The debtor took advantage of you. He paid every other invoice, then later he started to pay every third invoice. As a result, the debtor owed you substantial monies that were aged from 6 months to a year old. After several letters threatening suit and a number phone calls attempting to persuade and cajole the debtor into paying his debt, you finally receive payment of the old invoices. Not only are you happy because you received the payment, but about three weeks after you received the payment the debtor filed a petition in bankruptcy. Self-satisfaction and a job well done was the order of the day.

Unfortunately, the elation turned into despair when several months after the petition in bankruptcy was filed, you received a demand letter from the trustee in bankruptcy demanding that you return all the money that you received on these old invoices because he claimed that it was a preference. Many businessmen have absolutely no idea about the right of the bankrupt to recover money that was paid for an old debt until it happens to them.

One of the basic principles upon which the bankruptcy code is built is that creditors should be treated equally. The collateral purpose of the bankruptcy code was to discourage creditors from racing to execute on their judgment in anticipation of a bankruptcy to be filed by the debtor. To address both of these concerns, the code affords to the trustee in bankruptcy the power to avoid a preferential transfer.

A preferential transfer under the bankruptcy code requires the following specified elements. If these elements are present when a transfer is made by the bankrupt to a creditor, the trustee will have the power to avoid the preference and require the creditor to reimburse the estate of the bankrupt the amount of the transfer to the creditor. The six elements are as follows:

  1. A transfer of an interest in the debtor’s of property.
  2. For the benefit of the creditor.
  3. On account of an antecedent debt.
  4. Which transaction took place while the debtor was insolvent.
  5. Within 90-days before the date of filing.
  6. Enabling the creditor to receive more than such creditor would have received in a Chapter 7 liquidation of the estate.

The elements described appear to be simple and straightforward and a businessman should be able to quickly determine whether the monies received from the bankrupt qualify for a preference. What appears to be is not necessarily what is. The interpretations of those statements and the exceptions which have been carved out by the courts for several different reasons treat what often appears to be a preference as not a preference.

Furthermore, the attorneys for the trustee or the trustee are willing to settle preferences. A creditor who pays the full amount of a preference without consulting with an attorney experienced in the field will certainly qualify for the expression “when you represent yourself you have a fool for a client”. The interpretation of the six elements together with the exceptions that have been shaped by the judicial system plus the general reluctance, because they are so busy, of the trustees to litigate preferences provided an opportunity to oppose, or at least to radically reduce, the preference. We will consider how the court has interpreted the above elements and will discuss some of the exceptions to the preferential transfers.

A transfer must take place. A transfer is generally interpreted in broad terms and covers both voluntarily or an involuntarily transfer of property to a creditor. The granting of a mortgage, the execution and perfection of a security interest all would constitute transfers, but the transfer must be of the debtor’s property. No preference takes place when the debtor pays a debt from funds that is not the property of the debtor, but the property of a third party. Funds in escrow or funds that have been deposited for a letter of credit are not property of the bankrupt.

Date of Transfer

As a general rule a transfer occurs on a date that the creditor receives the property. Where there is a lien involved, the transfer will take place when the real estate mortgage is recorded. In the event it is a security agreement, the transfer will take place on the date it is perfected. Nevertheless, a 10-day period is afforded a creditor to perfect his security interest. If the perfection takes place within the 10-day period, it relates back to the date that the debtor actually borrowed the money and executed the papers. If the creditor perfects the security interest after the 10-day period, the date of perfection would be the date that the financing statement is recorded.

An issue sometimes arises as to when the transfer took place. The choice is between when the check is delivered, mailed, received or when its clears. The states are somewhat in conflict. The general resolution seems to be that the transfer takes place on the date that the bank actually pays the check by deducting the money from the debtor’s account.

For The Benefit of the Creditor

A transfer of property to someone who is not a creditor cannot constitute avoidable preference. An example is a contemporaneous exchange of property for money, for a transfer is not being made to a creditor but being made to a vendor who is transferring property to the bankrupt. The creditors of the bankrupt’s estate are receiving equivalent property for the transfer of the cash.

The courts define the term creditor in broad terms. Where a debtor transferred property to his wife who immediately mortgaged the property to a creditor, the mortgage was treated as being made directly from the debtor to the creditor. The court requires that the property received in a contemporaneous exchange be reasonably equivalent in value to the amount that was paid to the vendor, although some other cases hold that the amount transferred does not necessarily have to be equal in value.

An Antecedent Debt

Where new value is received in exchange for cash, no antecedent debt exists and thus the estate is not diminished because of the transaction. An installment loan is not considered a new debt when each installment becomes due, for the debt is deemed to have been incurred on the date of the original loan and periodic payments made within a 90-day preference period may be avoided as preferences.

