{"id":1349,"date":"2022-08-19T02:07:34","date_gmt":"2022-08-19T02:07:34","guid":{"rendered":"https:\/\/abtl.org\/northerncalifornia\/?p=1349"},"modified":"2022-08-19T16:03:15","modified_gmt":"2022-08-19T16:03:15","slug":"mitigating-preference-exposure","status":"publish","type":"post","link":"https:\/\/abtl.org\/northerncalifornia\/abtlreport\/mitigating-preference-exposure\/","title":{"rendered":"Mitigating Preference Exposure"},"content":{"rendered":"\n

By Diego Flores, Shartsis Friese LLP
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Diego Flores<\/figcaption><\/figure><\/div>\n\n\n\n

Entering Summer 2022, interest rates are on the rise and fears of a recession\u2014and the potential uptick in bankruptcy filings it would bring\u2014loom 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.

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01. What is a Preference? <\/u><\/strong>

\u00a0\u00a0\u00a0\u00a0 \u201cPreferences are transfers in which an insolvent debtor favors certain creditors over others.\u201d 5 Collier on Bankruptcy \u00b6 547.10 (16th ed. 2022). The elements of a preference claim are laid out in Section 547 of the Bankruptcy Code,which provides that \u201cany transfer of an interest of the debtor in property\u201d may be avoided where it is \u201c(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;\u201d (4) transfer was made within 90 days preceding the debtor\u2019s bankruptcy filing (or one year in the case of transfers to \u201cinsiders\u201d); and (5) allows the creditor to receive more than it would absent the transfer in a chapter 7 liquidation. 11 U.S.C. \u00a7 547(b).

\u00a0\u00a0\u00a0\u00a0 Under the Bankruptcy Code, \u201ctransfer\u201d is defined \u201cextremely<\/em> broad[ly]\u201d and captures in essence, anything a debtor might do to \u201cdispos[e] of or part[] with\u201d any property interest, whether directly or indirectly. See, e.g., Batlan v. Bledsoe (In re Bledsoe)<\/em>, 569 F.3d 1106, 1113 (9th Cir. 2009) (quoting Bernard v. Sheaffer<\/em> (In re Bernard)<\/em>, 96 F.3d 1279, 1282 (9th Cir. 1996)) (emphasis in original); 11 U.S.C. \u00a7 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.,<\/em> Stahl v. Simon (In re Adamson Apparel, Inc.)<\/em>, 785 F.3d 1285, 1292-93 (9th Cir. 2015). Involuntary transfers, such as sheriff \u2019s levies, are also susceptible to attack as preferences. See,<\/em> e.g.,<\/em> Richardson v. Wells Fargo Bank (In re Churchill Nut Co.)<\/em>, 251 B.R. 143, 147-48 (Bankr. N.D. Cal. 2000). And because \u201c[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[,]\u201d Johnson v. Barnhill (In re Antweil)<\/em>, 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.

\u00a0\u00a0\u00a0\u00a0 Given the broad definition of \u201ctransfer,\u201d the lack of any intent requirement, and a statutory presumption that debtors are insolvent \u201con and during the 90 days immediately preceding\u201d a bankruptcy filing, see<\/em> 11 U.S.C. \u00a7 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.<\/em>, Samir Parikh, Modern Forum Shopping in Bankruptcy,<\/em> 46 Conn. L. Rev. 159, 164, 180-93 (2013) (discussing corporate debtors\u2019 forum selection options); Heinrich v. Haley Techs., Inc. (In re Insys Theraputics, Inc.),<\/em> Adv. Proc. No. 21-50141 ( JTD), 2021 Bankr. LEXIS 1612, at *4 (Bankr. D. Del. June 17, 2021) (holding 28 U.S.C. \u00a7 1409\u2019s small-action venue rule inapplicable to preference actions).
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\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 \u00a0\u00a02. Strategies for Managing Preference Exposure.<\/strong><\/strong>

\u00a0\u00a0\u00a0\u00a0 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\u2014changing payment terms, obtaining credit support, utilizing \u201csafe harbors\u201d in the Bankruptcy Code, and carefully drafting nonbankruptcy settlement agreements\u2014and the concepts underpinning them are discussed below.

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     (a.) Seek Payment Terms That Limit Preference Exposure.<\/em>

     If a transfer is not \u201cfor or on account of an antecedent debt,\u201d meaning a debt that the debtor owed before the transfer, the transfer is not a preference. 11 U.S.C. \u00a7 547(b)(2). For example, where a buyer prepays a seller for goods, the buyer\u2019s payment generally will not be a preference. See, e.g., Maxwell v. Penn Media (In re marchFirst, Inc.),<\/em> 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 \u201creasonably equivalent value\u201d). See, e.g., id.<\/em> 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 \u201csubstantially contemporaneous exchange\u201d for \u201cnew value given to the debtor.\u201d 11 U.S.C. \u00a7 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\u2019 intent). Creditors should be aware that although the \u201csubstantially contemporaneous exchange\u201d 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\u2019l Tr. & Sav. Ass\u2019n<\/em>, 969 F.2d 321, 328-29 (7th Cir. 1992). Thus, a debtor\u2019s noncompliance with agreed-upon payment terms may hamper a subsequent attempt to invoke the contemporaneous exchange for new value defense to preference liability.

     <\/em>(b.) Obtain Credit Support<\/em>.

     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\u2019s property to secure the debtor\u2019s payment obligations. See, e.g., Telesphere Liquidating Tr. v. Galesi (In re Telesphere Communs.)<\/em>, 229 B.R. 173, 177-78 (Bankr. N.D. Ill. 1999) (discussing application of 11 U.S.C. \u00a7 547(b) (5) liquidation test to secured creditors). Thus, a valid and enforceable security interest gives a fully secured creditor a strong \u201cfirst line of defense\u201d that turns on readily-ascertainable facts and clear documentation.

