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Bankruptcy, Restructuring & Commercial Litigation

Preferences Under US Bankruptcy Law

Overview.

The U.S. Bankruptcy Code, Section 547, permits a debtor in bankruptcy or its trustee to “avoid” (i.e., force disgorgement or repayment) transfers made within 90 days of a bankruptcy filing (one year if the transferee was an insider). Such transfers are referred to as “preferences” or “preferential transfers.” The transferee’s liability is enforced by the commencement of a plenary law suit against any immediate and mediate transferees.

Policy.

The preference laws recognize that a financially troubled entity tends to pay only certain of its creditors, whether out of loyalty or necessity (usually insufficient cash flow). The preference laws are designed to promote the principle of equality of distribution among those who are creditors, not only on the filing date, but in the immediately preceding period as well. They also discourage the natural tendency of creditors to “race to the courthouse” in order to
collect.

Elements of Action.

An avoidable preference involves seven elements:
1) a transfer,
2) of property of the debtor,
3) to or for the benefit of a creditor,
4) on account of an antecedent debt,
5) while the debtor was insolvent,
6) within 90 days of bankruptcy or one year in the case of insiders,
7) which enables the creditor to receive more than if the bankruptcy estate was liquidated in a Chapter 7 case.

Transfer. The Bankruptcy Code broadly defines a transfer as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor’s equity of redemption.” Transfers include not only payment on debt but the transfer of property (including the return of previously sold inventory), the creation of liens, including judicial liens or security interests, the perfection of liens, the
effectuation property executions, and the like.

Property of the Debtor. This is relatively straightforward. Excluded, however, is property held by the debtor in trust for another. Examples include payment of trust fund taxes, payments on account of certain construction projects, contingent fees of attorneys, and contributions to self-insurance plans.

To or for the Benefit of a Creditor. This is also a relatively straightforward element. However, a creditor may be deemed the recipient of an indirect transfer, such as a payment by a debtor on a debt guaranteed by a third party.

Antecedent Debt. An antecedent debt is one that arose prior to the transfer. A debt is considered to arise at the time the debtor becomes legally obligated to pay it. This generally takes place upon the execution of a debt instrument, receipt of goods or services, upon receipt of an invoice, or on the date specified by contract.

Insolvency. For preference purposes, a debtor is rebutably presumed to be insolvent during the 90 day period immediately preceding the filing date. This presumption does not apply for the remaining period of insider exposure. “Insolvent” is defined as: “. . . financial condition such that the sum of [the debtor’s] debts is greater than all of [the debtor's] property, at a fair valuation. . . .” This definition excludes certain fraudulently transferred and exempt property (exemptions apply only to individuals). Insolvency must be determined as of the date of the transfer in question.

Time of Transfer. The period applicable to non-insiders is 90 days preceding the filing date. The period applicable to insiders is the one-year period preceding filing. The term “insider” is nonexclusively defined to include relatives, general partners, partnerships in which the debtor is a general partner, directors, officers, persons in control, affiliates, and insiders of affiliates of the debtor. In the case of payment by check, the transfer is deemed to occur on the date the check is honored by the transferor's bank as opposed to the date of its receipt by the payee.

Receipt of More Than Under Chapter 7. It is by virtue of this element that secured creditors are immune from preference liability, at least to the extent of the value of their collateral. Because valid and perfected liens are unaffected by the bankruptcy, a payment on account of a debt fully secured by a valid and perfected lien does not enable the transferee to receive more than it would under Chapter 7. Where the debt is only partially secured, however, the creditor may receive a preference to the extent its secured position is improved during the preference period. The same analysis may apply to a creditor with a right of setoff that increases during the preference period. The only other case in which this test is generally relevant is one in which there are sufficient assets to pay all creditors in full, a rare circumstance.

Burden of Proof.

The debtor or trustee has the burden of proof with respect to all elements of a preference, except for the rebuttable presumption the debtor was insolvent within the 90 day period prior to the bankruptcy (but not the one year insider period).

Parties Liable.

Parties liable for preferences include not only the initial transferee, but also the parties for whose benefit the transfer was made and immediate or mediate transferees of the initial transferee.

Defenses.

The Bankruptcy Code sets forth a number of transfers that are excluded from avoidance:

Contemporaneous Exchange. A preferential transfer may not be avoided if it was intended by the debtor and the creditor to be, and in fact was, a contemporaneous exchange for new value given to the debtor. “New value” generally means money or goods, services, new credit, or a release of property by the transferee. The determination of the parties' intent is a question of fact. An example of a contemporaneous exchange is giving a mortgage on property in exchange for the release of other property.

Ordinary Course of Business. This a common defense in preference actions. It is available where (a) the debt was incurred in the ordinary course of business or financial affairs of both the debtor and the creditor and (b) the payment was made in the ordinary course of business or financial affairs of both the debtor and the creditor, and the payment was made according to ordinary business terms. This defense has been held to apply to payments on long term debt as well as short term debt. Generally speaking, payments will not be avoidable as ordinary course if made within the terms of the applicable contract or invoice.

Purchase Money Security Interests and Enabling Loans. A security interest created in property acquired by the debtor is not a preferential transfer to the extent the security interest secures new value given by the creditor to enable the debtor to acquire the property and is perfected within 20 days (even if state law provides for a longer period). This exception applies most commonly to purchase money security interests and mortgages.

New Value. A creditor that has received an otherwise preferential transfer but thereafter extended “new value” has the ability to reduce the amount of its preference liability by the amount of the new value.

Inventory and Receivable Security Interests. Also excepted is the creation of security interests in accounts receivable, inventory, or their proceeds in connection with revolving lines of credit, except to the extent of an improvement in the creditor’s position during the preference period.

Statutory Liens, Family Obligations, and Consumer Debts. Also excepted from avoidance are: