Bankruptcy Law and Preferential Transfers: A Hidden Liability

The economic downturn and corporate scandals are important aspects of the current business climate. Emerging from this turmoil is an increasing use of the federal bankruptcy court to obtain creditor relief. The Bankruptcy Code provides protection for a troubled business through the “automatic stay.” However, the Bankruptcy Code also contains hidden liability for an unsuspecting creditor doing business with a troubled business. Under certain circumstances, a creditor may find that benefits of payments provided by a recently bankrupt debtor are capable of being rescinded. Creditors must recognize this risk and attempt to guard against it in order to prosper in the current economic climate.

The Bankruptcy Code provides that a trustee can be appointed by the bankruptcy court to administer a bankruptcy case and the assets of the debtor. The role of the trustee will vary depending upon the type of bankruptcy filed. In general, a trustee attempts to locate assets belonging to the debtor and distributes those assets to creditors. Id. To accomplish this goal, the trustee is given the capacity to sue in a bankruptcy case. 28 USC Sec. 959. For example, a trustee may sue to “avoid” certain actions taken by the debtor before the bankruptcy case is filed.

One of the goals of the Bankruptcy Code is to ensure an equitable distribution of the assets of a debtor. To foster this goal, and to prevent a race among creditors to dismember a debtor before bankruptcy, the trustee is given the power to avoid “preferential transfers.” 11 USC Sec. 547. Some restrictions already exist under Oregon state law limiting the transfer of assets to “inside” creditors under certain circumstances. ORS Sec. 956.200 et seq. However, the avoidance powers of a trustee for preferential transfers are far broader than Oregon law and are frequently used in a bankruptcy case.

Whenever a creditor receives a benefit from a recently bankrupt debtor a preferential transfer may exist. Fortunately, a trustee must independently establish six different elements in order for a preferential transfer to exist. 11 USC Sec. 547(b). The six elements are: (1) a transfer of an interest of the debtor in property; (2) to or for the benefit of a creditor; (3) for or on account of an antecedent debt; (4) made while the debtor was insolvent; (5) made 90 days before bankruptcy ; (6) the effect of which is to give the creditor more than they would receive in a bankruptcy case.

1) Under some circumstances a trustee will not be appointed but a debtor will remain a “debtor in possession” during the bankruptcy case. While the debtor in possession has many of the powers of a bankruptcy trustee this article focuses on the trustee for ease of reference.

2) The bankruptcy code also allows so called “fraudulent transfers” to be set aside pursuant to Oregon law. In some cases, the time period for this power may be up to six years before a bankruptcy filing.

3) If an “insider” is involved, the period is expanded to one year. An insider is a legal term of art but is generally someone closely related to the debtor, for example the president of a bankruptcy corporation.

Each of these elements is given a precise meaning and interpretation. While a comprehensive review of each element is beyond the scope of this article, an alert creditor will immediately notice several important aspects about the elements. For example, the easiest way to avoid a preferentially transfer is to ensure that any benefit occurs more than 90 days before a bankruptcy filing. In addition, the benefit must be for a preexisting debt or obligation. A preference does not exist where the transfer occurs contemporaneously or for a future obligation on the part of the debtor.

Given the broad nature of the powers provided to a trustee, a creditor is very vulnerable to an avoidance lawsuit by the trustee. Fortunately, there are some limits on the trustee’s power. The trustee must prove each of the elements of a potential transfer before a preferential transfer is found to exist. The Bankruptcy Code also recognizes that under certain circumstances a transfer may occur without affecting the equality of distributions to creditors. Under these circumstances the Bankruptcy Code provides a creditor defenses to the trustees avoidance power for preferential transfers. 11 USC Sec. 547(c).

A creditor’s defenses are very narrowly interpreted by the courts and are limited in the protection that they offer creditors. The defenses can be summarized as: (1) a contemporaneous exchange for new value; (2) payments received in the ordinary course of business; (3) enabling loans offered to a troubled business; (4) extension of additional unsecured credit after receipt of a preferential transfer; (5) inventory and accounts receivable financing liens; (6) payments made under a valid statutory lien; and (7) small consumer loan payments. Unless the creditor is a financial institution, most of the defenses are of little assistance in an avoidance action initiated by a trustee.

As with the elements of a preferential transfer, a detailed analysis of each of the defenses is beyond this articles scope. The most common defense raised by creditors is the ordinary course of business defense. To qualify, a creditor must show that the debt was incurred and paid in the ordinary course of business and that payment was made according to ordinary business terms. 11 USC Sec. 547(c)(2). To make this determination, a court will often look at the pattern of behavior between the parties and the ordinary course of business in the industry. A creditor faces a difficult challenge in overcoming a presumption of a preferential transfer under these circumstances.

As businesses see delayed payments and a troubled business climate it is important to keep in mind the avoidance powers of a trustee. Prior to entering into any agreement with a troubled customer, a creditor must carefully consider whether the transaction is a preferential transfer. In addition, a creditor should consider whether a transaction or payment agreement is structured to avoid concerns about preferential transfers. Whenever a creditor is faced with these concerns, careful planning and consultation with an attorney can pay significant dividends in avoiding future problems with a bankruptcy trustee or other creditors.