The debtor must be insolvent at the time of the transfer. The requirement of insolvency is a second reason why the time of transfer is so important. Under the bankruptcy code a presumption of insolvency exists within 90-days of the filing of the petition to assist the trustee in achieving the purpose of treating all creditors equally. The debtor is presumed to have been insolvent on and during the 90-days immediately preceding the date of filing the petition. The obligation of the creditor is to offer some evidence to rebut this presumption of insolvency. Once there is evidence offered, the trustee must prove the insolvency of the bankrupt at the time of the transfer.

If it is a public company, the 10Q’s and 8K’s financials filed with the Securities and Exchange Commission quarterly as well as the interim changes of financial condition which are periodically filed by the public companies will reveal whether or not the debtor was or was not solvent at the time of the transfer. If the debtor is a private company, the production of financial statements, bank statements, monthly profit and loss statements will be helpful in determining the solvency of the debtor within 90-days of the filing of the petition.

The 90-day period applies to creditors and does not apply to insiders. With regard to controlling shareholders, directors, family or other insiders, the period of time is one year prior to the date of filing the bankruptcy instead of 90-days. An insider is defined as an officer, director, partner, person in control or relatives of the aforesaid. It may also extend to those who control by virtue of a close relationship wherein significant influence can be exercised.

One of the common transactions that affect insiders is a situation when an insider has made a payment to a bank between the one-year and the 90-day period prior to bankruptcy and the loan to the bankrupt was guaranteed by the insider. The payment benefited the insider since his liability as a guarantor was reduced. Notwithstanding a minority view on the subject, most courts have held that the non-insider bank is vulnerable to the preference being avoided.

Definition of An Estate

As a general rule the courts tend to look at whether property transferred to a debtor within the 90-day period is a preference by applying the “diminution” of an estate doctrine i.e.: where the transfer diminishes the fund to which creditors of the same class may be entitled for payment of the monies owed to such creditors to such an extent that other creditors will not obtain as great a percentage as the preferred creditor, the transfer is avoidable.

Accordingly, the trustee must establish that the transfer to the creditor would have been more than the creditor would have received had the creditor filed a proof of claim in bankruptcy under liquidation pursuant to Chapter 7. When computing this amount that the creditor would have received, the court will treat the amount of the alleged preference as if it had not been transferred. Obviously, if the creditor would have received the full amount of the debt in a bankruptcy proceeding, then the transfer to the creditor could not be considered a preference. Thus, where a creditor is fully secured by equipment, automobile or otherwise and a payment is made to the secured creditor, this would not be considered a preference since the creditor will be able to satisfy the full debt from the security.

Ordinary Course of Business

“Ordinary course of business” exception is probably the one most used by creditors. It requires that payment of a debt be done in the ordinary course of business or financial affairs of the debtor.

Payment must be made in the customary manner of conducting normal business. If the customer must pay bills on terms of 90-days, then the bill would not be considered an antecedent debt and the payment is not a preference if it was consistently paid within 90-days. If the contract is actually entered into for payment to be made within 30-days, and the parties continually ignore the 30-day period and begin to make payment after 60-days, these circumstances may or may not be a defense of the ordinary course of business since the parties were not complying with the original credit terms.

The Earmarking Doctrine

The Earmarking Doctrine arose in cases in which the debtor owed money to a particular creditor under circumstances in which another party was the guarantor of the debtor’s obligation. Where the guarantor paid to the creditor the money owed by the debtor, the courts rejected the claim that such a payment was an avoidable transfer. The rationale to justify this was that no preferential transfer had occurred, because the transfer consisted of the new creditor’s property, not the debtor’s property and no diminution to the debtor’s estate resulted because the transaction merely substitutes one creditor for another.

The courts have extended this doctrine where the monies were paid to the debtor directly and the mere fact that the debtor may have had the power to divert the monies after it was deposited into the debtor’s account does not amount to control of the funds by the debtor. The money was paid over to the debtor and the debtor thereafter paid the old creditor. This doctrine also sometimes applies to the situation where money has been set aside in escrow accounts or even the situation where money is actually received by the debtor and a portion or all of that money is to be paid directly to the third party creditor.

Net Result Rule

Sometimes a debtor will have numerous exchanges with a creditor during the 90-day period. The debtor receives payment for an antecedent debt, and after that payment an advance is made to the debtor either equal to or more than the payment. The “net result” is that the creditors of the bankrupt have not suffered a loss.

Other Exceptions

Security liens granted to creditors for new advances, extensions of credit or loans are not considered preferences. This exception is targeted at sellers of goods or banks that extend credit to purchase property that then becomes security for the extension of credit.

Statutory liens such as those of garage man, mechanics and landlords are liens created under state law to provide protection for certain types of creditors and may only be avoided in bankruptcy under unusual circumstances by the trustee. Normally, the liens cannot be attacked as a preference.

With regard to consumers, if the total value of the property involved in the transfer is less than $600, the trustee cannot avoid the transfer.

The above are the principle highlights of some of the defenses that may be asserted against a preference. Consultation with experienced counsel is recommended.

Copyright © 2001, 2002 Winston & Winston P.C. All rights reserved.
Revised: July 29, 2003