Mitigating Preference Exposure

By Diego Flores, Shartsis Friese LLP

Diego Flores

Entering Summer 2022, interest rates are on the rise and fears of a recession—and the potential uptick in bankruptcy filings it would bring—loom large. Given the economic outlook, practitioners can expect calls from clients concerned that counterparties have not paid debts on time or otherwise may be in financial distress. Counsel advising clients in such situations should consider whether and to what extent the client might face preference exposure, and how to minimize that exposure.

                                                                  1. What is a Preference?

     “Preferences are transfers in which an insolvent debtor favors certain creditors over others.” 5 Collier on Bankruptcy ¶ 547.10 (16th ed. 2022). The elements of a preference claim are laid out in Section 547 of the Bankruptcy Code,which provides that “any transfer of an interest of the debtor in property” may be avoided where it is “(1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; [and] (3) made while the debtor was insolvent;” (4) transfer was made within 90 days preceding the debtor’s bankruptcy filing (or one year in the case of transfers to “insiders”); and (5) allows the creditor to receive more than it would absent the transfer in a chapter 7 liquidation. 11 U.S.C. § 547(b).

     Under the Bankruptcy Code, “transfer” is defined “extremely broad[ly]” and captures in essence, anything a debtor might do to “dispos[e] of or part[] with” any property interest, whether directly or indirectly. See, e.g., Batlan v. Bledsoe (In re Bledsoe), 569 F.3d 1106, 1113 (9th Cir. 2009) (quoting Bernard v. Sheaffer (In re Bernard), 96 F.3d 1279, 1282 (9th Cir. 1996)) (emphasis in original); 11 U.S.C. § 101(54). For example, where a debtor pays off within the preference period a debt that was guaranteed by a non-debtor, both the creditor and the guarantor may have preference exposure because the payment relieves the guarantor of its obligation to pay the debt and thereby provides value to the guarantor, which is itself a creditor by virtue of its contingent right to recover from the debtor if forced to pay on the guarantee. See, e.g., Stahl v. Simon (In re Adamson Apparel, Inc.), 785 F.3d 1285, 1292-93 (9th Cir. 2015). Involuntary transfers, such as sheriff ’s levies, are also susceptible to attack as preferences. See, e.g., Richardson v. Wells Fargo Bank (In re Churchill Nut Co.), 251 B.R. 143, 147-48 (Bankr. N.D. Cal. 2000). And because “[t]he intent or state of mind of the parties to a transfer is not material to the general question of whether that transfer is a preference[,]” Johnson v. Barnhill (In re Antweil), 931 F.2d 689, 692 (10th Cir. 1991) (citation omitted), even a transfer made and received in the utmost good faith is susceptible to attack as a preference if the statutory elements are met.

     Given the broad definition of “transfer,” the lack of any intent requirement, and a statutory presumption that debtors are insolvent “on and during the 90 days immediately preceding” a bankruptcy filing, see 11 U.S.C. § 547(f ), virtually any transaction in which a financially-distressed debtor gives up something of value on account of a pre-existing debt could give rise to preference exposure. Moreover, because many corporate debtors have a panoply of options when determining where to seek bankruptcy protection, the recipient of a purportedly preferential transfer may be forced to defend a preference action hundreds or thousands of miles away. See, e.g., Samir Parikh, Modern Forum Shopping in Bankruptcy, 46 Conn. L. Rev. 159, 164, 180-93 (2013) (discussing corporate debtors’ forum selection options); Heinrich v. Haley Techs., Inc. (In re Insys Theraputics, Inc.), Adv. Proc. No. 21-50141 ( JTD), 2021 Bankr. LEXIS 1612, at *4 (Bankr. D. Del. June 17, 2021) (holding 28 U.S.C. § 1409’s small-action venue rule inapplicable to preference actions).

