Outline the requirements for a preferential transfer in bankruptcy and its impact on creditors.
A preferential transfer in bankruptcy is a payment or transfer of property made by a debtor to a creditor shortly before the debtor files for bankruptcy, which gives the creditor more than it would have received in a Chapter 7 liquidation. Bankruptcy law seeks to ensure fair treatment among creditors. Allowing debtors to favor certain creditors just before filing bankruptcy would undermine this goal. Consequently, the Bankruptcy Code allows the bankruptcy trustee to avoid (recover) these preferential transfers.
The requirements for a transfer to be considered a preferential transfer are outlined in Section 547(b) of the Bankruptcy Code. A transfer must meet all of the following elements to be avoidable:
1. Transfer to or for the benefit of a creditor: This means the transfer must be made to a creditor, or for their benefit. This typically involves payments of debts owed.
*Example: A company owing money to a supplier pays the supplier $10,000 shortly before filing for bankruptcy. This payment directly benefits the supplier and satisfies this element. Or, a company guarantees a loan for its CEO. A payment to the bank to cover the CEO’s debt would be a transfer for the benefit of a creditor.
2. Made for or on account of an antecedent debt: The transfer must be made for a debt that was already owed before the transfer was made. In other words, the transfer must be for an old debt, not a new one.
*Example: A company pays an invoice that was due 60 days ago. This payment is for an antecedent debt. If a company purchased goods on credit and paid for them immediately upon delivery, this payment would not be for an antecedent debt, as the debt and payment were essentially simultaneous.
3. Made while the debtor was insolvent: The transfer must be made while the debtor was insolvent. Insolvency is defined as the debtor's liabilities exceeding their assets at fair valuation. This is presumed to exist during the 90 days before bankruptcy.
*Example: A company with $50,000 in assets and $75,000 in liabilities is considered insolvent. If the company makes a payment to a creditor during this time, the insolvency requirement is met.
4. Made on or within 90 days before the date of the filing of the petition (or between 90 days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider): The transfer must be made within a specific timeframe before the bankruptcy filing. For non-insider creditors, the period is 90 days. For insider creditors (e.g., relatives, officers, directors), the period is extended to one year.
*Example: A company files for bankruptcy on December 31. Payments made to a regular supplier between October 2 and December 31 would fall within the 90-day preference period. Payments to the company's CEO between January 1 and December 31 would fall within the one-year preference period for insiders.
5. Enables such creditor to receive more than such creditor would receive if (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title: This element requires that the transfer allows the creditor to receive more than they would have received in a Chapter 7 liquidation if the transfer hadn't occurred. This is typically the case when the debtor is not able to pay all creditors in full.
*Example: A company has $100,000 in assets and $200,000 in liabilities, owed to various creditors. If the company pays one creditor $20,000 shortly before filing bankruptcy, that creditor would receive more than the other creditors, who would likely receive only 50 cents on the dollar in a Chapter 7 liquidation.
Impact on Creditors:
Preferential transfers can have a significant impact on creditors. When the trustee avoids a preferential transfer, the creditor who received the transfer must return the money or property to the bankruptcy estate. This money is then distributed to all creditors according to the priority rules of the Bankruptcy Code.
The creditor who had to return the preferential transfer is then left with a general unsecured claim for the amount returned. This claim is treated the same as other unsecured claims and is typically paid a fraction of the full amount, depending on the availability of assets in the bankruptcy estate.
*Example: A creditor receives a $10,000 preferential transfer and is then forced to return it to the bankruptcy estate. The creditor is left with a $10,000 unsecured claim. If the bankruptcy estate only has enough assets to pay unsecured creditors 20 cents on the dollar, the creditor will only receive $2,000 on its claim. This is significantly less than the $10,000 the creditor initially received.
Exceptions:
There are several exceptions to the preferential transfer rule, which protect certain types of transfers from being avoided. These include:
1. Contemporaneous exchange for new value: A transfer that is intended by the debtor and the creditor to be a contemporaneous exchange for new value given to the debtor, and in fact a substantially contemporaneous exchange.
2. Ordinary course of business: A transfer made in the ordinary course of business or financial affairs of the debtor and the transferee, according to ordinary business terms.
3. Purchase money security interest: A transfer that creates a security interest in property acquired by the debtor, securing a debt incurred to acquire that property.
4. Consumer debt transfers: Transfers of less than a certain amount ($600 as of 2022) made by individual debtors whose debts are primarily consumer debts.
*Example: A company makes a payment to a supplier according to the usual payment terms and schedule. This payment would likely fall under the ordinary course of business exception and would not be avoidable, even if it meets all the other elements of a preferential transfer.
In conclusion, the preferential transfer rule aims to promote fairness among creditors in bankruptcy. The requirements are specific, and the impact on creditors can be significant. Understanding these rules is crucial for both debtors and creditors involved in bankruptcy proceedings.