March 6, 2014

The preference provisions contained in the current version of the federal bankruptcy law have their origins in England over 400 years ago.  They first appeared in American legislation in 1841.  Although the law has undergone a number of changes over the years, the objectives of the law have not changed.  The primary purposes of the preference law have been and remain twofold:

  • To guard against the debtor favoring one creditor over another as it slides into bankruptcy, and to provide for a re-distribution of the transfers made to those creditors; and
  • To discourage creditors from racing to the courthouse as the debtor’s financial condition deteriorates.

In reality, the preference law may do little to discourage creditors from undertaking collection  activity.    Many  would  also  argue  that  while  the  stated  purpose  of  re- distributing money paid to creditors that have been preferred is perhaps noble, the law is fatally flawed.  In particular, those arguing against the law point out that it draws into its net creditors whose claims go beyond what the statute was intended to (or should) cover, it discourages creditors from working with debtors when the debtor gets into financial trouble,  and  it  falls  far  short  of  equitably  distributing  avoided  payments  among  the creditor body.  As to this last point, there are many instances where creditors have been forced to pay back money received shortly before a bankruptcy filing to find out that that money will not be re-distributed so as to even out the distribution among the pre-petition creditors  but  instead  will  be  used  solely  for  the  purpose  of  paying  the  lawyers, accountants and other administrative claims in the case.

Overview of the Statute

In its simplest terms, the preference law allows a bankruptcy trustee (and other authorized individuals or entities) to recover for the benefit of the bankruptcy estate payments made to creditors shortly before a bankruptcy filing.  The preference law is contained in section

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547 of the Bankruptcy Code and is essentially divided into two parts—the elements of the claim that must be proved by the trustee, and the defenses that may be raised by the defending creditor.  As will be discussed, most preference disputes focus on the defenses. Section 547 is reproduced at the end of these materials.

Who May Bring a Preference Claim

The preference statute gives the bankruptcy trustee the power to bring a preference claim. Under  section 1107 of the Bankruptcy Code, however, debtors in possession in chapter 11 cases are granted most of the powers of a trustee, including the right to sue to recover preferences.  Pursuant to a plan of reorganization or court order, other parties—such as a creditors’  committee or a plan  administrator—are  sometimes  granted  the  power  to recover  preferences  on  behalf  of  the  estate. For the purposes of  simplicity,  these materials will refer to the party bringing the preference action or making the preference demand as the trustee.

To read the entire “Defending Bankruptcy Preference Claims” article, download the PDF below:

Click to Download: Defending Bankruptcy Preference Claims (PDF)