Chapter X. Automatic Stay and Preference Actions

• Jurisdiction: United States

X. Automatic Stay and Preference Actions

A. Automatic Stay

The automatic stay is one of the most important tools a debtor has when it declares bankruptcy. Upon filing a bankruptcy petition, the automatic stay of § 362 goes into effect.¹⁷⁹ The stay halts all "litigation, lien enforcement and other actions, judicial or otherwise, that are attempts to enforce or collect prepetition claims ... [including] a wide range of actions that would affect property of the estate."¹⁸⁰ Generally, the automatic stay halts creditor action against the debtor for prepetition claims and gives the debtor breathing room to begin an orderly reorganization or liquidation.

Yet the automatic stay is not absolute. Section 362(b) allows for certain litigation, claims, obligations, etc. to go forward during the bankruptcy case. For example, criminal actions against the debtor may proceed, environmental enforcement and government actions are not stayed, and enforcement of domestic support obligations continue.¹⁸¹ Numerous actions and obligations can continue despite the automatic stay, so § 362(b) demands attention.

One highly litigated exception to the automatic stay that any creditor may pursue is found under § 362(d). Section 362(d) allows the bankruptcy court to, after notice and a hearing, terminate, annul, modify or condition the automatic stay for "cause," including a lack of adequate protection of an interest in property"¹⁸² or for actions against specific property "if the debtor does not have an equity in such property and such property is not necessary to an effective reorganization."¹⁸³ A creditor may obtain relief from the automatic stay by moving to argue there is sufficient cause for such relief.¹⁸⁴ The Bankruptcy Code does not define "cause," therefore courts look at the totality of the circumstances to determine whether the creditor has shown cause.¹⁸⁵ Cause can turn on the claim the creditor asserts or the nature and stage of the pre-petition proceedings.¹⁸⁶ Cause is shown by the lack of adequate protection¹⁸⁷ of an interest in property, but is not the only instance of cause. Other causes might include the lack of any connection with or interference with the pending bankruptcy case. Generally, proceedings in which the debtor is a fiduciary, or that involve post-petition activities of the debtor, need not be stayed because they bear no relationship to the purpose of the automatic stay, which is protection of the debtor and his estate from his creditors.¹⁸⁸

Section 362(d)(2) provides that the stay may also be lifted when the debtor has no equity in the property and the property is unnecessary for an effective reorganization. The movant must show a lack of equity, while the debtor must show that the property is necessary for reorgani-zation.¹⁸⁹ A lack of equity arises in the "difference between the value of the subject property and the encumbrances against it."¹⁹⁰ If the property is "underwater" — i.e., the debt exceeds the value of the property — there is a lack of equity.¹⁹¹ Second, the debtor must show that there is "a reasonable possibility of a successful reorganization within a reasonable time,"¹⁹² and that the property is necessary for that reorganization.¹⁹³

Finally, an issue frequently litigated is whether the automatic stay of the debtor can apply to third parties, typically, the debtor's directors, officers or related entities.¹⁹⁴ Courts look to whether the litigation against a third party "could interfere with the reorganization of the debtor, would interfere with, deplete or adversely affect property of the estates or which would frustrate the statutory scheme of chapter 11[,] or diminish the debtor's ability to formulate a plan of reorganization."¹⁹⁵ Generally, however, bankruptcy courts are reluctant to extend the automatic stay to third parties.¹⁹⁶

B. Preference

Section 547(b) of the Code permits a debtor to avoid certain pre-bankruptcy transfers of property as "preferences." The power to avoid preferences is designed to "discourage creditors from racing to the courthouse to dismember the debtor during his slide into bankruptcy, and to facilitate the prime bankruptcy policy of equality of distribution among creditors of the debtor."¹⁹⁷

Under § 547(b), an avoidable preference is "any transfer of an interest of the debtor in property":

• to or for the benefit of a creditor;
• for or on account of an antecedent debt owed by the debtor before such transfer was made;
• made while the debtor was insolvent; and
• made:

o on or within 90 days before the bankruptcy petition was filed; or
o between 90 days and one year before the bankruptcy petition was filed, if such creditor at the time of such transfer was an insider; and
o the transfer enabled the creditor to receive more than it would have received in a chapter 7 distribution.

