31: Preferences© Charles Tabb 2010

What is a “preference”?

Transfer shortly before bankruptcy by an insolvent DR that favors (“prefers”) one creditor over other creditors

In way that undermines the bankruptcy distributional scheme

Simple hypo

Dr has 3 Crs – A, B, and C Owes each one 6 grand (so 18 total

debts) Only has 6K in assets A week before files bk, Dr pays off A

in full, nothing left If don’t recover payment to A, B and

C get nothing Bk distributional scheme is

undermined by eve-of-bankruptcy transfer

solution

Make A give back the 6 grand it got paid to the bk trustee

Then A, B, and C all get paid an equal amount (2K each -- 1/3 of the 6) in the bankruptcy

But isn’t it legal??

Crazy thing about “preferences” as avoiding power is it allows the bk estate to recapture a payment that was perfectly legal when it was made

Dr owes Bob a debt. Dr pays Bob. Dr files bankruptcy. Bob has to give $ back.

What about finality?

In that scenario, Bob has a perfectly legitimate complaint that he should be able to keep a payment of a valid debt.

And not only that, he may have to give it back many months later! So the strong commercial law policy of finality is seriously undermined

Hardship on Creditor?

Indeed, having to repay as a “preference” a validly paid debt could cause considerable hardship on a creditor – may well have already spent that money!

Say Bob is the family dentist, did $3000 of dental work on Debtor (should have known, with that name …), got paid – then Dr files Bk, Bob has to return the 3 grand

Why avoid?

So – why avoid? The core problem is making the

transition from state collection law, where the priority rule is “race”, to bankruptcy, where priority rule is “equality”

Why, cont.

Note would not be a problem if did not have a time lag between onset of dr’s insolvency and filing of bankruptcy

Insolvent-----------transfer------------Bankruptcy

If Dr becomes insolvent, though, and bankruptcy does not follow immediately, the state law “race” paradigm (i) undermines equality, and (ii) also may trigger destructive Cr race for assets, the “run on bank”

Common response to scarcity

The way that Crs react if find out Dr insolvent is common reaction by competitors for scarce resources

Examples: Oklahoma land rush “Sooners” College bowl games Federal judges selecting judicial clerks

Self-policing?

In each of the cases cited, all involved tried to agree to rules limiting ability to “get the jump” on others and take advantage

And it never works

So in event a Dr pays some creditors and not others when insolvent, and bk soon follows, only solution is ex post to impose retroactive repayment obligation

Debtor pick and choose

Just as Creditors may see bankruptcy looming and race in to grab something before it is all gone, the Debtor may see financial doom looming and pick and choose among favored creditors

DR

Loan shark

Mom

Credit

card

medical

Theory of why

Thus, the normative concept of preference law is to extend the equality norm back in time from the bk case to the pre-bk period, when Dr is insolvent

if Dr is solvent, then state law “race” paradigm not a problem, b/c by definition everyone will get paid in full

Original hypo: A, B, C each owed 6. If Dr had 20 in assets, then fine to pay A its 6 – not hurt B or C.

Why?, cont.

In theory, could extend preference reachback period as far back prior to bk as when Dr 1st became insolvent

b/c all transfers after that undermine equality, threaten ‘run on bank”

But in interests of (i) certainty and (ii) finality, use a set time period of vulnerability

Good or bad preferences – do motives matter?

If ONLY cared about equality norm, would have a much simpler preference rule

But hard to get away from notion that there is nothing “wrong” with paying debts in the normal course of affairs

Notion that should only set aside transfer as a “preference” if someone had bad motives

motives?

Original notion: only a preference if debtor had an “intent to prefer”

Then – only if creditor had an “intent to obtain a preference”

1898 Act – only if Cr had “reasonable cause to believe Dr insolvent”

Today – ok if paid “in ordinary course”

Today: standard litany of reasons

In sum, today the Supreme Court, and Congress, embrace the following as justifications for preference law:

1) equality

2) deter the “race” for assets Note not really a deterrence, though, b/c

worst that can happen is have to give it back

Structure of 547

1) elements of a preference: 547(b) Trustee has burden of proof Must prove all the elements

2) exceptions, i.e., safe harbors: 547(c) Creditor has burden of proof Any exception suffices

Elements of a preference a transfer, 547(b) of property of the debtor, 547(b) to or for the benefit of a creditor, 547(b)(1) for or on account of an antecedent debt,

547(b)(2) made while the debtor was insolvent,

547(b)(3), (f) made during the preference period of 90

days before bankruptcy (or one year for insiders), 547(b)(4)

that enables the creditor to receive more than it would have in a hypothetical chapter 7 liquidation, 547(b)(5).

