INTRODUCTION
It is often suggested that the success of a chapter 11 bankruptcy proceeding has more to do with the events and circumstances leading up to the bankruptcy filing than the post-petition conduct of the debtor, its creditors or the other parties in interest. Specifically, the debtor who has alienated its core creditor constituency in the years prior to a bankruptcy filing is likely to have an extremely difficult road to rehabilitation. Similarly, a chapter 11 debtor who commences a proceeding without sufficient funds to pay its ordinary course operating expenses, or who lacks a vehicle for obtaining new financing, is likely to have its case converted to a proceeding under chapter 7 in short order. On the other hand, the financially troubled debtor who has garnered the cooperation of its trade creditors, filed its bankruptcy proceeding at a time of high cash balances, or negotiated the consensual use of the cash collateral of its secured creditor has a substantially greater likelihood of success.
One critical factor to the success of a retail bankruptcy proceeding, and one which is often overlooked, is the importance of credit card processing arrangements. Typically, more than half of a retailer's revenues come from credit card proceeds, whether from the use of a Visa card, Mastercard, American Express card, Discover card or some private label facility. In the competitive retail environment of the 1990's, a debtor cannot successfully sustain operations without accepting most of the popular credit card forms of payment. The savvy chapter 11 debtor is well advised to consider credit card processing issues substantially prior to the filing of a voluntary petition.
The relationship between a company and a credit card servicer (or processing institution) is usually governed by a formal writing designated as either a merchant services agreement, an establishment agreement, a credit card processing agreement or a bankcard merchant agreement. The contract may be with a bank or other financial institution, a processing company such as First Data Corporation or National Data Corporation, or with a credit card carrier itself, such as American Express Travel Related Services, Inc. or Novus, Inc.
Typical provisions of these credit card processing agreements include the establishment of a system for the automatic credit to the retailer's bank account for authorized transactions less applicable fees, the automatic deduction from such account for credit card credits and "chargebacks," the ability of the processor to create a "reserve," "escrow" or a "security fund" to protect from future chargebacks, and termination rights which may also enable the processor to hold the retailer's funds for up to 180 days after processing ceases. Negotiations over the terms of such processing agreements are only slightly more flexible than in the case of insurance policies. Typically, only the discount rate assessed the retailer in connection with acceptance of each credit card is negotiable. Thus, absent a bankruptcy filing, the credit card processors are extremely well protected and take on little risk.
While such agreements provide a processor with a high degree of protection outside the bankruptcy context, there are a number of provisions of the Bankruptcy Code that create substantial concerns for the credit card processor. Pursuant to 11 U.S.C. §365(a), a debtor may assume or reject an executory contract at any time prior to confirmation. Moreover, the non-debtor party to an executory contract is prohibited from terminating the agreement post-petition absent relief from the automatic stay. Thus, if a credit card processing agreement is considered an executory contract, the debtor has the unilateral flexibility to compel the processor to continue to perform, and controls whether and when to terminate.
On the other hand, 11 U.S.C. §365(c)(2) and 365(e)(2)(B) provide that a contract to make a loan or extend debt financings or financial accommodations is not assumable by the debtor, and is terminable by the non-debtor party. Therefore, the first battle to be expected from a credit card processor surrounds the consequences of the executory contract or financial accommodation determination. Unfortunately, the case law on this issue is very sparse, with only one reported decision directly on point. In in re Thomas B. Hamilton Co., Inc., 969 F.2d 1013 (11th Cir. 1992), the court analyzed the legislative history behind §365 of the Bankruptcy Code, and concluded as follows:
...we hold that a credit card merchant agreement, such as the Agreement at issue in this case is not a contract to extend financial accommodations within the meaning of §365(c)(2) and 365(e)(2)(B). Subject to the bankruptcy court's approval, such agreements may be assumed by the trustee and may not be automatically terminated due to a bankruptcy filing.
The Hamilton holding serves to justify a credit card processor's reluctance to find itself involved in a chapter 11 bankruptcy proceeding. In the case of a failing chapter 11 retailer, the volume of anticipated credit card revenues may not be sufficient to protect against future credits and chargebacks, and yet the processor may be obligated to continue to endure this exposure. This reality makes processors very quick to respond to increased chargeback levels prior to any bankruptcy filing.
