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

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. T HE P URPOSE OF P REFERENCE L AW ............................................ 61 1. Equal Distribution ........................................................... 61 2. Deterrence ....................................................................... 64 B. E LEMENTS AND E XCEPTIONS ...................................................... 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. T HE P OLICY OF E QUAL D ISTRIBUTION IN C HAPTER 7 .................. 81 B. T HE P OLICY OF E QUAL D ISTRIBUTION IN C HAPTER 11 ................ 83 C. R EORGANIZATION AS L IQUIDATION IN C HAPTER 11 .................... 86 III. PART THREE: PROPOSALS FOR RECONCILIATION ............................ 87 A. P REFERENCES BY C HAPTER ......................................................... 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 bankruptcy filing, distinguishes preferences from fraudulent conveyance actions, which have historically been much easier to defend as a matter of policy. See Robert 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 to 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. 54 IOWA LAW REVIEW [Vol. 100:51 “No.” “And your client owed us the money it paid us?” “Yes.” “And you admit that we earned it?” “Yes.” “And you want the money back?!” “Yes.” At this point there was a lengthy pause. Then the secretary stammered, with some incredulity: “Okay, I’ll tell my boss.” 5 This dismay is natural among creditors who are non-repeat players in bankruptcy contexts. 6 Preference avoidance requires the creditor who received the targeted transfer (the “preferred creditor”) to return the value received from the debtor. In exchange the creditor gets a claim against the estate for a pro rata distribution of the debtor’s remaining assets. This often translates to exchanging full payment for pennies on the dollar, with the remaining debt discharged in bankruptcy. From the preferred creditor’s viewpoint, this exchange marks a dramatic loss of value. 7 Preferred creditors who must disgorge these preferential payments naturally feel blindsided. By its nature, preference law targets transfers made with no intent to defraud other creditors, no reasonable cause to believe that the debtor so intended, and no knowledge or reason to believe that the debtor was insolvent at the time the funds were transferred. 8 Payment is generally warranted and accepted in good faith, with no warning that a bankruptcy would thereafter commence and a preference action brought. 5. Conversation with Brent Wride, S’holder, Ray Quinney & Nebeker, in Salt Lake City, Utah (Feb. 6, 2013). 6. See Jennie D. Latta, What Every Tennessee Lawyer Should Know About Preferential Transfers , TENN. B.J., Oct. 1991, at 26 (noting that recipients of a trustee’s demand for return of a preference is generally met with outrage); see also Judy B. Calton & Seth D. Gould, Defending a Preference Action , MICH. B.J., July 1993, at 666 (“It is no wonder that clients hate preference actions.”). 7. This discount is commonly referred to as being paid in “bankruptcy dollars.” 8. See H.R. REP. NO. 95-595, at 178 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6139 (“To argue that the creditor’s state of mind is an important element of a preference and that creditors should not be required to disgorge what they took in supposed...