FUNDAMENTALS OF BANKRUPTCY FOR LENDERS
General Principles of Bankruptcy Law
6. PREFERENCES
a. When a debtor files bankruptcy (or his creditors file for him), the trustee responsible for administering the debtor’s estate may reclaim certain transfers made by the debtor within ninety days of the filing of the bankruptcy petition. These transfers, made to creditors, are generally referred to as preferences.
b. Property brought back into the estate is then shared by the debtor’s unsecured creditors on a pro rata basis.
c. A preference demand against an unsecured creditor could follow the receipt of money or other non-monetary assets of the debtor either through voluntary payments, garnishment, levy or other means.
d. A preference demand against a secured creditor could be made on the basis of a lien recorded against property of the debtor, and also on the basis of voluntary payments made toward the obligation secured by that potentially avoidable lien.
e. Elements of a Preference [§ 547]:
(1) In order for the Trustee or the Debtor to prove that an avoidable preference exists, the transfer must be:
(a) to or for the benefit of a creditor;
(b) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(c) made while the debtor was insolvent;
(d) made on or within 90 days before the date of the filing of the petition (or between 90 days and 1 year prior to filing if the creditor is an insider of the debtor); and
(e) that enables such creditor to receive a greater percentage of its claim than it would under the normal distribution provisions in a liquidation case under the Bankruptcy Code.
f. Potential Defenses:
(1) Once the Trustee has proven the basic elements of a preference, the creditor must prove that the transfer is not avoidable on the basis of one of the statutory defenses.
(2) While there are a number of possible defenses, the most common defenses asserted by creditors are: (a) Contemporaneous Exchange for Value; (b) Subsequent New Value; or (c) Ordinary Course of Business.
(3) Contemporaneous Exchange for Value [§ 547(c)(1)]
(a) In order to assert this defense, the creditor must show that the transfer
(i) was intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and
(ii) was in fact a substantially contemporaneous exchange
(b) An example of a contemporaneous exchange for value would be the receipt of cash payment at the time goods or services are delivered.
(c) Protection under this defense is only applicable to the extent that the creditor can prove that the exchange was contemporaneous. For example, courts have held that payment received in the form of a check at the time goods are delivered may be contemporaneous only if the check is honored. A dishonored check, even if later honored, will not qualify as a contemporaneous exchange.
(4) Subsequent New Value [§ 547(c)(4)]
(a) In order to assert this defense, the Creditor must prove that:
(i) after the alleged preferential transfer, the creditor gave new value to or for the benefit of the debtor that was not secured by an otherwise unavoidable security interest, and for which the debtor did not make a subsequent unavoidable transfer
(b) The term “new value” is defined by the Bankruptcy Code, for this purpose as:
(i) money or money’s worth in goods, services or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee under any applicable law, including proceeds of such property, but does not include an obligation substituted for an existing obligation.
(c) This defense was put in place to encourage creditors to continue to deal with troubled businesses.
(d) Allowing the trustee to recover a preferential payment made under these circumstances would put the estate in a better position than it would have been had the transaction never occurred.
(e) By way of example, suppose the debtor owes Creditor A $1,000 on an existing unsecured debt. On day 1, the debtor pays Creditor A $1,000. On day 45, the debtor goes to Creditor A and says, “You were willing to lend me $1,000. I paid you back. How about lending me another $1,000?” Creditor A, comfortable that the debtor is a good credit risk for at least $1,000, lends the debtor a fresh $1,000 on an unsecured basis. On day 60 the debtor files Chapter 7. The trustee brings a $1,000 preference action against Creditor A on account of the $1,000 payment made on day 1. Assume that all of the elements of § 547(b) can be proved with respect to the payment. If the trustee is allowed to recover that payment, the bankruptcy estate will be better off than it would have been had this series of transactions not taken place. It will now have $2,000 where on day 1 it had only $1,000. Creditor A, on the other hand, will be out $2,000 where on day 1 it was only subject to a claim to recover $1,000.
(f) To prevent this inequitable result, § 547(c)(4) allows the bankruptcy court to give credit for the amount of the subsequent advance.
(g) Timing of payments received and advances made is essential to this defense as advances may only be applied to payments received prior to the advance.
(5) Ordinary Course of Business [§ 547(c)(2)]
(a) In order to assert this defense, the creditor must prove that the transfer was
(i) made in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;
(ii) made in the ordinary course of business or financial affairs of the debtor and the transferee; and
(iii) made according to ordinary business terms
(b) Under current law, the statutory requirements of this defense are written in the conjunctive, meaning that a creditor must prove all three elements to successfully assert this defense.
(c) Under BAPCPA, the statute has been revised such that the creditor must prove element (i) and either element (ii) or (iii) above. This will make assertion of this defense much less expensive for creditors, and should make satisfaction of the basic elements much easier.
g. Other Preference Changes under BAPCPA
(1) Grace period extended to 30 days
(a) Under current law, in order to avoid a preference claim, the secured creditor must perfect a purchase-money security interest within 20 days and perfect all other security interests within 10 days.
(b) BAPCPA extends the grace period for perfection of all security interests to 30 days. This brings the bankruptcy code into harmony with the laws of many states, including the Commonwealth of Virginia with regard to timing requirements for perfection of security interests.
(2) Threshold limits for recovery of preferences
(a) Current law allows the recovery of preferential transfers by the Trustee only to the extent that the aggregate value of the transfer exceeds $600. This threshold is applicable to recovery against creditors holding both consumer and commercial claims.
(b) BAPCPA maintains the $600 threshold for recovery in bankruptcy cases in which the debts are primarily consumer.
(c) BAPCPA increases the threshold to $5,000 for recovery of preferential transfers in cases involving primarily commercial or business debts.
(3) Venue for preference cases
(a) Under current law, all preference cases are brought in the same court where the bankruptcy case is filed. This practice imposes enormous additional expense on creditors forced to defend cases in distant courts.
(b) This is particularly true for those creditors defending against relatively small claims. The costs associated with hiring local counsel and defending the case from afar often exceed the claim being made by the Trustee.
(c) To avoid the excessive expense of defending the case, the creditor is often forced to enter into a settlement rather than asserting its defenses.
(d) Under BAPCPA, any preference claim for less than $15,000 in a consumer case, or $10,000 in a non-consumer case, must be brought in the district where the defendant resides.
(e) This will likely decrease the number of small value preference claims made by trustees and debtors.
For more information or to request a presentation regarding BAPCPA, please contact Spotts Fain attorneys, Robert H. Chappell, III (804) 697-2025 or Jennifer J. West (804) 697-2094.
