Conflicting Preferences in Business Bankruptcy: The Need for Different Rules in Different Chapters

• Author: Brook E. Gotberg
• Position: Academic Fellow, J. Reuben Clark Law School, Brigham Young University
• Pages: 51-92

51

Conflicting Preferences in Business

Bankruptcy: The Need for Different Rules

in Different Chapters

Brook E. Gotberg

ABSTRACT: The law of preferential transfers permits the trustee of a

bankruptcy estate to avoid transfers made by the debtor to a creditor on

account of a prior debt in the 90 days leading up to the bankruptcy

proceeding. The standard for avoiding these preferential transfers is one of

strict liability, on the rationale that preference actions exist to ensure that all

general creditors of the bankruptcy estate recover the same proportional

amount, regardless of the debtor’s intent to favor any one creditor or the

creditor’s intent to be so favored. But preference law also permits certain

exceptions to strict preference liability and gives the estate trustee discretion in

pursuing preference actions. This undermines the policy of equal distribution

by permitting some creditors to fare better than others in the bankruptcy

distribution. However, these practices are arguably necessary to promote the

conflicting bankruptcy policies that seek to maximize the estate for the benefit

of creditors and also encourage the survival of struggling businesses.

As a result, the law of preferences is internally inconsistent and controversial,

attempting unsuccessfully to serve multiple policy masters simultaneously.

Much of the analysis on preferences up to now has proposed amending

preference law generally in an attempt to satisfy these often conflicting

demands. This Article recommends a more dramatic approach: returning

preference law to a mechanism of equal distribution in liquidation

proceedings by eliminating true exceptions to the rule, and doing away with

preference law in the context of bankruptcy reorganization.

 Academic Fellow, J. Reuben Clark Law School, Brigham Young University. I would like

to thank Susan Block-Lieb, Ken Kettering, Lawrence Ponoroff, and Michael D. Sousa for their

helpful advice, and Trent Maxwell for his valuable research assistance. Any errors are my own.

52 IOWA LAW REVIEW [Vol. 100:51

INTRODUCTION ............................................................................... 53

I. PART ONE: THE LAW OF PREFERENTIAL TRANSFERS ....................... 60

A. THE PURPOSE OF PREFERENCE LAW ............................................ 61

1. Equal Distribution ........................................................... 61

2. Deterrence ....................................................................... 64

B. ELEMENTS AND EXCEPTIONS ...................................................... 66

1. Narrowing Exceptions .................................................... 67

a. Substantially Contemporaneous Exchange .................... 67

b. Purchase Money Security Interest .................................. 68

c. Floating Lien ............................................................... 69

d. Transfers for the Benefit of an Insider ........................... 71

2. True Exceptions .............................................................. 72

a. Ordinary Course .......................................................... 72

b. New Value ................................................................... 74

c. Statutory Lien.............................................................. 75

d. Domestic Support Obligations ....................................... 76

e. Monetary Floors ........................................................... 76

f. Nonprofit Budget and Credit Counseling ...................... 77

C. ENFORCEMENT ACROSS CHAPTERS ......................................... 78

II. PART TWO: THE POLIC(IES) OF PREFERENTIAL TRANSFERS IN

IMPLEMENTATION ........................................................................... 81

A. THE POLICY OF EQUAL DISTRIBUTION IN CHAPTER 7 .................. 81

B. THE POLICY OF EQUAL DISTRIBUTION IN CHAPTER 11 ................ 83

C. REORGANIZATION AS LIQUIDATION IN CHAPTER 11 .................... 86

III. PART THREE: PROPOSALS FOR RECONCILIATION ............................ 87

A. PREFERENCES BY CHAPTER ......................................................... 88

1. Chapter 11 ....................................................................... 88

2. Chapter 7 ......................................................................... 89

CONCLUSION .................................................................................. 92

2014] CONFLICTING PREFERENCES IN BUSINESS BANKRUPTCY 53

INTRODUCTION

Preferential transfer law in bankruptcy has long been the subject of

significant controversy.1 Particularly in business cases, creditors have

consistently and strenuously objected to a trustee’s ability in bankruptcy to

avoid or reverse transfers from the debtor to a creditor made on account of a

legitimate debt in the 90 days prior to bankruptcy.2 The trustee can do so even

if the payment was warranted and the transferee had no reason to suspect that

the debtor would later enter bankruptcy,3 because preference law is one of

strict liability.4

The following conversation is a common response by defendant creditors

to preference proceedings. Soon after an attorney representing a corporate

client in a chapter 11 bankruptcy filed an action to recover a preferential

payment on a construction contract, he got a call from the secretary for the

owner of the construction company. She said, with the tone of someone who

expects to resolve the issue over the phone, “My boss has a few questions that

he wants me to ask you. Do you dispute that we performed the construction

work?”

“No.”

“And we did a good job?”

“Yes.”

“You don’t have any problems at all with the work we did?”

“No.”

“You don’t dispute the amount of the invoice?”

1. See generally C. Robert Morris, Jr., Bankruptcy Law Reform: Preferences, Secret Liens and

Floating Liens, 54 MINN. L. REV. 737, 737 (1970) (“The law is wrong. . . . [T]he law of preferences

is not the appropriate vehicle for handling secret liens in bankruptcy.”); Robert Weisberg,

Commercial Morality, the Merchant Character, and the History of the Voidable Preference, 39 STAN. L. REV.

3, 4–5 (1986).

2. The validity of preferential transfers, but for the bankrupt cy filing, distinguishes

preferences from fraudulent conveyance actions, which have historically been much easier to

defend as a matter of policy. See Rob ert Charles Clark, The Duties of the Corporate Debtor to Its

Creditors, 90 HARV. L. REV. 505, 513 (1977) (“[F]raudulent conveyance law embodies a general

ideal . . . of nonhindrance of creditors . . . made operational through the effectuation of the more

specific ideals of Truth, Respect, and Evenhandedness as well as a general, residual prohibition

of conduct which hinders creditors in attempting to satisfy their claims.”).

3. Erwin I. Katz et al., Types of Bankruptcy-related Disputes, in ABI GUIDE TO BANKRUPTCY

MEDIATION 11 (1st ed. 2005) (“Preference actions seem particularly unfair: creditors are often

shocked to learn that they may have to repay money to a debtor for receiving payment that was

lawful at the time but has become actionable upon the filing of bankruptcy.”); Lissa Lamkin

Broome, Payments on Long-Term Debt as Voidable Preferences: The Impact of the 1984 Bankruptcy

Amendments, 1987 DUKE L.J. 78, 95 (observing that lenders objected to the removal of the intent

requirement for preference law on the grounds that the law would be unfair if applied t o

unknowing creditors).

4. Note that strict liability applies only to initial transferees, not to subsequent transferees.

Transfers may not be recovered from subsequent transferees that take for value, in good faith,

without knowledge of the voidability of the transfer. 11 U.S.C. § 550(b) (2012). This Article

generally assumes application to initial transferees.