Preferences

A primary goal of bankruptcy is to treat creditors fairly and equally. The automatic stay effectuates this goal by stopping the creditors' race for the debtor's assets. However, a debtor can usually see that he will probably file for bankruptcy at least a couple of months before he actually files and after learning about how bankruptcy works, he may try to pay some creditors over others before filing. A debtor may prefer certain creditors, because they are relatives or friends or officers of a corporate debtor, or the debtor may have a continuing relationship with the creditor, such as a family doctor, that he doesn't want to jeopardize.

A preference (aka preferential transfers) occurs when a debtor transfers money or an interest in the debtor's property to a creditor that is greater than what the creditor would have received in a Chapter 7 liquidation. Preferential transfers differ from fraudulent transfers in that the transferee in a preference is a creditor rather than someone who is helping the debtor to hide or protect assets. Section 547 of the Bankruptcy Code governs preferential transfers in bankruptcy.

Since preferences are contrary to the policy of equal treatment of creditors under bankruptcy, the bankruptcy trustee is given great powers to avoid preferences by requiring the preferred creditors to pay back the preference to the bankruptcy estate or by removing liens on the debtor's property. That preferences can be avoided helps to prevent creditors from racing for the debtor's assets so that they can take advantage of the "first in time, first in right" policy that generally prevails under state law. Indeed, the trustee can avoid transfers that would be legal under state law.

The trustee can avoid transfers that occur within 90 days of the bankruptcy filing date or within 1 year if the transferee is an insider, such as a relative or friend. There is a longer period for insiders because generally insiders will be more knowledgeable about the debtor and will probably see the debtor's slide into bankruptcy long before other creditors, and so an insider would have an advantage over other creditors in receiving payment or securing a debtor's assets.  A transfer can be avoided even if it was not done in bad faith.

The 5 Elements of an Avoidable Transfer

There are 5 elements, listed in §547(b), that must be satisfied for a transfer to be avoidable. If any 1 of the elements is not satisfied, then the transfer cannot be avoided.

  1. There must have been a transfer of an interest in property from the debtor either to the creditor or for the benefit of the creditor. This includes not only money, but also any interests in property. For instance, if the debtor gives the creditor a security interest in some property of the debtor where there was none before, this would be considered a transfer.
  2. The transfer was made because of an antecedent debt, even if the debt was only incurred a short time before the transfer was made.
  3. The debtor must have been insolvent at the time of the transfer. Here, insolvency is defined by the balance sheet test. If the fair valuation of nonexempt assets minus liabilities is zero or less, then the debtor is insolvent under the balance sheet test. Only nonexempt assets are considered because the debtor is permitted to keep exempt assets.
  4. The transfer must have occurred within the prepetition avoidance period, which is the 90 days immediately preceding the bankruptcy filing date. However, if the transferee is an insider, which includes relatives, friends, or a corporate officer of a corporate debtor, then the avoidance period extends to 1 year before the filing date. Note that if the transferee is not an insider, but only benefits an insider, then the 90-day rule applies. For instance, if the debtor repays a loan that was co-signed by a relative to a creditor who was not an insider 180 days before filing, then this transfer cannot be avoided.
    1. Because almost all debtors are insolvent in the few months before bankruptcy and because of the difficulty of proving insolvency at a particular time, there is a presumption of insolvency during the 90-day period. It would be up to the creditor to rebut the presumption. However, there is no presumption of insolvency between 91 days and 1 year for a transfer to an insider. The trustee would have to prove insolvency.
  5. The last requirement, known as the improvement-in-position test, of an avoidable preference is that the transfer improved the creditor's position over what the creditor would have received in a Chapter 7 liquidation if the transfer had never happened. Note that this rule applies regardless of the bankruptcy chapter that the debtor is filing under. If the transferee got more from the preference than it would have gotten under a Chapter 7 distribution with the preference restored to the bankruptcy estate, then the preference is avoidable.
    1. The improvement-in-position test is not needed if the creditor's class would receive 100% of their debt or if the creditor is fully secured, since a fully secured creditor would always receive a full payment of its debt. However, there are 2 caveats for the secured creditor and both are based on the value of the collateral, since if the collateral is not worth the full amount of the debt, then the debt is bifurcated into a secured debt and an unsecured debt.
      1. The value of the collateral is determined at the time of bankruptcy, not at the time of the loan. So if the collateral is declining in value, the creditor may be undersecured on the bankruptcy filing date.
      2. The court may decide to use either a going concern valuation or a lower liquidation value, especially since a Chapter 7 bankruptcy is a liquidation.

To illustrate the improvement-in-position test, let's assume that Preferred Creditor got repaid the $1,000 of its debt before Debtor filed for bankruptcy. Let's also assume that Debtor has 9 creditors, not including the Preferred Creditor, and that there would be $4,500 left for distribution to unsecured creditors in a Chapter 7 liquidation. Whether the debtor is actually filing under Chapter 7 is irrelevant—the calculation is based on a hypothetical liquidation. After the preference, each creditor would receive $500. To calculate whether the Preferred Creditor improved her position by taking the preference, the Trustee calculates that if the preference is avoided and Preferred Creditor was forced to file a proof of claim, then the bankruptcy estate would have $5,500 to be distributed to 10 creditors. Hence, Preferred Creditor would have only gotten 10%, or $550, instead of $1,000, so the preference is avoidable. Note, too, that by avoiding the preference, the other creditors get an additional $50.

Transfer Date

In most cases, when the transfer occurred is apparent. However, in some cases, it may not be clear. The time of transfer is important, because only by knowing when the transfer occurred can it be determined whether it occurred within the avoidable period, whether the debtor was insolvent at the time, and whether the transfer was for an antecedent debt.

Section 547(e) stipulates that the transfer occurred when it became effective under nonbankruptcy law. If the transfer is an interest in property, such as a security interest, and it requires perfection under nonbankruptcy law, then the date of the transfer will be on the date of perfection, unless the property interest is perfected within 30 days of the transfer in property interest. To perfect a security interest means to complete the legal steps necessary to notify 3rd parties of the security interest, such as recording it in the title record for the property. The purpose for requiring perfection is to eliminate secret liens that would benefit some creditors over others in a bankruptcy.

Section 547(c)(3) further stipulates that no transfer can occur until the debtor obtains an interest in the property. For instance, in a garnishment, the creditor obtains a lien on the debtor's future wages, and the lien is perfected more than 90 days before the debtor files for bankruptcy. Are the wages that are garnished during the 90-day period a preference? They are a preference because although the creditor perfected her lien before the 90-day avoidance period, the debtor had no right to receive the wages until he earned them. Hence, in this case, the transfer date is after the perfection date.

The perfection date is defined, using nonbankruptcy law, as when, for real property, a bona fide purchaser of the property cannot obtain superior rights over the creditor. For all other property, the date of perfection occurs when a judicial lienor cannot obtain superior rights. However, state law often gives a lien an earlier, and therefore higher, priority if it is perfected within a certain time, usually 30 days. If the creditor perfects his security interest within the proscribed time, then his priority is backdated to when the creditor acquired an interest in the property.

However, the Supreme Court has ruled, in Fidelity Financial Services v. Fink, 522 U.S. 211 (1998), that because §547(e) states that perfection only occurs when a judicial lienor cannot acquire a superior interest in the property, and since it is possible for a creditor to obtain a superior interest until the transferee perfects the interest, the date of perfection must be when the act of perfection is actually completed, since only then will it be certain that a creditor with a judicial lien cannot obtain a superior interest. Hence, §547(e) trumps state backdating laws.