to that state, since most courts require that there be a reasonable relationship between the parties or transaction and the forum state before they will enforce the forum selection clause.

Creditors must also keep in mind that selecting a particular forum does not, in and of itself, guarantee that the laws of that jurisdiction will be the ones which are ultimately applied to the case. Each jurisdiction maintains its own “choice of law” rules which govern cases where parties from multiple jurisdictions with differing statutory and common law precepts are involved. In the case of credit agreements and contracts in general, many courts still apply the ancient rule “lex loci contractus,” which means that they will apply the substantive law of the jurisdiction where a contract was formed in rendering an interpretation of disputed provisions. Thus, it becomes vital that a creditor not only take into account the entire body of law of a particular jurisdiction when making a forum selection, including its choice of law rules, but also include in its credit agreements both substantive choice of law clauses and place of contracting clauses, the latter of which stipulates when and where a contract is formed.  For example, such a clause may read, “this contract shall be deemed to have been formed in the Commonwealth of Pennsylvania, and shall be governed by the laws of the Commonwealth of Pennsylvania.”

Finally, the creditor must also account for the attitude of particular jurisdictions towards forum selection clauses. Traditionally, forum shopping is discouraged, hence the requirement of a reasonable relationship between the selected forum on the one hand, and the parties and transaction on the other, noted above.  However, with the development of modern contract law, forum selection clauses are generally no longer disfavored, and will customarily be enforced subject to certain restrictions. A party challenging a forum selection clause has the burden of showing the clause is unreasonable. A party to the contract can show the clause’s unreasonableness by establishing that:

  1. it was induced by fraud or overreaching; or
  2. the forum is so unfair and inconvenient that it effectively deprives the party resisting the clause of a remedy or of its “day in court;” or
  3. enforcement would contravene a strong public policy of the State where the action is filed.

The Model Choice of Forum Act contains a balancing test, and states that an unselected court must give effect to the choice of the parties and refuse to entertain the action unless:

  1. the plaintiff cannot secure effective relief in the other state, for reasons other than delay in bringing the action; or
  2. the other state would be a substantially less convenient place for the trial of the action than this state; or
  3. the agreement as to the place of the action was obtained by misrepresentation, duress, abuse of economic power, or other unconscionable means; or
  4. it would for some other reason be unfair or unreasonable to enforce the agreement.

Due to all of the above considerations, it is very important that the inclusion of a forum selection clause in a credit agreement be done with extreme care, and preferably in consultation with a creditors’ rights attorney. While a carefully drafted forum selection clause and choice of law clause can facilitate the collection of the debt and ease the path toward judgment and execution, hastily prepared clauses, or ones prepared purely for convenience can just as easily delay the creditor’s obtaining of a judgment, increase costs, and adversely affect the overall viability of an otherwise sound cause of action.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

Federal Court Replevins Actions

Replevins, Making Use of a Valuable, but Often Overlooked Tool

So you’ve met with an attorney and you have been informed that you have a “strong” case. Of course you instruct your attorney to immediately run to the nearest courthouse and file a writ, summons, complaint or whatever legal document is necessary in order to immediately get the ball rolling. In the words of a certain sports broadcaster on crisp fall mornings, “Not so fast my friend!”1

Almost as important to the determination of whether or not you have a factual basis for a lawsuit, is the decision of what court to file that lawsuit in.2 However, before narrowing in on a particular court, there is the question of what type of court you will file in.

Our country has a dual court system; we have both state and federal courts. Generally, the difference between the two court systems boils down to jurisdiction. Jurisdiction is a court’s ability to hear a particular matter. State and local courts are, for the most part, courts of general jurisdiction with the ability to hear almost every type of dispute. Federal courts are established under the U.S. Constitution for the purpose of deciding disputes involving the Constitution and laws passed by Congress. However, there are certain scenarios where a particular matter may fall within both the jurisdiction of the state and federal court systems.

The decision of whether to file in either state or federal court also applies to replevin actions.3 While some attorneys and creditors may view replevin actions as a remedy solely for use in state court, there is a place for replevin actions in federal court. Specifically, Rule 64 of the Federal Rules of Civil Procedure provides that:

At the commencement of and throughout an action, every remedy is available that, under the law of the state where the court is ,4 provides for seizing a person or property to secure satisfaction of the potential judgment. But a federal statute governs to the extent it applies.

Fed.R.C.P. 64.