Problem 9.9(a)

Facts: Creditor loans Debtor, Inc. $8K on

January 5 The loan is guaranteed by Prez, the CEO

of Debtor, Inc.. On April 1, Debtor, Inc. pays Creditor

$8K On May 1, Debtor, Inc. files bankruptcy.

9.9(a)(1)

Preference as to Creditor? Analysis:

Transfer of Dr property? to or for the benefit of a Cr? antecedent debt? Dr insolvent? Preference period? Preferential effect? ▪ Also called “improvement-in-position” or

“greater %”

9.9(a)(2)

Preference as to Prez? Analysis:

Transfer of Dr property? to or for the benefit of a Cr? antecedent debt? Dr insolvent? Preference period? Preferential effect?

9.9(b)(1)

Same as a, except file bk September 1 (Cr was paid on April 1)

Analysis – preference as to Creditor?: Transfer of Dr property? to or for the benefit of a Cr? antecedent debt? Dr insolvent? Preference period? Preferential effect?

9.9(b)(2)

Preference as to Prez? Analysis:

Transfer of Dr property? to or for the benefit of a Cr? antecedent debt? Dr insolvent? Preference period? Preferential effect?

Deprizio

Payment to non-insider Cr more than 90 days before bk, on a debt guaranteed by an insider

Avoid as preference as to insider, not Cr, b/c of 90-day period

But allow recovery vs Cr as “initial transferee’ 550(a)(1), even though not avoidable as to Cr

Fixing Deprizio

550(c) (1994): may not recover from non-insider based on transfer made > 90 days before bk that is avoided only as to insider

But what if transferred a lien to non-insider? No “recovery” – just set aside lien – so 550(c) no help Add 547(i) (2005): avoidance only as to

insider

The Ponzi case:Cunningham v Brown

“Ponzi” scheme (“Peter-Paul”):

1st $

New $

New $

More

new $

More

new $

More

new $

Even

more

new $

Even

more

new $

Even

more

new $

Even

more

new $

Facts in Ponzi case

Charles Ponzi was promising 50% return in 90 days, or pay in full 45 days

“international postal coupons” Δs all invested between July 20-24 Money deposited in Hanover Trust –> balance

July 24 $871K, withdrawals > 871K July 26-28, but new deposits kept + balance

August 2 newspaper expose, “run” Δs were repaid Aug 2-4 Aug 9 – overdraft closed him down Aug 9 -- Bankruptcy filed Aug 12- Ponzi surrender to authorities

Preference action

Trustee in bankruptcy sued Brown and the other defendants for the recovery of the amounts paid to them by Ponzi on August 2, 3 and 4 on account of the debts incurred on July 20-24 as voidable preferences

Theory – while insolvent, & within preference period (Indeed in week before!), Ponzi repaid antecedent debts, allowing those repaid to recover more than their share

Why need preference law

The facts of the Ponzi case starkly illustrate why need a preference law

Wildly insolvent, “run” on assets

If allow payments to Brown et al to stand up, then they get paid in full while others similarly duped get nothing

Ponzi case – issue?

What did Brown & others argue by way of defense?

said were not paid with Ponzi’s property – instead, they said they just got “their” own money back – a rescission for fraud, based on constructive trust

If so would not be a preference, b/c only worry if deplete Dr’s own assets & prospective bankruptcy estate that can be used to pay creditors

Own property back?

Not a frivolous argument – e.g., payments to a trust beneficiary would ≠ preference

Begier – SCOTUS held ≠ preference when Dr paid US for trust-fund taxes during preference period b/c the taxes paid were the subject of a

statutory trust in favor of the U.S. govt

Other trust claimants?

Hypo: Department store, has an eyeglass section In fact the eye section is K’ed out by dept

store to an independent Optical Co. Arrangement is: $ paid to eyeglass section

originally go into store’s coffers, then each month the store remits back the collected proceeds to Optical Co, minus the store’s 15% fee

Issue: are remittances made to Optical Co in preference period recoverable as preferences?

Analysis of trust claim

Answer? Will depend on whether the relationship between Optical and Department Store truly is a trust arrangement, in which event the

monies remitted back are in fact, and always have been, the property of Optical

Or, just a debtor-creditor relationship, in which case is a transfer of the Dept Store’s property, paying on a debt, and thus is a preference

Holding in Ponzi case

Supreme Court in Cunningham held was NOT a return to investors of their own property, but a preferential transfer to them of Ponzi’s property

Rationale for Ponzi holding 1st – no evidence that there was a

“constructive trust” & that investors were “rescinding” for fraud – seems just getting paid on their debts

2nd – even if were a valid constructive trust & investors asserting a return of own property: Must TRACE their property – and cannot Presumptive tracing rules n/a, b/c everyone was

defrauded – ALL investors in the same “duped” boat

Credit card balance transfers &“earmarking”: Marshall

Facts: Dr had credit card accounts with (i)

MBNA & (ii) Cap One July 27: direct Cap One to make $38K in

balance transfers to MBNA Oct. 13 – file bankruptcy Trustee – sue MBNA to recover

preference

schematic

DR paid

MBNA Cap One

Trustee

Owe 38Claim for 38

Preference

suit

Pays 38, balance transfer

Defense?

