Chapter 18 Preferential- and Fraudulent-Transfer Issues

• Jurisdiction: United States

Chapter 18 Preferential- and Fraudulent-Transfer Issues

Preferential- and fraudulent-transfer claims, sometimes called "avoidance claims," are created by statute. The purpose of preferential- and fraudulent-transfer statutes is to prevent a debtor from preferring certain creditors over other similarly situated creditors as it slides into bankruptcy and to discourage attempts to place assets beyond the reach of creditors while the debtor is in financial distress. Preferential transfers are defined in § 547 of the Bankruptcy Code. Fraudulent transfers are defined by both state law and § 548 of the Bankruptcy Code. In addition to the avoidance powers enumerated in the Bankruptcy Code, § 544 of the Bankruptcy Code confers on a bankruptcy trustee the avoidance powers of certain hypothetical creditors under state law avoidance statutes.

A. Basic Elements of a Preferential Transfer

Section 547 of the Bankruptcy Code lists several elements that a trustee must satisfy before it may recover a payment as a preferential transfer. The payment or transfer must (1) be a transfer (broadly interpreted) of the debtor's property, (2) be made to or for the benefit of a creditor, (3) be made on account of a debt that the debtor owed to the creditor before the transfer was made, (4) be made during the appropriate preference period and (5) enable the recipient to receive more than it would have received if the debtor were liquidated.¹⁷⁹ Section 547 also sets forth a number of defenses to preference lawsuits. The preference period is the 90-day period before the bankruptcy petition date when the recipient of the transfer was not an insider of the debtor; the preference period is one year for insiders.

B. Basic Elements of a Fraudulent Transfer (Under the Bankruptcy Code)

Generally speaking, a fraudulent transfer as defined in the Bankruptcy Code is (1) a transfer of the debtor's property made with the intent to hinder, delay or defraud an existing or future creditor, or (2) a transfer of the debtor's property that was made in exchange for less than reasonably equivalent value while the debtor was (a) insolvent (or became insolvent as a result of the transfer), (b) undercapitalized for its business, (c) under the belief or intent that it would not be able to repay all of its debts as they matured, or (d) made to, or for the benefit of an insider under an employment contract not in the ordinary course of business.¹⁸⁰ Fraudulent transfers made within the two-year period before the filing of the bankruptcy petition may be recovered by a trustee under § 548 of the Code.¹⁸¹ Because the bankruptcy trustee also enjoys the avoidance powers of certain creditors under state law, the trustee may claw back much-earlier transfers, depending on the state.¹⁸² For example, under New York law, the trustee can reach back at least six years to recover fraudulent transfers, and in some cases even further.¹⁸³ A transferee who received the transfer in good faith and for value has a lien on or may retain the transfer up to the amount of the value that the transferee gave.¹⁸⁴

C. Potential Defendants in Avoidance Actions

Repayment of preferential and fraudulent transfers may be recovered from the initial recipients of the transfer.¹⁸⁵ The Bankruptcy Code also gives the power to the bankruptcy trustee to reach beyond the initial recipient to the next recipient of the transfer, known as the "immediate transferee" or "secondary transferee."¹⁸⁶

Importantly, a trustee may not recover from a secondary transferee who takes the transfer in good faith for value — which value may include the satisfaction or securing of an antecedent debt — and without knowledge of the avoidability of the transfer, nor may the trustee take from the secondary transferee's transferee.¹⁸⁷

D. Potential Preference Exposure for Depository Institutions on Account of Pre-Petition Overdrafts

Checking account overdrafts could bring preference exposure to a deposit bank. The case of Saracheck v. Luana Savings Bank offers a cautionary tale about what can happen when an account-holder is permitted to make repeated overdrafts.¹⁸⁸ Luana Savings Bank, a small bank in Luana, Iowa, had a large customer, Agriprocessors, which owned and operated meatpacking and food-processing facilities. Agriprocessors was an important client to the bank, but unfortunately, it wound up as a debtor in a chapter 7 bankruptcy case. As part of their administration of the bankruptcy case, the chapter 7 trustee analyzed the transactions between the bank and the debtor during the 90-day period before bankruptcy. The trustee discovered that the bank had allowed the debtor to make regular overdrafts on its operating account in an amount that aggregated more than $50 million during that period.

Specifically, the bank automatically provisionally honored all of Agripro-cessors' checks. Each morning after checks were presented, the bank president reviewed reports detailing what individual accounts at the bank had been provisionally settled on the previous day. At that time the bank would learn which accounts had insufficient funds to cover the provisional settlements. If there were not enough funds in an Agriprocessors account to cover the provisional settlement, a secretary of the bank would call Agriprocessors to make sure that a covering payment would be forthcoming. If Agriprocessors told the bank that funds were coming, the bank would usually wait to receive the funds before honoring the check. Most of the time, the funds were received that day. Sometimes, funds were not received before the midnight deadline, but the bank honored the checks anyway. Agriprocessors had two accounts at Luana: an operating account and another account in which it kept $1.4 million as a "cushion" for the operating account.

The trustee argued that each time Agriprocessors wired money to Luana to cover an overdraft, a preferential transfer occurred. The trustee reasoned that when the bank permitted an overdraft, the bank extended credit to the debtor, and when the debtor later paid the overdraft, it made a transfer on account of an antecedent debt — one of the essential elements of a preference claim.

The case was litigated before the U.S. Court of Appeals for the Eighth Circuit. Amicus briefs were filed by the American Bankers Association and the Iowa Bankers Association. Ultimately, judgment against Luana Bank was entered in excess of $1.5 million. The Eighth Circuit affirmed the lower courts' rulings finding that some of the payments covering overdrafts were preferential. A complete analysis of the Luana case is beyond the scope of this chapter, but in summary, the courts ruled that the "in-traday overdrafts" (i.e., provisional overdrafts cured before the midnight deadline) between these parties did not give rise to preferential transfers, but the "true overdrafts" did.

Institutions finding themselves in this or similar situations are recommended to take a close look at the Luana line of cases. While the facts of each situation might lead to a different result, some general takeaways from Luana when administering checking accounts of financially distressed customers are as follows:

1. When allowing overdrafts or receiving regular paymen ts, collateralize the operating account with a written agreement. In Luana, there was no written agreement between the bank and its customer to "net" the balances of the account when calculating overdrafts. While the bankruptcy court netted the accounts when calculating damages because it found that the parties intended to treat the

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