                                                                 2. Strategies for Managing Preference Exposure.

     Creditors have at their disposal a number of strategies to minimize the likelihood that a preference action will be brought and maximize the likelihood of a successful defense. A handful—changing payment terms, obtaining credit support, utilizing “safe harbors” in the Bankruptcy Code, and carefully drafting nonbankruptcy settlement agreements—and the concepts underpinning them are discussed below.

     (a.) Seek Payment Terms That Limit Preference Exposure.

     If a transfer is not “for or on account of an antecedent debt,” meaning a debt that the debtor owed before the transfer, the transfer is not a preference. 11 U.S.C. § 547(b)(2). For example, where a buyer prepays a seller for goods, the buyer’s payment generally will not be a preference. See, e.g., Maxwell v. Penn Media (In re marchFirst, Inc.), Adv. Proc. No. 03 A 1141, 2010 Bankr. LEXIS 3480, at *24 (Bankr. N.D. Ill. Oct. 14, 2010) (collecting cases). A party seeking to rely on prepayment to limit preference exposure should keep in mind that prepayments may be avoidable as fraudulent transfers if the goods or services for which prepayment was made are not actually delivered (since the transferor gave no “reasonably equivalent value”). See, e.g., id. at *27-29. It also bears mention that, where a buyer prepays for goods, the subsequent delivery of goods may expose the buyer to a preference action should the seller find itself in bankruptcy.) But true prepayments cannot be preferences. In addition, an otherwise-preferential transfer is not avoidable where the parties intend it to be, and it is, a “substantially contemporaneous exchange” for “new value given to the debtor.” 11 U.S.C. § 547(c)(1). Thus, cash-on-delivery and similar payment arrangements can protect a transferee from a preference action (particularly if documented, to establish the parties’ intent). Creditors should be aware that although the “substantially contemporaneous exchange” requirement is at least somewhat flexible, delay between an event triggering a payment obligation and the payment itself may increase the risk that a transfer will be found non contemporaneous. See, e.g., Pine Top Ins. Co. v. Bank of Am. Nat’l Tr. & Sav. Ass’n, 969 F.2d 321, 328-29 (7th Cir. 1992). Thus, a debtor’s noncompliance with agreed-upon payment terms may hamper a subsequent attempt to invoke the contemporaneous exchange for new value defense to preference liability.

     (b.) Obtain Credit Support.

     Because establishing preference liability requires showing that a creditor received more than it would have in a chapter 7 liquidation and fully-secured creditors in chapter 7 liquidations are generally paid in full, a creditor can eliminate its preference exposure by obtaining a security interest in the debtor’s property to secure the debtor’s payment obligations. See, e.g., Telesphere Liquidating Tr. v. Galesi (In re Telesphere Communs.), 229 B.R. 173, 177-78 (Bankr. N.D. Ill. 1999) (discussing application of 11 U.S.C. § 547(b) (5) liquidation test to secured creditors). Thus, a valid and enforceable security interest gives a fully secured creditor a strong “first line of defense” that turns on readily-ascertainable facts and clear documentation.

     To be sure, a security interest is not necessarily a “silver bullet.” Creation of a security interest is a “transfer” under the Bankruptcy Code, 11 U.S.C. § 101(54), and as such can be avoided as a preference if all Section 547(b) elements are satisfied (but not, for instance, if taken in a substantially contemporaneous exchange for new value, as discussed above). Insufficiently valuable collateral may leave a creditor undersecured and thereby exposed to a preference action. And a creditor with a so-called “floating lien” on inventory, receivables, or proceeds thereof may face preference exposure to the extent that the creditor was undersecured at the inception of the preference period and subsequent changes in the composition or value of collateral improve the creditor’s position during the preference period. See, e.g., Batlan v. Transamerica Commer. Fin. Corp. (In re Smith’s Home Furnishings, Inc.), 265 F.3d 959, 964-66 (9th Cir. 2001). Thus, proper diligence and counseling are critical in ensuring that security arrangements work as intended for bankruptcy and nonbankruptcy purposes alike.

