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Business Law Today

March 2010

Preferences: When Can a Trustee Claw Back Payments to Creditors?

J Henk Taylor and Justin Henderson


  • Though payments a debtor makes to creditors prior to bankruptcy may be preferential transfers under the Bankruptcy Code, creditors should not assume that a payment will be later avoided.
  • Preference actions are not automatic: a trustee or a debtor-in-possession has to affirmatively file suit and pursue litigation to recover preferences.
  • The authors trace what kind of transfers qualify as preferences, subject to claw back by a trustee or debtor-in-possession, and which transfers are exempt under the statute.
Preferences: When Can a Trustee Claw Back Payments to Creditors?

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A number of considerations will arise when a business begins to falter. If the business owes you money, you will want to do what you can to make sure you get paid. If you manage the struggling business, perhaps you have personally guaranteed a loan to the company and worry about your individual liability. Perhaps you want to maintain good relationships with certain vendors if the company continues to operate, but others are not so essential. Maybe some of your larger creditors already know of your situation and are calling, demanding payment. All of these pressures coalesce to create a situation in which it is likely that a troubled business will unfairly prefer one creditor to another just prior to filing for bankruptcy.

This state of affairs implicates the fundamental policy of the Bankruptcy Code (11 U.S.C. § 101 et seq.) of treating similarly situated creditors equally. At the same time, it is desirable to prevent bankruptcy in the first place, if possible. Neither of these policies can be furthered if creditors swoop down and "dismember" a troubled debtor, with stronger creditors more likely to recover. What a business facing bankruptcy needs is less monetary hemorrhaging, not more.

Given these concerns, the Bankruptcy Code permits the trustee or debtor-in-possession to "avoid" certain preferential transfers that a debtor made to creditors in the 90-day period prior to the filing of a bankruptcy petition. Preferential transfers should not be confused with fraudulent conveyances. Though they are often lumped together, they are distinct concepts. A preferential transfer focuses on whether a creditor has received a payment that results in that creditor getting better treatment than other creditors in light of the bankruptcy. A fraudulent transfer, on the other hand, looks at whether an insolvent entity has made a transfer to another party (perhaps a creditor, but often not) for which the insolvent entity did not receive reasonably equivalent value in return.

Faced with the possibility that the trustee or debtor-in-possession may claw back preferential transfers, the Bankruptcy Code encourages creditors to maintain normal business relationships with troubled debtors by providing several exceptions to the general rule. If creditors do not demand and receive immediate payment on outstanding debts, and instead continue working with the troubled business, there is a greater chance that the business might recover. Thus, the Bankruptcy Code ultimately tries to preserve the status quo in the days preceding the filing of a bankruptcy petition.

What Kinds of Transfers Qualify?

In evaluating preferential transfer problems, lawyers should always keep in mind that the overall goal of the preferential transfer statute (Bankruptcy Code § 547) is to avoid depletion of the debtor's bankruptcy estate prior to the filing. If it can be shown that there was no depletion of the estate such that other creditors obtain a lesser recovery on their claims, courts are more likely to find that either there was no preferential transfer in the first place or one of the exceptions to the general rule applies. Trustees may be more inclined to forgo pursuing an avoidance action, or to settle it for much less than initially demanded.

It is relatively easy, however, to establish that a prepetition payment to a creditor is, on its face, a preferential transfer. The Bankruptcy Code broadly defines "transfer" to cover every possible transfer of a property interest, including the granting of a security interest or lien, and even includes involuntary transfers, such as the attachment of a judicial lien. The starting point for figuring out whether a preferential transfer has taken place is section 547 of the Bankruptcy Code.

Section 547 lists five elements that make up a preferential transfer. First, the transfer must be to or for the benefit of a creditor. Second, the transfer must relate to an antecedent debt owed before the transfer. Third, the transfer must have been made while the debtor was insolvent. Fourth, the transfer must have occurred within 90 days prior to the filing of the bankruptcy petition, or one year prior to the filing if the creditor/transferee is an "insider" of the debtor. Last, the transfer must have provided a benefit to the creditor in excess of what the creditor would have received in a Chapter 7 liquidation if the transfer had not been made.

