Preferences under the Bankruptcy Code

Overview.

Section 547 of the Bankruptcy Code allows a debtor in bankruptcy or the trustee to “avoid” transfers (i.e., require repayment) made within 90 days of a bankruptcy filing or within one year if the transferee was an insider. The transferee’s liability for a preferential transfer is enforced by an adversary proceeding filed in bankruptcy court. “Adversary proceeding” is the name for federal lawsuits filed in bankruptcy court. The procedure is similar to standard federal lawsuits including discovery and pretrial orders.

Policy.

A financially challenged business tends to pay only certain of its creditors out of loyalty or necessity. The bankruptcy preference laws are designed to increase fairness by equality of distribution among those who are unsecured creditors, not only on the filing date, but in the immediately preceding period as well. Creditors who “race to the courthouse” in order to collect gain no advantage if the debtor files bankruptcy within the preference period.

Proving a voidable preference.

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. The Bankruptcy Code provides certain defenses to preference actions.

1) 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 such as judicial liens or security interests, property executions and attachments.

2) Property of the Debtor. Examples that may not be obvious include late payment of taxes, payments on account against an unpaid prior balance, unearned retainer fees of attorneys, and untimely contributions to pension plans. Property held by the debtor in trust for another is not “property of the debtor”.

3) To or for the Benefit of a Creditor. The unusual cases that arise under this element include a creditor being deemed the recipient of an indirect transfer, such as a payment by a debtor on a debt guaranteed by the creditor.

4) Antecedent Debt. 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. An antecedent debt is one that was not paid when due.

5) 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.

6) 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.

7) Receipt of More than Liquidation under Chapter 7. This factor immunizes secured creditors from preference liability to the extent of the value of their collateral. A creditor with a right of setoff that increases during the preference period may also be protected by this factor.

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 defense 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 (c) 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 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. 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 are not preferences.

Statutory Liens, Family Obligations, and Consumer Debts. Also excepted from avoidance are (a) fixing otherwise non-avoidable statutory liens, (b) payment of certain matrimonial and support obligations, (c) payments totaling less than $600 by individuals on account of consumer debts and (d) payments totaling less than $5,475 if the debts are primarily business debts.