     A third party guarantee can also reduce preference exposure. Under the “earmarking” doctrine, a codebtor/guarantor’s payment of the principal debtor’s antecedent debt is not an avoidable preference so long as there is no diminution of the debtor’s estate because the payment is not a transfer of the principal debtor’s property. See, e.g., Manchester v. First Bank & Tr. Co. (In re Moses), 256 B.R. 641, 645-51 (B.A.P. 10th Cir. 2000) (discussing earmarking doctrine with reference to in- and out-of-circuit cases). However, earmarking generally will not apply where an unsecured debt is replaced by a secured debt. Id. at 651 (citations omitted). Similarly, where the debtor pays a debt that a third party has guaranteed and the debtor has no recourse to the guarantor for reimbursement, the guarantee may not shield the payment from preference exposure. Cf., e.g., Buchwald Capital Advisors LLC v. Metl-Span I., Ltd. (In re Pameco Corp.), 356 B.R. 327, 336 (Bankr. S.D.N.Y. 2006) (“[A] prepetition transfer to a creditor that is fully secured by property of a third party in which the debtor holds no interest is subject to avoidance and does not come within the § 547(b) (5) exception.”). Thus, a creditor seeking preference insulation via a guarantee should be mindful of the guarantee’s structure and, to the extent reasonably practicable, how that structure would be viewed under the precedents applicable in the venue(s) where the debtor can reasonably be expected to file for bankruptcy protection.

     (c.) Consider Using Section 546’s “Safe Harbors.”

     The Bankruptcy Code contains “safe harbors” that place beyond the reach of avoidance actions certain payments made in connection with securities, commodities, or forward contracts; repurchase agreements; and swap agreements. See 11 U.S.C. § 546(e)-(g). Certain parties may be able to structure transactions so that they fall within a Section 546 safe harbor. For example, if a prospective borrower holds securities, a counterparty could enter into a repurchase agreement with that prospective borrower rather than provide a secured loan. See, e.g., Palmdale Hills Prop., LLC v. Lehman Commer. Paper, Inc. (In re Palmdale Hills Prop., LLC), 457 B.R. 29, 42, 56-57 (B.A.P. 9th Cir. 2011) (noting economic similarities and legal differences between repurchase agreements and secured loans). A creditor that is able to avail itself of the Section 546 safe harbors will also obtain significant exemptions from the automatic stay and thereby avoid having to wait for distributions from the bankruptcy estate should the debtor file for bankruptcy before the creditor is paid in full. See, e.g., Calyon N.Y. Branch v. Am. Home Mortg. Corp. (In re Am. Home Mortg., Inc.), 379 B.R. 503, 512 (Bankr. D. Del. 2008) (discussing treatment of repurchase agreements under the Bankruptcy Code).

     Given the subject matter of Section 546’s safe harbors and the expertise required to structure a transaction falling within them, using those safe harbors to prevent preference exposure will be impractical for many (if not most) parties dealing with financially distressed counterparties. But given the significant and valuable benefits they confer, the Section 546 safe harbors should be given serious consideration whenever it appears one or more may be viable.

     (d.) Draft Nonbankruptcy Settlement Agreements Carefully.

     A creditor dealing with a financially distressed counterparty may wish to simply cut its losses, salvage whatever value it can, and move on from the relationship. Often, the terms of the parties’ split will be reduced to a settlement agreement that provides the creditor some recovery in exchange for a release of liability. But settlement payments are transfers and are typically made on account of an antecedent debt, so they are vulnerable to attack as preferences. Moreover, if the settlement agreement releases the debtor from liability other than the obligation to make a settlement payment and the settlement payment is subsequently attacked as a preference, the creditor may be left out in the cold entirely.