The last requirement gets fully secured creditors out from under the statute. A secured creditor is entitled to receive the value of its collateral in a Chapter 7 liquidation up to the amount of its debt. It is only when the creditor gets paid that is changed when a debtor makes a prepetition transfer to a fully secured creditor, not the amount the creditor is paid. Thus, payment to a fully secured creditor does not deplete the debtor's bankruptcy estate to the disadvantage of other creditors.

Payment to an unsecured or undersecured creditor, on the other hand, will almost always satisfy the fifth element. In Palmer Clay Products Co. v. Brown, 297 U.S. 227 (1936), the Court explained why, using an example similar to the following. Say a debtor owes $11,000 in credit card debt and pays $1,000 toward that debt prior to filing bankruptcy. Typically an unsecured creditor in a Chapter 7 case receives much less than 100 cents on the dollar. If the distribution to unsecured creditors in a subsequent Chapter 7 were 50 percent, the credit card company would receive $5,000 in the distribution, plus the $1,000 prepetition payment, for a total of $6,000. If the payment had not been made, the credit card company would receive only $5,500—half of the $11,000 owed. When the $1,000 payment is made, it benefits the credit card company at the expense of other unsecured creditors, which is exactly what the preference statute seeks to prevent.

Most payments to unsecured or undersecured creditors in the 90-day window will easily satisfy the elements of a preferential transfer under section 547. Take, for example, payment of a utility bill 45 days before the petition is filed. Utility companies typically bill their customers in arrears for past service. Thus, the payment is to a creditor, relates to an antecedent debt owing before the transfer, was made within 90 days of the petition, and enriches the utility company to an extent that a Chapter 7 liquidation would not. That leaves insolvency, which would otherwise be a fact-intensive inquiry, but is actually easy to establish because section 547 presumes that a debtor is insolvent for the 90-day period prior to the filing of the petition.

Because a transfer must merely benefit a creditor, even transactions that only indirectly enhance a creditor's position may qualify. For example, a prepetition payment to a creditor on a loan will be a preferential transfer as to the creditor and to a guarantor of the loan because the guarantor is benefitted to the extent its obligation to the creditor on the guaranty is reduced by the payment.

So what kinds of transactions are not preferential transfers? One commonly recognized nonpreferential transfer occurs when a debtor receives loan funds that are earmarked to pay a creditor. If the lender restricts the use of the funds to paying the creditor, the debtor never truly owns the funds and hence the debtor's other creditors have not been harmed when these funds are paid over to the designated creditor. One creditor has simply been replaced by another. Similarly, if a third party or co-obligor pays a creditor of the debtor, that payment also would not qualify as a preferential transfer because the payor (not the debtor) is the one who transferred funds to the creditor.

It is easy to see that nearly every company is likely to have a multitude of transfers that would qualify as preferential transfers, from loan payments to purchases of goods on 30 days' credit, to paying the bill for the Internet and the water delivery service. The real fight is over the exceptions to the rule.

It is common for a trustee to file, or threaten to file, lawsuits addressed toward any transfer made within the 90-day period that arguably qualifies as a preferential transfer. But a good many of these transfers will qualify for an exception, and creditors should evaluate whether they are truly liable for what the trustee demands. Creditors are often able to argue that a particular transaction qualifies for more than one exception, and their lawyers should evaluate each.

The exceptions are designed to encourage creditors to continue dealing with a faltering company in the hope that bankruptcy can be avoided. The most commonly invoked exceptions are generally known as the "ordinary course of business" and "new value" exceptions.

Ordinary Course of Business

The ordinary course of business exception in 11 U.S.C. § 547(c)(2) is not difficult to understand, though its application is fact-driven and consequently may be difficult to predict and unlikely to be overturned on appeal. The policy underlying the exception focuses a little less on the depletion of the estate, and more on encouraging normal business relationships, which favors creditors who work with struggling businesses. The "ordinary course" defense typically arises in preference claims where a trustee seeks to avoid payments to trade vendors such as utilities, goods suppliers, service professionals, and landlords who routinely provided the debtor with goods and services used in the course of the debtor's business prior to bankruptcy.

