Preferences Under the Bankruptcy Code – Generally
November 8, 2022
In this Surety Today Blog post we will discuss bankruptcy preferences. Someone in the industry coined the phrase “zombie claims” in reference to preference actions because preferences can be used to re-open and set aside a transaction that was concluded up to two years earlier. With the end result being that the surety may have to pay back funds or return collateral it received. Like a zombie rising from the dead and refusing to die, a preference action, can bring a claim and/or loss back to life. In this post we will look at what a preference action is, its elements and other procedural aspects. In later posts we will get into other issues relating to preferences such as defenses and potential preference scenarios to watch out for.
Under the bankruptcy preference powers, a trustee or debtor in possession (“DIP”) is able to reach back in time, prior to the bankruptcy filing, and void, undo or set aside certain transfers of the debtor’s assets. The Bankruptcy Code at 11 U.S.C. §547 establishes the power of a bankruptcy trustee or DIP to assert a preference action. In general, a “preference” exists when a person or entity makes payment or other transfers to some creditors and not to others prior to a bankruptcy filing. Such “favoritism” or “preferential treatment” in close proximity to the filing of bankruptcy is prohibited by the Bankruptcy Code. Kenan v. Fort Worth Pipe Co., 792 F.2d 125, 127 (10th Cir. 1986); Sigmon v. Royal Cake Co., 13 F.3d 818 (4th Cir. 1994).
The bankruptcy preference powers have two primary purposes:
- to promote the bankruptcy policy of equality of distribution among creditors by ensuring that all creditors of the same class will receive the same pro rata distribution share of debtor’s estate, and
- to reduce creditors’ incentive to rush to dismember a financially unstable debtor by providing for the recapture of last-minute payments to such creditors.
Matter of Smith, 966 F.2d 1527 (7th Cir. 1992), certiorari dismissed 113 S.Ct. 683, 506 U.S. 1030, 121 L.Ed.2d 604; Butler v. David Shaw, Inc., 72 F.3d 437 (4th Cir. 1996).
The preference powers are designed to help creditors by allowing the avoidance of transfers that favor certain “preferred” creditors and enables the bankruptcy estate to recover those assets for equitable distribution to all the creditors. In re Hechinger Inv. Co. of Delaware, Inc., 288 B.R. 398 (Bkrtcy.D.Del. 2003). Thus, the preference powers put all creditors on a relatively level playing field with respect to use of a debtor’s assets that may have been available prior to bankruptcy and “during the debtor’s slide into bankruptcy.” In re Keller Tool Corp., 151 B.R. 912 (Bkrtcy.E.D. Mo. 1993).
The Elements of a Preference
Section 547(b) of the Bankruptcy Code provides the elements of a preferential transfer and states that the “trustee may avoid any transfer of an interest of the debtor in property –
- to or for the benefit of a creditor;
- for or on account of an antecedent debt owed by the debtor before such transfer was made;
- made while the debtor was insolvent;
- made –
- on or within 90 days before the date of the filing of the petition; or
- between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
- that enables such creditor to receive more than such creditor would receive if –
- the case were a case under chapter 7 of the Bankruptcy Code;
- the transfer had not been made; and
- such creditor received payment of such debt to the extent provided by the provisions of the Bankruptcy Code.
To decipher the meaning of Section 547(b), one has to deconstruct the elements and look at a number of defined terms in the Bankruptcy Code. Step #1 – what does it mean to “avoid any transfer of an interest of the debtor in property?” First, a preference is “voidable,” not automatically “void.” Second, the “transfer” definition is very broad and includes both a debtor’s voluntary or involuntary disposal of or parting with its property. And third, the transfer must involve “an interest of the debtor in property,” which is defined broadly under Section 541 of the Bankruptcy Code as “all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case.”