MBNA argued no transfer of property of Dr – paid by Cap One, not Dr

Just a substitution of one Cr for another, no preference

Which look like? Claim purchase?

Along the lines of the old Sesame Street game “one of these things looks like another,” must decide which of following scenarios the balance transfer is more like:

1st: one Cr buys another Cr’s claim –> NOT preference b/c no transfer Dr property DRCr One Cr

Two

Owe 38Claim for 38

Pays $, buys claim

Or, Loan to DR then payment to CR?

Or, 2nd, Dr borrows money & uses loan proceeds to pay off debt – IS a preference

Debtor

Creditor One Creditor Two

Owe 38Use

loan to

pay loan

No different if bypass Dr

If like a 2nd scenario case, would not change the result if Dr instead of borrowing money 1st, then paying it over, just told Cr Two to pay the loan directly to Cr One

Debtor

Creditor One Creditor Two

Owe 38

Use loan to pay

loan

Possible tests

Court considered two tests:

“dominion & control” – does Dr have dominion & control over the $ being “loaned” from Cap One?

“diminution of the estate” – is the estate being depleted by the balance transfer?

Applying the tests

How apply:

Dominion & control test?

Diminution of the estate test?

Why not earmarking?

Earmarking:

1) what is it?

2) why did court hold did not apply here?

Are balance transfers bad?

Did the balance transfer from Cap One to MBNA implicate the sorts of concerns that justify preference law?

If allow recapture from MBNA, did estate’s other Crs get a windfall?

What now?

After Ct holds that MBNA is liable for the preference, what happens? What happens to estate? What about claims?

Timing rules

Critical to know WHEN a transfer is deemed “made” for preference purposes: Was the transfer made within the

preference period? Was transfer made on account of

antecedent debt?

Timing rule

547(e)(2):when transfer? When effective between transferor and

transferee, IF perfected within 30 days Not until perfected if > 30 days

547(e)(1): “perfected”? Real property – bfp can’t beat Personal property – lien Cr can’t beat

Applying timing rules

Outright transfer (e.g., paid cash) Effective instantly, & good agst the

world (bfp, lien cr)

Transfer of a lien Need to record in public records

Delay in recording?

Hypo: Jan 1: Dr borrow $25K from Cr, grants Cr

art 9 security interest in collateral to secure

March 1: Cr perfects May 1: bankruptcy filed

Can trustee avoid the Cr’s lien as a preference?

Delayed perfection, analysis In hypo, the Cr and Dr intended to make a

simultaneous exchange (loan for security), so if Cr had perfected right away, not a preference b/c no “antecedent debt”; also, not within 90 day period

BUT since delayed beyond 30 days – deem the “transfer” of security interest to be on March 1: Now IS for antecedent debt (arose Jan 1) Within 90 days of May 1 bk filing

So is avoidable as preference!

Delay, but < 30 days

Change hypo: loan for security on Jan 1, Cr not perfect until Jan 29; bk filed May 1

NOT a preference: Since perfected within 30 days of when lien

effective btwn Dr and Cr (i.e., on Jan 1) (here, 28 days), treat as if transfer made back on Jan 1

So:▪ No antecedent debt, never a preference▪ Plus here, not within 90 days of bankruptcy

Grace period matter of federal law

Note that the 30-day grace period in 547(e)(2)(A) has nothing to do with any particular state law or status (e.g., need not be a PMSI)

Solely a creature of federal bankruptcy law – anyone & everyone always gets 30 days to perfect for preference purposes

What about a CHECK? - Barnhill

In Supreme Court case of Barnhill v Johnson, Ct had to decide when a transfer was made by check: When check was delivered to payee? (at

day 92) Or, when check was honored by bank?

(day 90)

Holding in Barnhill

For purposes of applying the elements of a preference under 547(b), the Court held in Barnhill that a check is not transferred until it is honored by the bank

Rationale: under state law (e.g., UCC Art 3), no actual transfer of property from drawer of check to payee until honor “Many a slip” between delivery & honor, payee get $0

Court left open possibility that a delivery date might be used for preference exceptions

Freedom Group

Facts: June 2: LH judgment vs Dr (FG), $7K+ June 12: notice of garnishment issued June 15 [day 91]: garnishment served on Dr’s bank▪ “Lien” arise under state law

June 16 [day 90]: DR deposit $18K in account June 17: final order issued Bank pays LH $7743 pursuant to garnishment Sept 14 – bk filed FG (DIP) sue LH to recover $7743 payment -

preference

Payment or lien?