Another related bankruptcy proposition which impacts upon the credit card processing relationship is the prohibition against the setoff of prepetition and post-petition claims. Pursuant to 11 U.S.C. §553, a prepetition claim held by a creditor can be set off only against a mutual prepetition debt owing by the creditor. Consider the furniture retailer who is in chapter 11, and has accepted prior to the filing a credit card deposit towards some future merchandise delivery. In circumstances of an intervening chapter 11 proceeding, and some default by the retailer in the anticipated furniture delivery, the customer's claim against the debtor is a prepetition priority claim pursuant to the provisions of 11 U.S.C. §507(a)(6). Where the deposit was paid via credit card, the customer is likely to contact his or her card issuing bank and demand a credit. The issuing bank may be obligated to reverse the original charge, and through a series of agreements and operating guidelines, may be able to obtain reimbursement of the credit from the credit card processor. In such circumstances, it is ultimately the processor who holds the outstanding claim against the debtor. While such a claim transfer would be avoided if the debtor obtained authorization to satisfy prepetition consumer claims in the interests of promoting the debtor's reorganization efforts, there are circumstances where a debtor may be unable or unwilling to obtain such relief. If the processor's claim is determined to be a post-petition claim, then the processor can set off such claim against post-petition revenues otherwise payable to the debtor, as occurs absent the bankruptcy filing. On the other hand, if the chargeback claim is deemed to be a prepetition claim, then the credit card processor cannot set off. This potential exposure, together with the obligation to continue to process, makes credit card processors very uncomfortable with the chapter 11 process.
While there is little case law directly on point, the better analysis seems to suggest that a credit card chargeback relating to a prepetition transaction constitutes a prepetition claim. Firstly, 11 U.S.C. § 507(a)(6) speaks of claims "arising from the deposit, before the commencement of the case," in connection with goods not delivered. If the claim is a prepetition claim when held by the consumer, why should its status change if the claim reverts to a processor? In re Calstar, Inc., 159 B.R. 247 (Bankr. D. Minn. 1993), requiring the return of proceeds wrongfully set off by a processor, is premised on the conclusion that chargeback claims relating to prepetition transactions are prepetition claims, even if the chargeback itself is processed after the filing.
Thus, the prospect of a credit card processing agreement being deemed an executory contract (as opposed to an agreement for the making of a financial accommodation), and the limitation on setoffs associated with chargebacks relating to pre-petition transactions creates substantial exposure for a credit card processor in a chapter 11 proceeding, and exposure it would not endure outside of the bankruptcy context.
In order to reduce this exposure, processors typically demand the entry of a stipulation affording the processor the ability to set off without regard to the prepetition or post-petition nature of the claim, the entry of an order deeming the contract assumed, the entry of a stipulation enabling the processor to terminate the agreement on short notice, and the creation of a judicially sanctioned additional reserve account. The savvy credit card processor should also mandate that the debtor obtain authorization from the bankruptcy court to pay prepetition customer refund claims so as to minimize its potential chargeback liability. Absent these arrangements at the outset of the case, the credit card processor is likely to place an administrative freeze on any funds due the debtor immediately upon being notified of a bankruptcy filing, and to request stay relief to offset such funds. Debtor's counsel must be aware that credit card proceeds otherwise anticipated may not be forthcoming once a case is commenced.
While such a freeze may encourage a debtor to locate an alternative processor, changing processing arrangements post-petition is difficult. Why would a processor willingly agree to enter the more risky bankruptcy environment? Even if a new processor can be located, substantial delays in implementation can be expected, and most importantly, a new processor is likely to require the establishment of a very large reserve account. In most instances, the practical reality confronting a prospective chapter 11 debtor is that the only credit card processing facility available to it will be those agreements existing prior to the filing of the bankruptcy proceeding.
A related issue which also suffers from the absence of substantial precedent is the application of 11 U.S.C. §507(d), which provides that a subrogee of certain priority claims is not entitled to priority status. A literal reading of 11 U.S.C. §507(d) suggests that a processing bank's credit card chargeback claims may be relegated to general unsecured status. In an effort to avoid what would appear to be the clear mandate of the statutory language itself, in In re Missionary Baptist, 667 F.2d 1240 (5th Cir. 182), the court agreed with the claimant's assertion that it was an assignee of the subject claim, not a subrogee and, therefore, was entitled to the assignor's priority status. Missionary Baptist involved a check cashing service's claim to employee wage priority pursuant to 11 U.S.C. §507(a)(4). However, the only two cases to decide the issue as concerns credit card chargebacks In re Mid-American Travel Services, Inc., 145 B.R. 969 (Bankr. E.D. Ark. 1992), and In re P.J. Nee Co., 36 B.R. 6098 (Bankr. D. Md. 1983), both concluded that a processing bank's chargeback claim was a subrogated claim and therefore not entitled to priority status.
Credit card processors may thus be subject to being compelled to process, may be precluded from setting off chargebacks relating to prepetition sales, and may be relegated to a claim status lower than that of the original claimholder. It is no wonder that credit card processors view the bankruptcy forum as hostile.
The application of the Bankruptcy Code to credit card processing agreements is a complex and subtle area of the law not typically considered prior to the commencement of a proceeding. The small amount of case law on point, and the practical limitations on a debtor's ability to change processors, suggests that as with bankruptcy cases in general, negotiation and compromise may be the only way for the parties to arrive at mutually beneficial and acceptable solutions.