The aforementioned rule affords the parties to a federal action on all prejudgment remedies, including replevin, as they are provided for under the law of the state in which the federal court is . In fact, “state provisions about the circumstances and manner in which provisional remedies can be used … must be honored.”5

The operation of Federal Rule of Civil Procedure 64 embodies the Erie Doctrine as it implements the provisional remedies of replevin, attachment, garnishment, etc. made pursuant to local (state) statutes in federal diversity litigation.6 While federal courts must apply state substantive law pursuant to the Erie Doctrine, federal courts apply federal procedure to diversity matters.

Of course this use of state court prejudgment remedies doesn’t always mesh with federal court procedure. For example, in replevin actions, Pennsylvania Rule of Civil Procedure 1081(a) provides that, “[a] claim secured by a lien on the property may be set forth as a counterclaim. No other counterclaim may be asserted.”7 Thus, the only defenses that may be asserted to a replevin action in Pennsylvania are either title to the subject property or a lien against said property. However, Federal Rule of Civil Procedure 13 compels a defendant to assert his counterclaim, “if it arises out of the transaction or occurrence that is the subject matter of the opposing party’s claim.”8

The question then becomes whether or not a defendant in a replevin action in a Pennsylvania federal court may assert a counterclaim? When confronted with this issue, the United States District Court for the Eastern District of Pennsylvania found that the assertion of a counterclaim in a federal court replevin action was procedural in nature rather than substantive, and allowed the defendant to assert a counterclaim when it was clear the defendant had no lien rights.9

The fact is that the ability to utilize a replevin action and/or other such seizure remedies in federal court has existed for quite some time, but it is not a tool that is often utilized by creditors’ rights attorneys. I suspect that this is because of the amount in controversy requirements involved in meeting diversity jurisdiction. However, when proper jurisdiction exists, there are a number of factors that suggest that federal court may be the proper forum for your replevin action.

I suggest that the most important factor to examine is one that is inherent within the replevin process itself. That is the speed with which the matter is adjudicated. The purpose of a replevin action, particularly where pre-judgment seizure is sought, is to quickly determine ownership of a particular piece of property, so that the displaced owner can immediately begin receiving the benefit of possession of that property. In theory, everyday that the owner is deprived of possession damages continue to accrue.

Federal courts have less of a caseload than state courts. Therefore, it reasons that federal court litigation will be faster than state court. Other differences between state and federal courts, such as electronic filing and the requirements regarding service of original process, can provide a plaintiff with the ability to speed litigation along. State courts may not have the ability to file electronically, or may require the use of a public servant (i.e. sheriffs, constables, etc.), both of which can lead to unnecessary delays in litigation. Another factor may simply be the familiarity with the applicable rules of civil procedure. State court procedure varies greatly from state to state, whereas all federal courts adhere to the Federal Rules of Civil Procedure. Your attorney is going to be able to work faster and better serve you if he or she is more familiar with the civil procedure rules at hand. This will also eliminate the need for local counsel to do additional legal work.

While this article suggests that there are many benefits to filing a replevin action in federal court, it is not meant to condemn state courts or their handling of replevin actions. It is merely written to inform both creditors’ rights attorneys and their clients that there are other options available to remedy the situation at hand.

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1 These are the words often uttered by football analyst Lee Corso on millions of television sets across the nation each Saturday morning on ESPN’s College Game Day.

2 Of course, there are a number of issues, including witness travel, litigation strategy, etc., that must be addressed before the filing of any lawsuit. However, this article is being written for the sole purpose of introducing attorneys and creditors to federal court replevin actions.

3 Generally speaking, a replevin action is a legal remedy by which a plaintiff may recover goods, unlawfully withheld from his or her possession, by means of a special form of legal process in which a court may require the defendant to return the specific goods to the plaintiff prior to the entry of judgment. In other situations, the plaintiff, or the court, may elect to adjudicate the right to possession prior to obtaining the relief to recover the goods in question.

4 Weener Plastics, Inc. v. HNH Packaging, LLC., 590 F. Supp. 2d 760, 764 (E.D.N.C. 2008).

5 Weener Plastics, Inc. v. HNH Packaging, LLC., 590 F. Supp. 2d 760, 764 (E.D.N.C. 2008), quoting, 11A C. Wright A. Miller & M. Kane, Federal Practice & Procedure, § 2932, p. 7 (2d ed. 1995).

6 Erie R. Co. v. Tompkins, 304 U.S. 64, 58 S. Ct. 817, 82 L. Ed. 1188 (1938) (holding that federal courts must apply state substantive law when hearing diversity cases).

7 Pa.R.C.P. 1081(a).

8 Fed.R.C.P. 13.

9 Wright v. Redding, 408 F. Supp. 1180, 1183 (E.D.Pa. 1975) (“Federal rules determine such things as the commencement of action, pleading, joinder of actions and parties, use of discovery, mode of trial, and other procedural matters regulated in the Rules.”).

For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.