Note that DIP is seeking to recover the payment by bank of $7743 as a preference, but court is focusing on when LH’s garnishment lien was effective – why?

Issue

The decisive issue in case, then, is when the garnishment lien was “transferred” from Dr to LH

If transfer was within 90-day preference period, then lien is indisputably avoidable 90-day mark was June 16

Creditor’s argument

LH argued that the “transfer” was made on June 15 (conveniently, day 91!) when the garnishment lien is deemed perfected (in sense that no other cr could become a lien cr and get priority over it) – date notice served on bank

holding

7th circuit held, however, that the transfer was not made until the court issued final order – until then, rights purely tentative Analogized to Barnhill check delivery

case, deference to state law Said here had perfection (on service)

before transfer

rationale

Statute Must have an effective transfer of property

as between Dr and Cr under state law, whether or not perfected – see 547(e)(2)(A)

Preference policy b/c of continuing nature of garnishment

lien, otherwise allow Dr to “prefer” LH by depositing $ in account within 90 days, after LH’s “perfection” intact

What about the $18k deposit? Assume, for sake of argument, that 7th

circuit had agreed with Cr that the transfer was effective from time was “perfected”, which was on date of service (June 15), which was day 91, outside preference period

Is it nevertheless a problem that the $18K was not deposited in the account until June 16 (which was day 90)? i.e., could there be a transfer of a lien on $18K

before the $18K existed??

Palmer Clay Products

Facts: During preference period, Dr made

several payments ($1843) to Cr Dr insolvent at time Allegedly, % paid to Cr at time was not >

% would have gotten if Dr’s assets then liquidated

Trustee sue Cr

Issue in Palmer

Question before the Court was how to construe the “greater %” test (i.e., what today would be 547(b)(5))

Creditor’s argument?

What exactly was the Creditor arguing in terms of how the greater % test should be interpreted?

Holding of Court

Court holds that must construe test in terms of the actual effect of how affects Cr’s recovery

Rule of thumb after Palmer

Payment = preferential effect unless: 1) all unsecured creditors will be paid

100% in bkOr 2) the creditor transferee is fully secured

Court’s hypo

Claim = $10K Paid $1000 during preference period Bk distribution = 50%

(1) without challenged transfer? Cr get $5K (50% of 10K)

(2) with challenged transfer? Cr would get $5,500 (100% of the $1,000 paid, plus 50% of remaining $9k. i.e., $4500)

Why rule of thumb works

The reason the Palmer rule of thumb works is that if the bankruptcy distribution would be less than 100% to unsecured creditors, the preferred creditor has to be better off if gets to keep 100% of any pre-bk payment made On those $, is getting 100%, not smaller

bk % In hypo, the $500 difference is explained

by difference in getting 100% of $1000 vs just 50% of that same $1000

Problem 9.10(a)

Facts: Debtor owes Creditor $20K for debt incurred

on January 1, for which Debtor granted Creditor a perfected security interest in collateral worth $20K (i.e, fully secured)

On April 1 Debtor pays Creditor $10K On April 2 Debtor files bankruptcy

Is the $10K payment to Creditor a voidable preference?

Analysis 9.10(a)

Issue is whether payment has a “preferential effect,” i.e., does it enable Cr to receive more than it would have in a hypothetical chapter 7 liquidation, under 547(b)(5)?

NO preferential effect – b/c Cr was fully secured So would have gotten paid in full in bk

case anyway

9.10(b)

Facts: Debtor owes Creditor $20K for debt incurred

on January 1, for which Debtor granted Creditor a perfected security interest in collateral worth $12K (i.e, undersecured)

On April 1 Debtor pays Creditor $10K On April 2 Debtor files bankruptcy

Is the $10K payment to Creditor a voidable preference?

Analysis 9.10(b)

Without payment, what would Cr get in bankruptcy? 12K secured claim – paid in full, 12K 8K unsecured claim (20-12) (assume 25% to unsec. Crs)

= 2K▪ Total 14 K

With payment, what will Cr get in bk? 10K payment before bk 10K debt remaining, secured for 12, so get 10K total▪ Total 20K

Yes, is a preference

Why?

Reason is a preference is b/c would bifurcate the 20K claim into: Secured = 12 Unsecured = 8

Then, the 10K payment prior to bankruptcy is allocated first to pay off the unsecured claim (for 8), and as to that 8K, the payment has a preferential effect, since unsec crs in bk only get 25%