The 2005 amendments to the Bankruptcy Code made it easier for creditors to prevail using this exception by decoupling two elements of the defense. Under both versions of the statute, a creditor must prove that the debt paid by the preferential payment arose in the ordinary course of the debtor's business. This element focuses on whether the debt was incurred as part of the debtor's normal business operations. Most debts satisfy this criterion such as debts owed to trade vendors. But if the debt is an aberration for a business, such as a construction company that incurs a debt to purchase a yacht for the company's president, then payments on that debt will not qualify for the defense.

Prior to 2005, creditors also had to prove that the transfer was made "in the ordinary course of business" and was "made according to ordinary business terms." After 2005, creditors need only prove one or the other of these elements.

Whether a transfer was made in the ordinary course of business is referred to as the subjective test. Under it, courts evaluate whether the course of dealing between the debtor and the specific creditor indicates that the transfer was not unusual. The creditor must establish the baseline of past practices between it and the debtor so that the court has something to compare the transfer to. After the baseline is established, the court determines whether the amount, form, timing, method of collection, or any other characteristic of the transfer is different from past transfers. In many cases, the question of whether a transfer was made in the ordinary course of business comes down to whether the timing of the preferential payment versus the payment due date is consistent with the timing of prior payments by the debtor to the creditor. For example, if a creditor routinely sent the debtor invoices due "net 30 days," and the debtor timely made these payments in the past, then a payment within the preference period made within 30 days of the invoice date is protected from avoidance.

Unusual patterns of activity are not enough, in and of themselves, to overcome the defense. For example, if a creditor has a history of accepting late payments from the debtor, then a late payment made within the preference period will still qualify as "ordinary course" as long as the timing of that payment fits within the established pattern. Thus, even if a payment is made much later than is normal in the industry, so long as the payment is still within the bounds of the past billing and payment practices of the debtor and creditor, the defense applies.

Even if a payment represents the first transaction between the parties, it may still fall within the exception. The exception is not intended to protect only creditors with long-standing relationships with a debtor. Rather, the exception is designed to protect normal financial relationships. If taking on a debt would not be out of the ordinary for a person in the debtor's shoes, the exception applies if the payments that follow are also ordinary.

The overall focus is on whether the transfer is arm's length, routine, and ordinary. Accordingly, payment of long-term and short-term debt generally qualifies. But, as was the case in In re Hechinger Investment Company of Delaware, Inc., 489 F.3d 568 (3d Cir. 2007), if a creditor takes steps such as accelerating a debtor's payments; reducing its credit limit; forcing it to make large, lump-sum payments by wire transfer; and/or sending the debtor dunning letters, the exception may be held inapplicable because the payment will be "out of character with the long historical relationship between the[] parties."

If the course of performance between the parties cannot be proven, perhaps because of poor record keeping, a creditor also can try to prove that a transfer was "made according to ordinary business terms." This is referred to as the objective test. Courts look to industry standards to determine whether the transfer was normal, and oftentimes expert testimony is necessary to establish what is common in the industry. Despite the "objective" moniker, the test is fairly flexible and easy to satisfy. Only transactions that are an aberration in a particular industry would fall out of the exception. The test takes into account a broad range of business terms, including those that would be common in cases where debtors are in financial distress. Thus, if expert testimony establishes that the industry standard is to pay invoices within a wide range of days after the billing date, and the challenged transfers paid invoices within that range, the ordinary course exception may apply, despite the fact that late payments are usually viewed with suspicion.

New Value

The primary "new value" exceptions can be found in section 547(c)(1) and (4) of the Bankruptcy Code. They generally prevent the trustee from avoiding preferential transfers when the transfer was made in exchange for something that increases, or at least does not deplete, the debtor's assets. New value can take virtually any form, including cash, property, or release of a lien, but does not include the swap of an existing obligation for a new one.

