I’m back.  I have been busy writing a book on Chapter 13 bankruptcy — I was asked to do so by a publisher.  I should have it completed in a few months, so watch for it.  In any event, I am ready to start posting again.

Some time ago I posted on preferential transfers (a.k.a. preferences).  Since I will be speaking on preferential transfers (and on fraudulent transfers) in May these topics have been on my mind.  Today’s post will look at the statutory definition of a preference.  It’s complicated, which is why the post a bit long.  However, it’s worth the read.  Subsequent posts will look at preference avoidance and defenses to preference avoidance.

I.          Introduction

There are two main goals of bankruptcy.

The first goal is to give the debtor a fresh financial start .  This goal has a laudable pedigree that has its origins in the Bible, ancient Roman law, and the U.S. Constitution .

The second goal is to ensure that all creditors who are similarly situated are treated equally and fairly.  There are two ways in which debtors sometimes violate this second big goal:  (1) They don’t list all of their creditors in their bankruptcy papers, and (2) They make preferential payments to certain creditors in anticipation of bankruptcy.

If a debtor omits a creditor from the list, then the debt to that creditor will not be discharged at the conclusion of the case.  (See 11 U.S.C. §§ 523(a)(3) and 1328(a)(2). But see In re Beezley, 994 F. 2d 1433 (9th Cir. 1993) (Unscheduled debt is discharged in a no-asset Chapter 7 case if the debt would have been discharged if it had been listed).)  If the debtor purposely omitted the creditor, and thus “made a false oath,” i.e., committed perjury, the debtor may either be denied a discharge, or have a discharge revoked.  (See 11 U.S.C. §§ 727(a)(4)(A), 1144, 1230, and 1328(e)(1).)  However, there can be a bright side to this scenario:  the debtor may end up receiving free room and board at government expense, which could greatly reduce any stress over finances .

The focus of these posts is on the other way debtors violate the second big goal:  preferential transfers.  We begin with the definition.

II.        Statutory Definition Of A Preference

The Bankruptcy Code defines important terms associated with preference law in 11 U.S.C. § 547(a), states the conditions under which a preference can be avoided in §§ 547(b) and (d), and lists exceptions to preference avoidance in §§ 547(c) and (h).  Other Code sections that can play a role include § 522(h) and various parts of §§ 546 and 550.  We begin by considering § 547(b)’s implicit five-part definition of a preference.  A preference is a:

transfer of an interest of the debtor in property  —

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made —

(A) on or within 90 days before the date of the filing of the

petition; or

(B) between ninety 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; and

(5) that 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.

There are thus five components or requirements to the definition.  Let’s look at them in seriatim.

1.        Preferences Benefit Creditors

The first thing to observe is that a preference is only to or for the benefit of a creditori.e., someone to whom the debtor owes a debt.  A transfer to or for the benefit of a non-creditor is thus not preference .  For example, a transfer of real property from a parent to a child as a way of avoiding future probate problems is not a preference unless the child is a creditor of the parent.  However, such a transfer can be a fraudulent transfer.  After the preferential transfer series, I’ll do a series on fraudulent transfers.

By the way, although a preference is usually money, it need not be.  A debtor can pay a debt with something other than money.

2.        Preferences Are Payments On Already Existing Debts

The second requirement is that the transfer was made as a result of a debt that was incurred to the creditor prior to the transfer.  If, for example, the debtor transferred an asset to an entity that was not a creditor, and later incurred a debt to that same entity, the transfer would not be a preference (though it could be a fraudulent transfer).

3.        Preferences Only Happen When The Debtor Is Insolvent

Third, the transfer must have occurred when the debtor was insolvent.  (“Insolvent” is defined in 11 U.S.C. § 101(32).)  For the vast majority of cases the shorthand:  “Liabilities exceed assets” suffices.  That is, the sum of the debtor’s debts exceeds the aggregate value of the debtor’s assets.

11 U.S.C. § 547(f) states:  “For the purposes of this section, the debtor is presumed  to have been insolvent on and during the 90 days immediately preceding the date of the filing of the petition.”  (However, this presumption is rebuttable.  See, e.g., In re Molded Acoustical Products, Inc., 18 F. 3d 217, 221 n. 4 (3rd Cir. 1994).)

Therefore, if the transfer was made more than ninety days prior to the bankruptcy filing, there could be a very fact specific battle over whether the debtor was insolvent, and thus whether a preference even occurred if the creditor was an insider.  Consequently, this question of insolvency can play a significant role in the second part of the next requirement.

4.        The Look-Back Period

The fourth requirement focuses on the look-back period, i.e., how much time must pass before a transfer is no longer a preference.

To understand this fourth requirement we must divide creditors into two categories:  ordinary creditors and insider creditors.  As previously stated, creditors are obviously entities to whom the debtor owes money.

Insider creditors are creditors who are also entities of the sort listed in 11 U.S.C. § 101(31):

The term “insider” includes —

(A) if the debtor is an individual—

(i) relative of the debtor or of a general partner of the debtor;

(ii) partnership in which the debtor is a general partner;

(iii) general partner of the debtor; or

(iv) corporation of which the debtor is a director, officer, or person in control;

(B) if the debtor is a corporation—

(i) director of the debtor;

(ii) officer of the debtor;

(iii) person in control of the debtor;

(iv) partnership in which the debtor is a general partner;

(v) general partner of the debtor; or

(vi) relative of a general partner, director, officer, or person in control of the debtor;

(C) if the debtor is a partnership—

(i) general partner in the debtor;

(ii) relative of a general partner in, general partner of, or person in control of the debtor;

(iii) partnership in which the debtor is a general partner;

(iv) general partner of the debtor; or

(v) person in control of the debtor;

(D) if the debtor is a municipality, elected official of the debtor or relative of an elected official of the debtor;

(E) affiliate, or insider of an affiliate as if such affiliate were the debtor; and

(F) managing agent of the debtor.