C. Definitions and Meani ngs of Terms

The Code's definition of "transfer" is broad. Section 101(54) defines "transfer" as:

• the creation of a lien;
• the retention of title as a security interest;
• the foreclosure of a debtor's equity of redemption; or
• each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (a) property or (b) an interest in property.

To determine whether an interest is "an interest of the debtor," courts primarily look to state law to determine whether the property is an asset of the debtor. The determination on whether the debtor had an interest in the transferred property turns upon whether the transfer diminished or depleted the debtor's estate. An "interest of the debtor" is often viewed to be the equivalent of "property of the estate," as defined in § 541 of the Bankruptcy Code, which generally means property that would have belonged to the bankruptcy estate but for the transfer.¹⁹⁸

Under the "earmarking doctrine," however, when a third person provides funds to the debtor to pay a designated debt, such funds may not be recoverable as a preference from the creditor receiving the funds, based on the theory that the property transferred was never property of the debtor. Most courts apply a three-part test to determine whether the earmarking doctrine applies: (1) there must have been an agreement between the debtor and the third party that the funds advanced by the third party would pay a specific antecedent debt; (2) the debtor must have performed the agreement according to its terms; and (3) the transaction must not have resulted in an diminution of the estate or prejudice to other creditors.¹⁹⁹

An antecedent debt is a debt that was owed and that the debtor was obligated to pay before the transfer was made.²⁰⁰

If this transfer is a mortgage or security interest, § 547(e)(2)(A) specifies when that mortgage or security is deemed to have been made. Under applicable law in most states, a mortgage takes effect only when the mortgagee advances money, not when the mortgage documents are signed. Under § 547(e)(2)(A), if a mortgage or security interest is perfected within 30 days from the time the funds were advanced, the mortgage or security interest will be deemed contemporaneous with the underlying debt and not because of an antecedent debt.²⁰¹

Section 101(5) generally defines "creditor" to include any entity that holds a pre-petition claim against the debtor, including claims that may be contingent or unliquidated.

Section 101(32)(A) of the Bankruptcy Code defines "insolvent" as follows:

A financial condition such that the sum of such entity's debts is greater than all of such entity's property, at fair valuation, exclusive of (i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity's creditors; and (ii) property that may be exempted from property of the estate under Section 522 of the Bankruptcy Code.²⁰²

The courts frequently refer to this as "balance sheet" insolvency under which the basic requirement is that a debtor's assets exceed its liabilities on the date that this transfer took place.²⁰³ Because the determination on the value of the debtor's assets and liabilities is a fact-intensive inquiry, expert testimony is frequently required.²⁰⁴

Status as an "insider" of the debtor can turn on whether the person or entity is a statutory insider or the more expansive non-statutory insider. For statutory insiders, § 101(31) of the Code provides a nonexclusive list of entities that will qualify as "insiders" for preference avoidance. Whether an entity qualifies as a non-statutory insider is determined case by case and is typically evaluated by examining these factors: (1) factual contexts analogous to Code-listed types of statutory insiders; and (2) whether the entity has any influence, short of actual or legal control, over the debtor, or there is a lack of an arm's length aspect to its dealings with the debtor.²⁰⁵

In recent decisions, certain courts have rejected the view that a finding of control is necessary for a party to qualify as a non-statutory insider and, instead, apply this two-part test: (1) whether there is a close relationship between the debtor and creditor; and (2) whether there is anything other than closeness to suggest that any transactions were not conducted at arm's length.²⁰⁶ "Arm's length" has been defined as "a transaction in good faith and in the ordinary course of business by parties with independent interest ... that each, acting in his or her own best interest, would carry out."²⁰⁷

D. Exceptions to Preferential Transfers: § 547(c)

The Bankruptcy Code provides for certain exceptions to the bright-line rule of preferential transfers, which require consideration of the evidence unique to the creditor that received the preferential treatment.²⁰⁸

1. Contemporaneous Exchanges for New Value

Section 547(c)(1) provides that the trustee may not avoid a transfer if (1) the transfer extended new value to the debtor, (2) the parties intended the new value and the debtor's payment to be contemporaneous exchanges, and (3) the exchanges were substantially...