     To be sure, a security interest is not necessarily a \u201csilver bullet.\u201d Creation of a security interest is a \u201ctransfer\u201d under the Bankruptcy Code, 11 U.S.C. \u00a7 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 \u201cfloating lien\u201d 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\u2019s position during the preference period. See, e.g., Batlan v. Transamerica Commer. Fin. Corp. (In re Smith\u2019s Home Furnishings, Inc.)<\/em>, 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.<\/p>\n\n\n\n


\u00a0\u00a0\u00a0\u00a0 A third party guarantee can also reduce preference exposure. Under the \u201cearmarking\u201d doctrine, a codebtor\/guarantor\u2019s payment of the principal debtor\u2019s antecedent debt is not an avoidable preference so long as there is no diminution of the debtor\u2019s estate because the payment is not a transfer of the principal debtor\u2019s property. See, e.g., Manchester v. First Bank & Tr. Co. (In re Moses)<\/em>, 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.<\/em> 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.)<\/em>, 356 B.R. 327, 336 (Bankr. S.D.N.Y. 2006) (\u201c[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 \u00a7 547(b) (5) exception.\u201d). Thus, a creditor seeking preference insulation via a guarantee should be mindful of the guarantee\u2019s 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.

\u00a0\u00a0\u00a0\u00a0 (c.) Consider Using Section 546\u2019s \u201cSafe Harbors.\u201d<\/em>

\u00a0\u00a0\u00a0\u00a0 The Bankruptcy Code contains \u201csafe harbors\u201d 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. \u00a7 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),<\/em> 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.)<\/em>, 379 B.R. 503, 512 (Bankr. D. Del. 2008) (discussing treatment of repurchase agreements under the Bankruptcy Code).

\u00a0\u00a0 \u00a0\u00a0Given the subject matter of Section 546\u2019s 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.

\u00a0\u00a0\u00a0\u00a0 (d.) Draft Nonbankruptcy Settlement Agreements Carefully.<\/em>

\u00a0\u00a0\u00a0\u00a0 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\u2019 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.

\u00a0\u00a0\u00a0\u00a0 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 \u201cnew value\u201d in 11 U.S.C. \u00a7 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.<\/em> \u00a7 547(c)(9); 5 Collier \u00b6 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 \u201cipso facto\u201d clause (i.e., <\/em>a clause that automatically terminates or modifies the contract upon a party\u2019s bankruptcy filing). See, e.g., In re Margulis<\/em>, 323 B.R. 130, 135 (Bankr. S.D.N.Y. 2005) (discussing ipso facto clauses).

\u00a0\u00a0\u00a0\u00a0 An outright attempt by the debtor to waive the creditor\u2019s preference exposure, however, is likely to fail because \u201cpreference 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.\u201d CapCall, LLC v. Foster (In re Shoot the Moon, LLC)<\/em>, 635 B.R. 797, 827 n.108 (Bankr. D. Mont. 2021) (citing Cont\u2019l Ins. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.)<\/em>, 671 F.3d 1011, 1026 (9th Cir. 2012) and Bakst v. Bank Leumi, USA (In re D.I.T., Inc.),<\/em> 575 B.R. 534, 536 (Bankr. S.D. Fla. 2017)).

\u00a0\u00a0\u00a0\u00a0 \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03.<\/strong> Notes Regarding Preference Litigation<\/u><\/strong>

\u00a0\u00a0\u00a0\u00a0 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.

\u00a0\u00a0\u00a0\u00a0 First, the Bankruptcy Code provides an affirmative defense for payment of debts incurred \u201cin the ordinary course of business or financial affairs of the debtor and the transferee\u201d so long as the transfer was also \u201cmade in the ordinary course of [the parties\u2019] business or financial affairs\u201d or \u201cmade according to ordinary business terms.\u201d 11 U.S.C. \u00a7 547(c)(2). Creditors should understand that taking any of the above steps may jeopardize their ability to successfully invoke that \u201cordinary course\u201d defense. See, e.g., Wahoski v. Classic Packaging Co. (In re Pillowtex Corp.),<\/em> 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.

\u00a0\u00a0\u00a0\u00a0 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. \u00a7 547(c)(4). \u00a0Unfortunately, the applicable statutory framework is not a model of clarity, so the precise contours of the \u201csubsequent new value\u201d defense may vary from jurisdiction to jurisdiction. But, where a creditor has at least arguably provided \u201cnew value\u201d 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.

\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 4. Conclusion.<\/u><\/strong>

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 \u201cprincipal 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.\u201d Charisma Investment Company, N.V., Plaintiff-Appellant, v. Airport Systems, Inc. (In re Jet Fla. Sys.),<\/em> 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.<\/p>\n\n\n\n

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Diego B. Flores <\/strong>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. <\/em> dflores@sflaw.com<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

By Diego Flores, Shartsis Friese LLP Entering Summer 2022, interest rates are on the rise and fears of a recession\u2014and the potential uptick in bankruptcy […]<\/p>\n","protected":false},"author":6,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":[],"categories":[8,20],"tags":[],"_links":{"self":[{"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/posts\/1349"}],"collection":[{"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/users\/6"}],"replies":[{"embeddable":true,"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/comments?post=1349"}],"version-history":[{"count":7,"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/posts\/1349\/revisions"}],"predecessor-version":[{"id":1378,"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/posts\/1349\/revisions\/1378"}],"wp:attachment":[{"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/media?parent=1349"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/categories?post=1349"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/abtl.org\/northerncalifornia\/wp-json\/wp\/v2\/tags?post=1349"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}