Rather than sifting inch-by-inch through the list it is helpful to note that in most bankruptcies an insider can generally be thought of as a family member, or a close business associate.  However, the Code states that this definition of insider “includes” the given list.  Since the rule of statutory construction found in 11 U.S.C. § 102(3) states that “`includes’ . . . [is] not limiting,” the definition can include entities other than those listed in § 101(31).  For example, the Court in Matter of Kucharek, 79 B.R. 393, 397 (Bankr. E.D. Wisc. 1987) found a very close friend to be an insider.

Any creditor that is not an insider is an ordinary creditor.

The starting point used to measure the look-back period is the same moment as is used in much of bankruptcy law:  the date the bankruptcy petition was filed.  If the creditor is an ordinary creditor, the look-back period is ninety days.  If the creditor is an insider, the look-back period is one year.  These time periods are fixed:  there is no extending them.  See, e.g., In re Greene, 223 F. 3d 1064 (9th Cir. 2000).

The crucial question for this fourth requirement is:  when did the transfer take place?  Generally, this happens when the transaction is fully completed and recipient has possession of the asset.  For example, if the transfer was a payment by check, then the Supreme Court  has held that the transfer occurred when the check was honored by the bank.  See Barnhill v. Johnson, 503 U.S. 393 (1992).

Another example that illustrates a statutory burden placed on a secured creditor transferee, involves the transfer of a security interest in a motor vehicle made during the 90-day preference period.  If the transfer was not perfected within the statutory perfection period specified in 11 U.S.C. § 547(c), then the transfer is a preference.  See Fidelity Financial Services, Inc. v. Fink, 522 U.S. 211, 221 (1998) (“. . . a creditor may invoke the enabling loan exception of § 547(c)(3) only by acting to perfect its security interest within 20 days after the debtor takes possession of its property”).  In the 2005 amendment to the Code, the 20-day period was extended to 30 days.

5.        A Preference Gives A Creditor More Than It Should Get

The last requirement focuses on the unfairness associated with a preference, and only makes sense in the context of bankruptcy.  In order to appreciate it a little background is in order.

a.         Personal Chapter 7 Bankruptcy

The goal in a personal Chapter 7 bankruptcy is to discharge unsecured debts without the debtor paying anything at all.  From the creditors’ perspective this is a pretty heavy hit.  Therefore, as you might imagine, there have to be some limitations.  One such limitation is on what the debtor gets to keep at the conclusion of the case.

Therefore, as part of the bankruptcy filing the debtor is required to list everything that the debtor owns or has an interest in.  The assets are then divided into two categories:  exempt and nonexempt.  The debtor is free to keep the exempt possessions , but the nonexempt assets are fair game for the Chapter 7 Trustee assigned to the case to seize and liquidate, ostensibly for the benefit of the creditors.  After administrative expenses have been paid, the trustee distributes the remainder to the creditors on a pro rata basis according to the priority rules found in 11 U.S.C. §§ 507 and 726.  Thus, if there are nonexempt assets the creditors may receive some payout in a personal Chapter 7.

b.        Business Chapter 7 Bankruptcy:  Total Liquidation

Although most business bankruptcies are reorganizations filed under Chapter 11, sometimes a business opts for a total liquidation.  Total liquidation can be done using either Chapter 7 or Chapter 11.

As with a personal Chapter 7, in a business Chapter 7 the Chapter 7 Trustee assigned to the case seizes and liquidates assets for the benefit of creditors.  However, since the business will cease to exist at the conclusion of the case, it does not receive a discharge, and does not keep any assets.  (Cp. 11 U.S.C. § 727(a)(1) with 11 U.S.C. § 1141(d)(3))  All of the assets are liquidated and the proceeds are distributed to the creditors.

c.         The Fifth Requirement

According to the fifth requirement, a transfer is a preference if it enables a creditor to receive more than it would have received in a Chapter 7 liquidation, more than it would have received if the transfer had not occurred, and more than it would have received in a bankruptcy case — whether in a liquidation or through a Chapter 11, 12, or 13 plan .

The Ninth Circuit Court of Appeals has distinguished between secured and unsecured creditors in its § 547(b)(5) jurisprudence:

Whether section 547(b)(5)’s requirements have been met turns in part on the status of the creditor to whom the transfer was made.  Pre-petition payments to a fully secured creditor generally “will not be considered preferential because the creditor would not receive more than in a chapter 7 liquidation.”  With respect to unsecured creditors, however, the rule is quite different: “[A]s long as the distribution in bankruptcy is less than one-hundred percent, any payment ‘on account’ to an unsecured creditor during the preference period will enable that creditor to receive more than he would have received in liquidation had the payment not been made.”

In re Powerine Oil Co., 59 F. 3d 969 (9th Cir. 1995) (internal cites omitted).

Thus, on the one hand, if the recipient creditor is a fully secured creditor, § 547(b)(5) is not satisfied and the transfer was not a preference.  On the other hand, if the debt was unsecured, or only partially secured, then the transfer was a preference  unless all creditors are paid in full, either through the Chapter 7 liquidation, or through a rehabilitation plan under Chapter 11, 12, or 13.

Next time we’ll look at preference avoidance and defenses to preference avoidance.