Chapter IV Pre-Petition Payments and Transfers by the Debtor

• Jurisdiction: United States

IV. Pre-Petition Payments and Transfers by the Debtor

A. General

A fundamental precept of bankruptcy law is that unsecured creditors, unless the Code otherwise provides, share equally in the distribution of the estate. To effect this, the Code contains specific provisions permitting the trustee to "avoid," i.e., undo, certain pre-petition payments or transfers, whether voluntary or involuntary, and recover the transferred property for the estate.

Frequently, a debtor makes a payment or attempts to transfer property shortly before filing for bankruptcy. Such payment or transfer generally falls into one of four categories: normal payment; payment made in an attempt to avoid bankruptcy by fending off a creditor; payment or transfer of property to a favored creditor; or an attempt to keep property away from creditors by transferring it to an insider.

B. Effects of Avoidance

1. Effect on the Transferee

When a transfer of the debtor's property is avoided, the affected creditor must return to the trustee the money or property transferred. The creditor is entitled to a claim for the amount or value of the recovered property. For example, an unsecured creditor is owed $4,000 on the date the petition is filed, but received an avoidable preferential payment of $1,000. The creditor must surrender the $1,000 to the trustee, but the creditor's claim is increased to $5,000.

2. Effect on the Debtor

a. Voluntary Preferential Transfer

Unless the transfer is fraudulent, generally the existence of an avoidable transfer has no impact on whether the debtor receives a discharge or the amount of property, if any, that must be surrendered to the trustee for liquidation.

b. Involuntary Preferential Transfer

The property recovered by a trustee's avoidance of a preferential transfer may be exempted by the debtor if the transfer was not voluntary and the debtor did not conceal the property, or the debtor could have avoided the transfer because it is a lien that impairs an exemption to which the debtor is entitled.²⁷⁴

C. Preferential Transfers

1. Definition

A preferential transfer is one that:

• is of either money or property, made to or for the benefit of a creditor on an antecedent debt, i.e., pre-petition obligation, including an obligation that is not yet matured or due (e.g., future installment loan payments);
• is made while the debtor was insolvent (there is a rebuttable presumption that a debtor is insolvent during the 90-day period preceding the date the petition is filed);²⁷⁵
• allows the creditor to receive more than in a chapter 7 case than if the transfer were not made; and
• is more than if the creditor received only what would otherwise be received from a distribution made from the bankruptcy estate.²⁷⁶
The purpose of the trustee's avoidance powers is to prevent the debtor from favoring one creditor over another, as well as to avoid a "race to the courthouse" by creditors to seize and liquidate the assets of a financially troubled debtor. By avoiding such transfers, the trustee can ensure the pro rata distribution of a debtor's assets among the creditors. In crafting the statute, Congress determined that, as a matter of policy, a creditor should not be permitted to improve its position on the eve of bank-ruptcy.²⁷⁷

2. Classification of a Claim

Classification of the creditors' claim on the date the petition is filed is an important initial step. In an ordinary case, the amount and priority of an unsecured creditor's claim is fixed on the date of filing. Similarly, the amount of a secured creditor's claim is fixed, and the value of the security ascertained as of that date. The claim may be either fully or partially secured.

a. Fully Secured Creditors

If a creditor is fully secured, a pre-petition transfer is not preferential because the secured creditor is entitled to receive 100 percent of its claim. However, it is important to note that the controlling value is that of the collateral at the time the petition is filed, not at the time of transfer. Thus, if at the time the petition is filed the value of the collateral has deteriorated to an amount less than the creditor's claim (adding back in the amount of the transfer), the creditor is undersecured. Also, payments made during the preference period that change a creditor from being partially unsecured to fully secured may be preferential.

b. Unsecured Creditors

In general, any payment made to an unsecured creditor during the preference period is a preferential transfer unless all creditors in the same class will be paid in full through the bankruptcy proceedings. In determining the amount that the transfer enables the creditor to receive, the creditor must be charged with the value of what was transferred, plus any additional amount that the creditor would be entitled to receive from a chapter 7 liquidation. The net result is that, as long as the distribution in bankruptcy to the creditor's class (as determined under 11 U.S.C. § 726) is less than 100 percent, any payment "on account" of a previously existing debt to an unsecured creditor during the preference period will enable that creditor to receive more than the creditor would have received in liquidation had the payment not been made.

c. Undersecured Creditor

Treatment of the undersecured creditor depends on the claim to which the payment is applied and the source of the payment. In bankruptcy, an undersecured creditor holds two different claims, each of which receives different treatment in bankruptcy: (1) its claim against the collateral and (2) the amount that the debt exceeds the value of that property, which is by definition "unsecured." If payment is applied to the unsecured claim, the creditor typically will have received more than the creditor would receive in a chapter 7 liquidation, satisfying the trustee's burden on that element. Conversely, if the source of the payment is the creditor's own collateral, the creditor will have received no more than it would receive in chapter 7 anyway, and the trustee will have failed to sustain his burden on that element. Even a payment that has been applied to the unsecured claim of an undersecured creditor will not trigger the liquidation analysis if the source of the payment is the creditor's own collateral.

3. Exceptions to Avoidance

Certain preferential transfers are specifically excepted from avoidance. These exceptions are generally of two classes: (1) the transaction does not result in a diminution of the debtor's assets to the detriment of other creditors; or (2) for public policy reasons, Congress deemed the transfers entitled to exception. The following discussion does not include all of the exceptions; some (e.g., "running" or "open" accounts, reclamation rights and "floating liens") rarely, if ever, arise in the consumer context.

a. Contemporaneous Exchange for New Value

A transfer may not be avoided if it was a voluntary and a substantially contemporaneous exchange for new value given to the debtor.²⁷⁸ "New value" means money or money's worth in goods, services or new credit, or a release of property previously transferred to the transferee, including proceeds of the property, but does not include an obligation substituted for an existing obligation.²⁷⁹ This defense is grounded on the principle that new value given by the creditor to the debtor will offset the payments made to the creditor. Thus, the debtor's estate was not depleted to the detriment of other creditors by the transfer.

i. The otherwise-preferential transfer is insulated from avoidance only to the extent of the new value given. The transferee must prove the specific new value, measured as of the date of the transfer. Thus, a transfer of $100,000 in exchange for goods having a value of $50,000 at the time of transfer would be protected from avoidance only to the extent of the $50,000 in "new value" actually received by the debtor.
ii. To be excepted from avoidance, the transfer of the debtor's property must be substantially contemporaneous with the new value given in return.
• The Bankruptcy Code does not define "contemporaneous," and case law provides no bright-line test. Clearly, if A hands B a $20 bill and B hands A a widget worth $20, there is a contemporaneous exchange. However, if A pays B with a $20 check for a transaction that is ordinarily on credit, the determination depends on whether the check is honored in due course. If the check is presented to and honored by the bank upon presentment, the exchange is substantially contemporaneous. However, if the check is not honored, the transaction becomes a credit transaction, and subsequent payment or honoring of the check does not constitute a contemporaneous exchange.
• Delay in the transfer is not invariably fatal. Most courts examine whether an exchange is substantially contemporaneous

...