In my last post I looked at the definition of a preference. I now turn to its consequences.
The reason preferences are significant for the recipients is found in beginning of § 547(b): “. . . the trustee may avoid any transfer of an interest of the debtor in property . . .” (In case you don’t speak legalese, this use of the word “avoid” means to make void or of no effect; to invalidate.)
This means that if the case is one under Chapter 7, 12, or 13, the chapter trustee can undo the transfer and seize the asset. And in a Chapter 11, the Debtor-In-Possession (“DIP”) has the same power. See 11 U.S.C. § 1107(a).
By the way, in most Chapter 11 cases there is no Chapter 11 Trustee. Instead, the debtor serves as a quasi-trustee known as the debtor-in-possession. This doesn’t mean that the fox is guarding the henhouse: the U.S. Trustee and the judge keep the DIP on a fairly tight leash. And if things get out of hand, the Court can appoint a Chapter 11 Trustee pursuant to 11 U.S.C. § 1104.
The trustee will learn of the transfer because the debtor is required to report it in item 10 of the Statement of Financial Affairs. Failure to report the transfer is perjury that can afford free room and board for the debtor.
The vehicle for avoiding a preference is an adversary proceeding pursuant to Fed. R. Bankr. Proc. 7001(1):
The following are adversary proceedings: (1) a proceeding to recover money or property, other than a proceeding to compel the debtor to deliver property to the trustee, or a proceeding under §554(b) or §725 of the Code, Rule 2017, or Rule 6002. . . .
An adversary proceeding is the bankruptcy world’s version of a lawsuit. The topic of adversary proceedings is vast. I plan to cover it in a series of posts sometime in the future, so I will not discuss it further here, other than to observe that “the trustee has the burden of proving the avoidability of a transfer under subsection (b) of this section . . .” 11 U.S.C. § 547(g).
I will add, however, that the authority of the Bankruptcy Court to hear a preference avoidance action, or indeed any action, is in a state of flux due to the Supreme Court’s holding in Stern v. Marshall, 131 S. Ct. 2594 (2011). Much ink has been spilled analyzing Stern and its progeny, and there are cases currently pending before the Supremes that will ultimately affect bankruptcy jurisprudence. Therefore, you, the reader, will have to keep up with the developments as they arise to know what tactics should be used. I’ll try to keep you apprised in this blog.
Why does the Bankruptcy Code provide for the avoidance of preferences? When a debtor files bankruptcy papers an estate is created that consists of all of the debtor’s assets (except those the debtor can exempt). In theory, the debtor ceases to be liable for those debts (this ultimately happens when the debtor receives a discharge, though some types of debts may not be dischargeable), and the debtor’s debts become claims against the estate. The estate is the pot from which creditors are to be repaid. A preference diminishes that pot. It is for this reason that the absence of the exceptions in § 547(c) (which I will examine in the next several posts), preferences are avoidable under § 547(b).
In spite of the rationale for preference avoidance given in the previous paragraph, under certain circumstances the debtor can avoid a preference and keep the recovered asset. This is done pursuant to 11 U.S.C. § 522(g)(1) and (h) (emphasis added):
(g) Notwithstanding sections 550 and 551 of this title, the debtor may exempt under subsection (b) of this section property that the trustee recovers under section 510 (c)(2), 542, 543, 550, 551, or 553 of this title, to the extent that the debtor could have exempted such property under subsection (b) of this section if such property had not been transferred, if—
(A) such transfer was not a voluntary transfer of such property by the debtor; and
(B) the debtor did not conceal such property . . .
(h) The debtor may avoid a transfer of property of the debtor or recover a setoff to the extent that the debtor could have exempted such property under subsection (g)(1) of this section if the trustee had avoided such transfer, if—
(1) such transfer is avoidable by the trustee under section 544, 545, 547, 548, 549, or 724 (a) of this title or recoverable by the trustee under section 553 of this title; and
(2) the trustee does not attempt to avoid such transfer.
The one somewhat unexpected condition is that the transfer cannot have been voluntary. Normally, we think of preferences as being voluntary payments by the debtor to a creditor. However, an involuntary transfer such as a wage garnishment can constitute a preference. If the debtor can exempt the money using § 522(g)(1), and if the Trustee does not attempt to avoid the preference, then the debtor can. See, e.g., In re Wade, 219 B.R. 815 (B.A.P. 8th Cir. 1998) (debtor permitted to avoid wage garnishment done during the ninety-day prepetition period).
Given the relatively small amounts involved, the cost of an adversary proceeding may dissuade most debtors from using § 522(h) to recover garnished wages. However, in spite of Fed. R. Bankr. Proc. 7001(1)’s adversary proceeding requirement, a debtor can try to recover the money by motion. In the absence of opposition the Court may grant the motion. See, e.g., In re Shorts, 63 B.R. 2 (Bankr. D. D.C. 1985) (since there was no opposition, the debtor’s § 522(h) motion was granted). But see In re Baker, 246 B.R. 379 (Bankr. E.D. Mo. 2000) (debtor’s motion pursuant to § 522(h) denied because adversary proceeding was required). Of course, one cannot know a priori if the motion will succeed, so if you’re not a gambler it’s probably safest to use the adversary proceeding.
Next time I’ll begin the discussion of defenses against preference avoidance actions.
If you’re facing problems associated with a preferential transfer, don’t go it alone. Contact a highly skilled bankruptcy attorney to protect your rights.