Preferences under the Bankruptcy Code
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.
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
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 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.
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.