The Bankruptcy Code aims to achieve equality of distribution to creditors who are owed money while giving an honest debtor a fresh start. It is no surprise then, that pre-bankruptcy transfers of an insolvent debtor's assets that favor one creditor over another, called preferences, are the subject of regulation and scrutiny by a trustee and other parties in interest once bankruptcy is filed.
What are preferential transfers? Preferential transfers are transfers made by an insolvent debtor within 90 days of bankruptcy. This 90-day period is known as the preference period, during which a trustee or bankruptcy judge analyzes a debtor's transfer of assets to one preferred creditor while others are not paid. Section 547 of the Bankruptcy Code empowers a trustee or debtor to reverse these preferential transfers and bring the assets back into the bankruptcy estate. Unsecured creditors and secured creditors who failed to properly or timely perfect their security interests in collateral, or whose collateral decreased in value during the preference period, are most vulnerable to a preference attack. However, as a creditor, it is possible to challenge a party's preference attacks.
The purposes of preference avoidance in bankruptcy are tied to the bankruptcy policy of equality of distribution for similarly situated creditors. Preference avoidance discourages creditors from racing to collect from a debtor as they file for bankruptcy. Preference avoidance also maximizes the value of the debtor's estate which in turn, maximizes value to creditors.
A transfer of a debtor's interest in property can be either voluntary or involuntary; for example, the granting of a security interest in its property is voluntary, while a judicial lien placed on property following a court order or judgment is involuntary. A transfer made by any entity other than the debtor is not considered a preference. Only a transfer made by an entity preparing for bankruptcy, and that actually files for bankruptcy, can be characterized as a preference. Say for example a related entity, such as an individual guarantor, repays the debtor's creditor - the repayment is not a preference because it was not made by the debtor. The analysis becomes a bit trickier when a third party provides funds to the debtor to repay the debtor's pre-existing debt. Courts will generally not treat this as a preference so long as the funds were "earmarked" for that specific purpose. In addition, a bit trickier for the untrained eye is identifying when a preference is an indirect (as opposed to a direct) payment to a debtor's creditor. The classic example is that of a guarantor who is a creditor of the debtor because the guarantor has a claim against the debtor for any amounts the guarantor pays on a guaranty. If a debtor makes a payment on a guaranteed debt, the guarantor indirectly benefits because the payment reduces the guarantor's liability.
As mentioned, even when a debtor launches a successful preference attack, a creditor can assert that an exception applies and circumvent the preference avoidance altogether. Exceptions to preference actions are the subject of another article. In this article, we provide a few of the more important exceptions available to a corporate debtor, including a transfer that was intended by a creditor and the debtor to be a contemporaneous exchange for new value given to the debtor, and not on account of an antecedent debt, or payments made to creditors in the ordinary course of the debtor's business, which do not reflect any effort by the debtor to prefer one creditor over another.
There are several strategies a creditor can employ to preserve its rights, and several considerations exist for an insolvent company contemplating bankruptcy or in bankruptcy regarding preferences.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
