Craig King was plenty disappointed when Trans World Airlines Inc. filed for bankruptcy in 2001 still owing him $7,400 for building a break room and installing ticket counters at Anchorage International Airport. It was only the second time in the 19 years as owner of a small construction company in Alaska that a customer hadn't paid him in full. But King's hurt was just beginning. Nearly two years later, TWA lawyers slapped him with a lawsuit for the return of an initial $10,000 the airline had paid him for the work seven weeks before it went bust. King was given a choice: Pay back 80% of the money or fight the case in a Delaware court. "I was flabbergasted," says King.
Thousands of suppliers are feeling just as dumbfounded now. Like King, they have been hit by lawsuits filed in the names of bankrupt companies by lawyers working for contingency fees, typically 33% of what they recover. The preference actions, as they're called, seek to reclaim money the debtors paid out in the 90 days before they filed for bankruptcy. They're based on the centuries-old legal principle that no creditor should get preferential treatment, especially those who were paid when the deadbeat company was about to go to court. Such suits are growing fast: Last year they totaled some 60,000 -- nearly three times as many as in 1999, according to the Administrative Office of U.S. Courts.
A string of mega-bankruptcies has spurred the surge. Last year, the failure of Bethlehem Steel Corp. alone spawned more than 3,000 lawsuits, plus 1,300 letters demanding repayments. Thousands more suits flowed from the collapses in 2001 and 2002 of Enron (ENRNQ ), WorldCom (MCIP ), and 360networks. Now, UAL Corp. (UALAQ ), parent of United Air Lines Inc., is gearing up to file as many as 2,500 suits before early December, when the two-year statute of limitations on its claims runs out.
Because of the wave of cases, suppliers are getting more leery about giving credit. Already, they're backing away from giving struggling customers extra time to pay because the law, perversely, guts their defenses if they have made an exception to their usual payment terms. "The specter of [lawsuits] is reshaping business credit policy," says Robin Schauseil, president of the National Association of Credit Management (NACM), a creditor trade group that has been lobbying for years to reform bankruptcy law.
Advances in technology are adding to a sense of unease among creditors. Thanks to widespread electronic record-keeping, versatile computer software, and broadband connections, it's easier than ever for lawyers to pursue claims. And some attorneys seem to operate on an industrial scale: In the Bethlehem Steel case, one firm, Gazes & Associates LLP, fired off 1,500 lawsuits and 1,300 letters in just nine weeks.
Technology has also dramatically cut the cost of preference actions. Jack B. Fishman, a lawyer and president of bankruptcy-services firm Novare Inc., says he will now go after amounts as small as $500, compared with the $10,000 minimum lawyers used to require. Because it costs $150 to file a case in court, he first sends letters demanding repayment. Fishman was recently hired by UAL's bankruptcy lawyers to help retrieve as much as $450 million paid in the fall of 2002 before it filed for bankruptcy. Small cases add up, he says, figuring that if he can get 2,000 defendants to cough up an average of $5,000, he'll bring in $10 million. "I have no qualms about what I do," says Fishman. "I've been called everything from extortionist to scam artist."
Indeed, some suppliers say many preference actions are little more than legally sanctioned extortion. For one thing, even as the cost of making claims is falling, the expense of fighting them is rising. Under the current law, defendants have to show why they should keep the money. So suits for less than $10,000 are rarely worth fighting. Shelling out cash to settle often makes more sense. "It has become abusive," says Robert P. Simons, a bankruptcy lawyer at Reed, Smith LLP in Pittsburgh who represents suppliers caught up in the series of recent steel industry bankruptcies. "The pressure is on the defendant to cut a deal."
Mounting a viable defense to preference actions is difficult. For starters, creditors often have to deal with letters and lawsuits that demand the return of a sum total of payments without saying exactly when they were made, for what, or by which of the debtor's operating units, says Kelton Farris, vice-president for collections at Premium Assignment Corp., an insurance finance unit of Suntrust Banks Inc. (STI ) About once a month, he receives a demand for repayment from lawyers who have apparently downloaded his address with others from the old check registers of bankrupt companies. "They deal in such volume that if you call them, you're lucky to get a call back within a week," says Farris.
Lawyers who bring the cases counter that they're following professional standards and use the law and modern technology quite legitimately to help bankrupt companies. Ian J. Gazes of Gazes & Associates argues that the claims he pursues help make the bankruptcy process fairer by retrieving money from creditors who by luck or by inside information get paid ahead of others. Fishman says it's sometimes difficult for lawyers filing suit to provide the detail some of the defendants seek. On occasion, he says, there isn't time to track down the particulars of the payments before the statute of limitations runs out. At other times, the bankrupt company's records are a mess.
As more companies securitize their assets, the arguments become even more bitter. Bankrupt companies have often pledged a large chunk of their assets to secured creditors. As a result, there are fewer sources of cash left to pay the lawyers except for the preference actions. "They're a hidden source of funding for many bankruptcy cases," says a lawyer who asked not to be named because he is defending suppliers of several of the big bankrupt companies.
For years, the NACM has been pushing to change the law. The fixes it seeks include setting a minimum threshold for lawsuits, shifting the burden of proof to plaintiffs, and shortening the "clawback period" to 30 days from 90 days before a bankruptcy filing. Although the reforms have general support on Capitol Hill, NACM President Schauseil says they've been held up in a stalemate over consumer issues in a pending overhaul of the bankruptcy code.
Reform might have come sooner if it were clearer exactly how much money is recovered and by whom under the existing law. Suits often linger for years after companies are liquidated or are out of bankruptcy. "There's little public accountability," says Thomas D. Goldberg, a lawyer for trade creditors at Day, Berry & Howard. "Trying to find out how much has been recovered and what the benefit is to whom is almost impossible in most cases."
That's certainly true for TWA and the money returned by Anchorage's King. He paid $1,500 to a local lawyer who put up such a stink in settlement talks that King had to pay TWA only $1,500. But King doesn't know what became of that money. Lawyers for the TWA estate declined to discuss the case. Bankruptcy court documents filed in 2002 indicate that at least 96.7% of preference recoveries would go to lawyers and other priority creditors of TWA. Unsecured creditors such as King would share no more than $4.8 million, or just a quarter penny for every $1 they were owed. With odds like that, it's no wonder creditors believe the law prefers the lawyers.
By David Henry in New York