Preferential Transfers in Bankruptcy and the Subversion of Fairness

Preferential transfers are the most difficult bankruptcy issues to explain to our clients. The concept is easy enough in a vacuum. 11 U.S.C. §547 prevents a debtor from making large payments to one creditor at the expense of others on the eve of bankruptcy. It has been said §547 protects creditors from the “brother-in-law loan.” Imagine a debtor is indebted to the usual collection of mortgage lenders, credit cards companies, physicians and banks. Imagine that in addition to the usual creditors, the debtor also owes $5,000 to his brother-in-law. We would all agree that debtor should not be permitted to pay his brother-in-law in full the day before bankruptcy and force all of his other creditors to take what is left over a period of months or years through bankruptcy. That is the goal §547 seeks to accomplish.

11 U.S.C. §547 allows a bankruptcy trustee to avoid the transfer of assets, usually payments, to a creditor that occurred shortly before bankruptcy while the debtor was insolvent and which enables the creditor to receive more than it would have received in bankruptcy. The trouble with §547 comes in when innocent, arms-length creditors receive payments on past-due invoices shortly before one of their customers files a bankruptcy petition. If the debtor meets the specific requirements of §547, payments that were made on even routine past-due balances become suspected preferential transfers. Far from protecting creditors from the dubious payment of cash to the brother-in-law, §547 forces essentially every vendor who had not been paid on time to demonstrate the payments they actually received before their customer filed a bankruptcy petition were part of their ordinary course of business or part of the exchange for new value (along with a few other exceptions). The practical result can be that vendors who were owed substantial sums by a customer who enters bankruptcy may be forced to repay what little partial payments they were able to collect in the months leading up to bankruptcy.

In the name of protecting creditors in general from the bad acts of a debtor, §547 sometimes requires vendors to defend adversary proceedings intent on clawing back payments the debtor made before it entered bankruptcy, even if the debtor left large sums unpaid. What is worse: vendors who make concessions to customers by extending payment terms unwittingly tilt themselves into a preferential transfer trap if that customer later files a bankruptcy petition. Vendors who have slow-paying customers actually make matters worse for themselves if they grant additional credit or extend payment terms to that customer. From that standpoint, preferential transfers represent a tremendous risk to commercial creditors that often result in an unfair outcome.

Wolfe Jones and our experienced team of bankruptcy attorneys represents creditors when their customers enter bankruptcy. Part of that representation includes the defending preferential transfer actions filed under 11 U.S.C. §547. The better part of that representation includes providing advice to creditors before their customers file bankruptcy.