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 debtor.

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” defense:

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 unavoidable instrument.

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 rights.

I wish you well.

This 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.