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March 16, 2017 Articles

A Primer on Preference Actions in Bankruptcy

Your guide to the basics of preference actions and common defenses.

By Patrick Byrnes

The preference provisions of the Bankruptcy Code allow a bankruptcy trustee (or debtor in possession) to avoid and recover for the bankruptcy estate certain payments or other prepetition transfers made by a debtor to a creditor that allow the creditor to receive more than it would receive in a Chapter 7 liquidation. The preference statute, 11 U.S.C. § 547, serves at least two purposes: First, it facilitates a core bankruptcy policy of equality of distribution among the debtor’s creditors. This policy runs counter to the “first in time, first in right” system that characterizes non-bankruptcy debt collection. Second, the statute is intended to reduce creditors’ incentives to collect on debts that may push the debtor into bankruptcy. By deterring collection efforts, preference law may allow the debtor to improve its financial condition to the point that filing for bankruptcy is unnecessary.

Elements of a Preference Claim
With these goals in mind, the Bankruptcy Code provides that certain transfers made by a debtor within a specified time prior to the filing of a bankruptcy petition are avoidable. Generally speaking, a bankruptcy trustee (or debtor in possession) may recover property from creditors for the benefit of the debtor’s estate as a preference under 11 U.S.C. § 547 upon proof of the following elements:

1. Transfer of an interest of the debtor in property to or for the benefit of a creditor
2. for payment of an antecedent debt (as opposed to current debt)
3. made while the debtor was insolvent
4. to a non-insider creditor, within 90 days of the filing of the bankruptcy (or within one year of the filing of the petition if the creditor was an insider),
5. that allows the creditor to receive more on its claim than it would have received had the payment not been made and the claim paid through the bankruptcy proceeding.

The trustee (or debtor in possession) has the burden of proving each element of a preference claim. The elements are discussed in turn below.

1. Transfer. “Transfer” is defined broadly by the Bankruptcy Code to include any conceivable conveyance of an interest in property of the debtor, including involuntary transfers. Thus, for example, a judicial lien obtained by a creditor that secures a previously unsecured claim will typically be avoidable if the other statutory requirements are met. Notably, the debtor’s and creditor’s intent is not material in determining whether a transfer is avoidable as a preference, which is not the case in claims for fraudulent transfer.

2. For payment of an antecedent debt. While “antecedent debt” is not defined by the Bankruptcy Code, courts have interpreted the requirement that a transfer be made for an antecedent debt to apply to transfers made on account of debts that precede and are not incurred contemporaneously with the transfer. See, e.g., In re Enron Corp., 357 B.R. 32, 44 (Bankr. S.D.N.Y. 2006). Further, “debt” is synonymous with “claim” under the Bankruptcy Code, meaning that “debt” encompasses any right to payment, including unmatured or unliquidated claims. See In re Bullion Reserve of N. Am., 836 F.2d 1214, 1218 (9th Cir. 1988). Applying this broad definition, the court in In re Bullion Reserve held that an individual who paid money to a corporation for the purpose of having the corporation purchase and store bullion for him accrued a right to demand payment (and, thus, the corporation incurred an antecedent debt) at the time he gave the company funds to purchase bullion. Therefore, the corporation’s subsequent return to the individual of bullion worth $212,138.60 shortly before it filed for Chapter 11 relief constituted a transfer for an antecedent debt and was avoidable as a preference.

3. Made while the debtor is insolvent. Insolvency is determined under section 547 by a “balance sheet” test, in which the debtor is considered insolvent when its liabilities exceed the fair value of its nonexempt assets. Section 547(f) also provides a presumption that the debtor was insolvent on and during the 90 days preceding the filing of the bankruptcy petition. This presumption facilitates the trustee’s ability to establish a preference claim because the party defending the claim must come forward with evidence showing that the debtor was not insolvent at the time of the transfer.

4. Timing requirements. 11 U.S.C. § 547(b)(4) provides that, to be avoidable as preferential, a transfer must be made on or within 90 days before the date of the filing of the bankruptcy petition or between 90 days and one year prior to the date of the filing of the petition if the creditor was an insider of the debtor at the time of transfer. This temporal limitation on avoidable preferences serves to focus preference law on attempts by the parties to restructure the creditor’s position in light of a potential bankruptcy filing or financial failure.

5. The transfer must allow the creditor to receive more than it would have in a Chapter 7 liquidation. The final element of a preferential transfer is that the creditor must have received more than it would have in a hypothetical Chapter 7 liquidation. Thus, the trustee (or debtor in possession) must prove that the creditor received more than it would have received if the case were a Chapter 7 liquidation case, the transfer had not been made, and the creditor received payment to the extent provided by the provisions of the Bankruptcy Code. Analysis of how much a creditor would have received in liquidation generally turns on what class the creditor falls into. For instance, payment in full to a secured creditor is not preferential. However, payment in full to an unsecured creditor is preferential unless unsecured creditors are receiving full payment on their claims.

Defenses to Preference Actions
11 U.S.C. § 547 contains a number of defenses to preference actions that a creditor can assert. Two common defenses are the “contemporaneous exchange for new value” defense and the payment in the “ordinary course of business” defense. To prove the first defense, the creditor must show that (1) it extended new value to the debtor; (2) the parties must have intended that the new value and reciprocal transfer by the debtor be contemporaneous; and (3) the exchange must, in fact, have been substantially contemporaneous. Thus, for example, if the creditor receives a $1,000 payment on December 15 and delivers goods worth $1,000, and if the parties intended the payment to be for those goods, the contemporaneous exchange defense applies. But, if the parties intended the $1,000 payment to be for a previous invoice, the defense is not applicable.

To prove the second defense, that the payment was made in the ordinary course of business, a creditor must generally show that the payment was not made as a result of collection activities and was made in a similar manner as previous, non-preference-period payments by the debtor to the creditor. 11 U.S.C. § 547(c)(2) establishes two ways for a creditor to make this showing. First, the creditor may show that the payment was made in the ordinary course between the debtor and transferee. This takes into account the manner and timing of the payments in question compared with previous payments made by the debtor to the particular creditor. Alternatively, the creditor can show that the manner and timing of payments was consistent with the manner and timing of other payments within the parties’ industry.

Keywords: bankruptcy and insolvency litigation, preference, 11 U.S.C. § 547, antecedent debt, transfer

Patrick Byrnes – March 16, 2017