After the last edition of the Creditworthy News, where Rich Hill wrote
an article examining the history of the Bankruptcy Code, we received
several questions about bankruptcy and in particular preferences.
An elder bankruptcy attorney I know once told me
he would rather visit his proctologist then deal with preference
issues. “At least when I visit the doctor I know the end result”,
he used to chuckle. The Code covers preferences in §547.
Unfortunately, not all jurisdictions interpret §547 the same way and
there have been cases that make the preference section read more like
an old episode of the Twilight Zone. As my attorney friend remarked
there is no guarantee what the outcome will be. There have been cases
where the preference question was decided based on what the common
industry practices were rather than the Code.
For the record, §547 says that a trustee or
debtor in possession may seek to recover payments or other transfers
of assets made by the debtor to a creditor within 90 days of a
debtor’s bankruptcy filing. The idea behind this was to prevent the
debtor from treating one unsecured creditor more favorably than any
other unsecured creditors. The authors of the preference statute
believed that an unsecured creditor, who repaid a preference, would
share in the recovery with the other unsecured creditors.
Unfortunately, they either failed to consider the
position of secured or priority creditors or overlooked it in their
rush to complete the section. Regardless, secured and priority
creditors are supposed to have their claims satisfied before unsecured
creditors can collect and, as we all know, the full recovery of assets
by secured and priority creditors is a rare occurrence.
A preference is defined as any payment or
transfer of assets. Thus, a preference could be a payment on a past
due balance or it could be giving an unsecured creditor a security to
elevate the creditor to secured status. It could also include the
conversion of an open account balance to a promissory note.
In order for a preference to be recovered by the
debtor in possession the following has to exist:
A transfer of property was made from the debtor
for the benefit of the unsecured creditor.
The transfer occurred within 90 days of the
bankruptcy filing or up to one year if the transfer was made to
officers, directors, affiliated companies or shareholders of the
The transfer was made for existing indebtedness.
The transfer was made at the time the debtor was
insolvent (liabilities exceeded assets)
The transfer allowed the creditor to recover more
than they would have received in Chapter 7 liquidation.
There is a creditor defense to a preference
action and it is found in §547(c)(4) of the Code. Commonly referred
to as the New Value Defense. The new value defense was created to
encourage creditors to continue doing business with and extending
unsecured credit to companies in financial difficulty.
The following is an example of “new value”
Debtor owes creditor $100,000 that is past due
and wants to purchase $20,000 in new orders. Debtor does not have the
$100,000 to pay the past due but does have $20,000 for the new order.
Debtor pays $20,000 and the creditor applies the payment against the
$100,000 past due balance. Creditor than invoices $20,000 for the new
purchase on open account terms.
The result being the unsecured creditor is no
worse off, they are still owed $100,000, but the debtor has received a
benefit by being able to replenish its assets. Therefore, there is no
preference. At least that is what the Code says.
In order to qualify, as a non-preference the new
value cannot be secured by a security interest (UCC) and the transfer
cannot be made with a cashier’s check, money order or any other
Preference rules although written in black and
white in the Code remain a gray area in the practice of bankruptcy. It
is recommended that if you receive notice from a trustee or debtor in
possession that they want payments returned to them due to preference
issues that you first consult with competent legal counsel preferably
one who is board certified in either bankruptcy law or creditors
I wish you well.
information is provided as information only and not legal advice.
Legal advice should be obtained from a competent, licensed attorney,
in good standing with the state bar association.