Attorney at Law Magazine – Published August 2012

Bankruptcy 101: The Bankruptcy Preference

Introduction

Preference.  It has a nice ring to it.  It speaks of choice, of what you want.  Not in a bankruptcy case.  The preference commonly takes the form of a debtor’s pre-bankruptcy payment on an overdue debt.  Under the Bankruptcy Code, if a creditor receives a preference, the trustee[1] can sue to take it back.  In bankruptcy, a preference is something nobody prefers to get.

The Definition

11 U.S.C. §547 governs preferences.  A preference is any transfer of a debtor’s interest in property to or for the benefit of a creditor, made: for or on account of an antecedent debt; while the debtor was insolvent; on or within 90 days before the date of the bankruptcy petition, or one year before the petition date if the creditor was an “insider” of the debtor; and, which enables the creditor to receive more than in a Chapter 7 absent the transfer.

The Policy And Elements

The policy behind the preference statutes is to prevent either the pre-bankruptcy debtor from only paying favored creditors, or the aggressive creditor from seizing all the debtor’s assets through forced collection, either of which situations leaves fewer assets for other equally deserving creditors.

The statute is far broader than the policy.  Intent is not an element; it’s all numbers and timing.  The preference statute helps ensure that nobody gets more than their fair share by beating the bankruptcy judge to the debtor’s assets.

A frequent preference scenario is the client who has been sued, or has a demand letter, from a bankruptcy trustee demanding that a payment the client received be returned.  The client received the payment from a customer on an overdue receivable, months before the customer filed bankruptcy.  The debtor indisputably owed the money.  Let’s look at whether that payment constitutes a preferential transfer:

The Transfer

“Transfer” has a broad statutory definition – any direct or indirect, absolute or conditional, voluntary or involuntary, disposition of or parting with, property or an interest therein.  Transfers include payments, granting liens, and repossessions.  In our client scenario, the payment is clearly a transfer.

Cash payments constitute a transfer when the cash changes hands.  Payments by check constitute transfers when the check clears.  Foreclosures, repossessions, or acquiring liens depend on non-bankruptcy law to establish when the transfer is complete.

The Interest of the Debtor in Property

An “interest of the debtor in property” means an interest that would be bankruptcy estate property if the debtor filed a bankruptcy petition.  Bankruptcy estate property includes all the debtor’s interest in property as of the bankruptcy petition date.  In our scenario, the payment would be estate property had the debtor kept it and filed bankruptcy.

The Creditor

“Creditor” is defined broadly – an individual or entity with a claim against the debtor that arose before the bankruptcy filing.  “Claim” means a right to payment, whether or not reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured.  A creditor is anyone with a right to demand payment from the debtor, including the client in our scenario.

The Antecedent Debt

“Debt” means liability on a claim.  Antecedent debt is a debt existing prior to the transfer.  Open accounts, lines of credit, or contractual liabilities are antecedent debts.  Our client received payment on a common antecedent debt – an overdue receivable.

Insolvency

The bankruptcy courts take a “balance sheet” approach, examining whether the debtor’s liabilities exceed the fair value of its assets.  The debtor is presumed to be insolvent during the ninety days prior to bankruptcy.  This is a rebuttable presumption; a cash-strapped debtor may not be insolvent based on the value of its non-cash assets.

The 90-day Or 1-Year Lookback

For arm’s length creditors, the preference liability period is ninety days prior to the bankruptcy petition date.  The preference period for “Insider” creditors is one year prior to the bankruptcy petition.  An “insider” is anyone with a sufficiently close relationship that they might control or influence the debtor.  The Bankruptcy Code provides a non-exhaustive list of those deemed to be insiders – relatives, general partners, and business entities in which the debtor is a director, officer or general partner.  For business entities, insiders include general partners and their relatives, directors, officers, or others controlling the debtor, and their relatives.

The Liquidation Test

The final element requires the trustee to prove that the transfer netted the creditor more than a Chapter 7 distribution would have if the transfer hadn’t been made – the “liquidation test.”

The liquidation test involves estimating the outcome of a Chapter 7 case – assets, claims, and distributions.  If the value of the transfer exceeds the value of the Chapter 7 distribution, the liquidation test is satisfied.

EXCEPTION DEFENSES

The trustee must prove all five of the elements to establish a preference.  However, even if he can do so, the trustee cannot avoid the transfer if any of nine exceptions in 11 U.S.C. §547(c) apply – the “exception defenses”.  Those exception defenses are for transfers that:

(1) Are a contemporaneous exchange for new value given to the debtor.  Example – the COD transaction.

(2) Are in payment of a debt incurred in the ordinary course of business or financial affairs of both debtor and creditor, made in the ordinary course of business/financial affairs of both, or made according to ordinary business terms.  Example: timely monthly payments on a routine promissory note for an ordinary business expense.

(3) That create a purchase money security interest, if perfected within 30 days after the debtor receives possession of the property.

(4) Transfers after which the creditor gave new value to the debtor that wasn’t secured, and that wasn’t followed by an unavoidable transfer.  Example – shipping additional goods on open account after the debtor pays older account items.  If the creditor isn’t paid for the new shipment, its value can be offset against the earlier payment.

(5) That create a perfected security interest in inventory or a receivable, provided that interest doesn’t improve the creditor’s collateral position;

(6) That create a statutory lien that isn’t avoidable;

(7) That are a bona fide payment of a domestic support obligation;

(8) That total less than $600 in an individual case with primarily consumer debts; and,

(9) That total less than $5,850 in cases with primarily nonconsumer debts.

The exception defenses protect creditors that continue to do business with struggling debtors and don’t take aggressive collection tactics.  Any of these exception defenses will defeat a trustee’s preference claim even if the transfer otherwise constitutes a preference.

CONCLUSION

Preferences are among the most frequently litigated items in bankruptcy because of the numerous payments a debtor makes within the lookback period.  An exhaustive discussion of preference issues and defenses is beyond the scope of this article, butit’s the trustee’s burden to prove the elements of a preference, and there are always many factual issues in play.  Even if the trustee meets his burden the creditor can defeat the trustee’s claim by proving any of the exception defenses.

Finally, preference cases often beg to be settled because litigation fees aren’t recoverable, and because of the economics of bankruptcy cases.  Trustees sometimes assert preference demands based on nothing more than the existence of a payment in the lookback period.  Once the client gets by the initial indignation of being sued for receiving a payment he had every right to receive, a careful review of the facts, elements, defenses and exceptions often results in a solid defense or basis for a favorable settlement.

[1] Because a Chapter 11 debtor in possession functions as its own trustee, I’ll use the term “trustee” throughout this article to refer to either or both.