The "substantially contemporaneous exchange for new value" exception applies where a debtor pays a creditor for goods or services contemporaneously with the supply of those goods and services. COD payments are classic examples of these types of protected payments. Consistent with the purpose of the exception, the trustee may only be prevented from clawing back a transfer to the extent of the new value provided. If a debtor pays more than something is worth, the trustee may seek to recover the excess. The applicability of the exception depends to some extent on whether the transaction resembles one based on credit rather than a contemporaneous transfer, but all transfers falling under the exception are necessarily preceded by a debt for some length of time, or they wouldn't be preferential transfers in the first place. Thus, the mere passage of time is not the end of the analysis.

The intent of the parties is the most important consideration, and the exchange need only be "substantially contemporaneous." However, even when there is intent for a transfer to be for new value, it may be avoided in certain circumstances. For example, where payment for services is made by check, and a bank later dishonors the check, courts have held that the transfer falls out of the contemporaneous exchange exception.

Creditors also may be successful in retaining preferential transfers under the "subsequent new value" exception. A creditor's liability for a preferential transfer may be offset by the creditor's giving the debtor new value (often in the form of goods and services) subsequent to the contested payment. For instance, where a vendor has received a preferential payment from a customer, such as payment for goods previously shipped, if the vendor subsequently provides more goods to the customer on credit, the value of the newly shipped goods can be used to set off dollar-for-dollar the vendor's liability on the previous preferential payment. The critical point is that the vendor must not have received payment for the newly shipped goods prior to the customer filing bankruptcy. As explained in In re Inland Global Medical Group, Inc., 362 B.R. 459 (Bankr. C.D. Cal. 2006), the principle underlying the exception is that new value replenishes the estate, and recovery of the preference is not necessary to place creditors on equal footing. If the customer/debtor in fact paid for the subsequent goods, however, then the vendor effectively did not provide any new value to the customer because the repayment depleted the estate.

It is important to recognize that subsequent value must be just that—subsequent. A creditor cannot simply aggregate the value of the goods or services it provided during the preference period and offset this value directly against the amount of preferential transfers it has received. For example, if a creditor receives a preferential transfer of $5,000 and later provides $10,000 worth of new value, the subsequent new value exception prevents the trustee from avoiding any of the preference. If, after these transactions, the creditor had received another preferential transfer of $5,000, the trustee could avoid that $5,000 because there was no subsequent new value provided by the creditor.


The Code treats insiders differently than other creditors. Insiders include a debtor's corporate officers, their family members, general partners, as well as corporate affiliates of the debtor. Transfers made to these creditors are subject to a look-back period of one year rather than the standard 90 days. However, the presumption that the debtor is insolvent applies only to the 90-day window. Thus, if the trustee sues an insider for return of a transfer made more than 90 days before the filing of the petition, the trustee must prove that the debtor was insolvent at the time of the transfer.

After the 2005 amendments, transfers to a noninsider that occur between 90 days and one year of the petition filing that are avoided as benefitting an insider creditor are only avoided as to the insider. So if a debtor transfers money to a noninsider bank to pay down a loan 100 days prior to filing bankruptcy, any avoidance of the transfer would operate against an insider who guaranteed the loan, but not against the bank.


Though many payments a debtor makes to creditors on the eve of bankruptcy may be preferential transfers under the Bankruptcy Code, creditors should not assume that a payment will be later avoided. Generally speaking, if a creditor can get payment from a debtor, even a debtor tottering on the edge of bankruptcy, the creditor should do so. This is true if the payment is preferential and the creditor may not qualify for one of the statutory exceptions. That is because there is no guarantee that the creditor will face a preference suit down the road. Preference actions are not automatic: a trustee or a debtor-in-possession has to affirmatively file suit and pursue litigation to recover preferences. Many factors can impact whether a trustee or debtor-in-possession ever brings such an action. Even if a creditor is sued for a preference, the creditor may defend such an action, argue the exceptions, and perhaps settle the claim for much less than the amount of the payment. Meanwhile, the creditor will have the use of the funds it received from the debtor prior to bankruptcy. In any case, the potential of a preference claim counsels creditors dealing with financially troubled debtors to keep adequate records to prove when payments were received, what value they provided to debtors, and what the ordinary course of business is between the parties.