In latest edition of The Weekly Wright Report:
- Preferences Under the Bankruptcy Code – Generally Pt.1
Preferences Under the Bankruptcy Code – Generally Pt.1
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 you may have to pay back funds or return collateral 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 article we will look at what a preference action is, its elements and other procedural aspects.
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.
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.
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. 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.
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 was 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.
Step #3 requires that the transfer of the property must occur “while the debtor is insolvent.” The Bankruptcy Code states that “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, 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.
Step #5 is the last element, and requires that the creditor receive more than it would have received if the bankruptcy case was 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 a creditor 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 creditor’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
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. It is the effect of the transaction, rather than the Debtor’s or creditor’s intent, that is controlling. Once court 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.”
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.
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.
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 article, 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).