     A number of risk mitigation strategies are available. For example, a settlement can be structured to require payments by an affiliate of the debtor with a stronger balance sheet. A settlement can also be structured to include a substantially contemporaneous exchange for new value (although parties opting for this approach should pay careful attention to the definition of “new value” in 11 U.S.C. § 547(a)(2)). If payments will be required over an extended period of time, or there is a contemporaneous exchange for new value, taking a security interest to ensure payment may be attractive. Or, if the debt is relatively small, it can be made payable in installments of $6,824.99 or less and at least 90 days apart. See 11 U.S.C. § 547(c)(9); 5 Collier ¶ 547.04[9]. Parties can also provide that the debtor will only obtain a full release once the preference period has passed, although careful thought should be given in drafting such a provision to minimize the risk it will be found an unenforceable “ipso facto” clause (i.e., a clause that automatically terminates or modifies the contract upon a party’s bankruptcy filing). See, e.g., In re Margulis, 323 B.R. 130, 135 (Bankr. S.D.N.Y. 2005) (discussing ipso facto clauses).

     An outright attempt by the debtor to waive the creditor’s preference exposure, however, is likely to fail because “preference actions are creatures of the Bankruptcy Code that exist only [upon a bankruptcy filing] for the benefit of the estate, not the debtor, and hence are unaffected by pre[-bankruptcy] acts of the debtor.” CapCall, LLC v. Foster (In re Shoot the Moon, LLC), 635 B.R. 797, 827 n.108 (Bankr. D. Mont. 2021) (citing Cont’l Ins. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011, 1026 (9th Cir. 2012) and Bakst v. Bank Leumi, USA (In re D.I.T., Inc.), 575 B.R. 534, 536 (Bankr. S.D. Fla. 2017)).

                                                                  3. Notes Regarding Preference Litigation

     Two points warrant mention regarding the interplay of the above issues with potential defenses once a bankruptcy petition is filed and a preference action is commenced.

     First, the Bankruptcy Code provides an affirmative defense for payment of debts incurred “in the ordinary course of business or financial affairs of the debtor and the transferee” so long as the transfer was also “made in the ordinary course of [the parties’] business or financial affairs” or “made according to ordinary business terms.” 11 U.S.C. § 547(c)(2). Creditors should understand that taking any of the above steps may jeopardize their ability to successfully invoke that “ordinary course” defense. See, e.g., Wahoski v. Classic Packaging Co. (In re Pillowtex Corp.), 427 B.R. 301, 309 (Bankr. D. Del. 2010) (holding triable issue of material fact existed as to whether change in payment terms defeated ordinary course defense). Whether and to what extent preference mitigation efforts will actually preclude an ordinary course defense (and whether and to what extent that matters), however, must be evaluated on a case-by-case basis with reference to the specific parties involved.

     Second, in addition to shielding itself from prospective preference exposure via the contemporaneous new value defense, a creditor can effectively reduce its preference exposure where it provides new value after a preferential transfer. 11 U.S.C. § 547(c)(4).  Unfortunately, the applicable statutory framework is not a model of clarity, so the precise contours of the “subsequent new value” defense may vary from jurisdiction to jurisdiction. But, where a creditor has at least arguably provided “new value” to a financially distressed counterparty following a potentially preferential transfer and is threatened with a preference action, counsel should consider the applicability of the subsequent new value defense.

                                                                              4. Conclusion.

The above-discussed strategies by no means represent an exhaustive list of options that a creditor seeking to limit preference exposure might consider. But most fundamentally, counsel should keep in mind the “principal policy objectives underlying the preference provisions of the Bankruptcy Code[:] . . . encourag[ing] creditors to continue extending credit to financially troubled entities while discouraging a panic-stricken race to the courthouse [and] . . . promot[ing] equality of treatment among creditors.” Charisma Investment Company, N.V., Plaintiff-Appellant, v. Airport Systems, Inc. (In re Jet Fla. Sys.), 841 F.2d 1082, 1083 (11th Cir. 1988) (citations omitted). When confronted with a financially distressed counterparty and either of those policy concerns is implicated, a closer look at preference law may be warranted.

Diego B. Flores is a litigation associate at Shartsis Friese LLP. He represents clients private and public sector clients in a broad range of matters, including commercial and trust litigation and in connection with debtor-creditor and insolvency issues.