Step #2 is the determination that the transfer of the property was made to a “creditor” for or on account of an antecedent “debt” owed by the debtor to the creditor before the transfer was made. Obviously, the surety is a “creditor” of the Debtor under the pre-petition indemnity agreement and as a result of the execution of the pre-petition bonds for the Debtor, and the Debtor owes an “antecedent debt” to the surety for the surety’s actual or potential “claim” under the indemnity agreement and/or the bonds whether that pre-petition Debtor liability is contingent, liquidated, fixed, disputed, undisputed or otherwise at the time of the Debtor’s filing of the bankruptcy case.
Step #3 requires that the transfer of the property must occur “while the debtor is insolvent.” See Section 547(f) – for the purposes of Section 547, “the debtor is presumed to have been insolvent on and during the 90 days immediately preceding the date of the filing of the petition.”
Step #4 relates to the timing of the transfer of property. There are two periods of time that a transfer of property may be avoidable – on or within 90 days before the filing of a bankruptcy case – which we will address as the most frequent timing situation – and for “insider” situations, between 90 days and one year before the filing of the bankruptcy case. There is a long definition of who are the Debtor’s individual, corporate and/or other insiders that must be reviewed, but it is very doubtful that a surety can be an insider of a Debtor even though some trustees have alleged this can happen.
Step #5 is the last element, and requires that the creditor receive more than it would have received if the bankruptcy case is a liquidation under Chapter 7 and the amount the creditor receives is greater than the distribution is or will be to other creditors in a like situation. For example, if the surety was an unsecured creditor and then obtained collateral within 90 days of the filing of the bankruptcy case that would provide a 25% repayment of the surety’s debt, and yet other unsecured creditors would receive a distribution of only 5% of their debt in a Chapter 7 liquidation, then this element of a preferential transfer would be met.
Preferences Under the Bankruptcy Code – Procedural
a. Intent Not Required
It should be noted that in establishing the elements of a preference action, the Debtor’s or creditor’s intent or motive is not material. Perma Pacific Properties, 983 F.2d 964 (10th Cir. 1992). It is the effect of the transaction, rather than the Debtor’s or creditor’s intent, that is controlling. The Court in In re Messenger, 166 B.R. 631 (Bkrtcy.M.D. Tenn. 1994) observed that the “[p]reference statute is blind to intent or default; enactment of the Bankruptcy Code removed any scienter requirement for preference recovery and knowledge or intent of the creditor is irrelevant in determining whether an avoidable transfer occurred.”
b. Statute of Limitations
The Bankruptcy Code at section 546(a) provides that a preference action must be commenced within 2 years after the entry of the order for relief or 1 year after the appointment or election of the first trustee in a chapter 7 or chapter 11 bankruptcy case, if such appointment occurs within the 2 year period after the entry of the order for relief. The “order for relief” in this context means the date that the bankruptcy petition in a voluntary bankruptcy case was filed. The time of appointment of a trustee varies depending on the chapter. In chapter 7 bankruptcies, the trustee is appointed when the permanent trustee is elected at the meeting of creditors or automatically at the meeting if no election is held. Under chapter 11, a trustee is appointed when the court signs the order approving the appointment of the trustee.
While a trustee or DIP must file a preference action within the limitations period to obtain affirmative relief, the preference powers may be used defensively outside of the limitations period to contest the validity of liens or claims against the bankruptcy estate.
c. Nature of a Preference Action
Under Bankruptcy Rule 7001(1) the trustee or DIP must file an Adversary Proceeding to initiate a preference action. This means that an adversary complaint must be filed, a summons must be issued and served. A preference action may not be initiated as a mere motion.
d. Preferential Transfers are Voidable
As noted above, preferential transfers are not automatically “void,” but rather are “voidable,” which means that the trustee or DIP must affirmatively file an avoidance action.
e. Burden of Proof
For the purposes of a preference action, the trustee has the burden of proving the avoidability of a transfer by establishing each and every element of a preference by a preponderance of the evidence. The creditor against whom recovery or avoidance is sought, has the burden of proving any applicable defense by a preponderance of the evidence. See Section 547(g).
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 or firstname.lastname@example.org) or George J. Bachrach, Esq. (410-659-1308 or email@example.com) or any member of the Surety and Fidelity Practice Group.
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