Editor’s Note: This article is intended for educational purposes only. It is not intended to be legal, accounting or other professional advice. A party should consult with legal counsel when dealing with the issues addressed in this article. The views expressed in this article are solely those of the author and do not necessarily represent the views or opinions of Husch Blackwell LLP.
Bankruptcy trustees frequently assert demands for alleged preferential transfers under 11 U.S.C. § 547(b) against any entity that received monies from the debtor in excess of $5,850[1] during the 90-day period preceding the debtor’s bankruptcy filing. In turn, recipients of those transfers commonly assert the typical defenses found in 11 U.S.C. § 547(c), including the contemporaneous exchange, ordinary course and/or subsequent new value defenses.[2] In addition, there are a few less common defenses outside of § 547(c) that can be extraordinarily powerful in the right situation.[3] While not a true affirmative defense, a defendant's best “defense” will frequently be a good offense aimed at demonstrating that the trustee cannot prove his/her prima facie case under § 547(b).
Section 547(b): Elements of a Preference Claim
Section 547(b) of the Bankruptcy Code sets forth the elements by which a trustee may avoid any transfer of an interest of the debtor in property. Specifically, it provides that
(b) Except as provided in subsection (ac) and (i) of this section, the Trustee may avoid any transfer of an interest of the debtor in property —
(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;
(3) made while the debtor was insolvent;
(4) made —
(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider.
(5) that enables such creditor to receive more than such creditor would receive if —
(A) the case were a case under chapter 7 of this title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title.[4]
The trustee has the burden of proving each of these elements[5] so a defendant’s first line of attack when defending a preferential transfer should be to defeat one of the essential elements if possible.
Section 547(b)(5)
Section 547(b)(5) of the Bankruptcy Code provides that a transfer cannot be avoided if the recipient would have otherwise received the same amount in a chapter 7 liquidation if the transfer had not been made.[6] In this regard, it is important to stress that “[a] payment is avoidable as a preference only if the payment improved the creditor’s position as compared to other creditors of the same class.”[7] Stated differently, the trustee can only avoid transfers where the creditor receives more than it would have otherwise received in a chapter 7 liquidation. The purpose of this provision is to avoid a scenario where the preference is avoided and then redistributed to the creditor.[8]
As a practical matter, any payment to a general unsecured creditor will always be avoidable unless there is to be a 100 percent distribution to all general unsecured creditors.[9] In contrast, secured creditors generally (but not always) can use this provision as an absolute defense to an alleged preference because the creditor is entitled to receive 100 percent of its claim.[10] The rationale for this approach is that in a chapter 7 liquidation, the secured creditor’s claim would have been fully satisfied through the liquidation of the underlying collateral that is securing its claim.[11] However, a payment to a “fully” secured creditor can be avoided if, at the time of the bankruptcy petition date, the creditor has become undersecured[12] because such a payment enables the creditor to ultimately get more than it would have otherwise received in the hypothetical chapter 7 liquidation.[13]
Section 507(a)
While bankruptcy frequently focuses on distributions to secured and general unsecured creditors, one must never lose sight of the several classes of priority unsecured creditors that fall somewhere between secured and general unsecured creditors. Section 507(a) of the Bankruptcy Code establishes a priority-distribution scheme that dictates the order and amounts of payments to certain classes of claimants.
The fifth item in the Code’s priority-distribution scheme “consists of allowed unsecured claims for contribution to an employee-benefit plan arising from services rendered within 180 days before the earlier of the date of the filing of the petition or the date of the cessation of the debtor’s business.”[14] “Section 507(a)(5) was enacted in response to U.S. Supreme Court cases decided under the Bankruptcy Act, which held that fringe benefits, unlike wages, were not entitled to priority status.”[15]
“The legislative history refers to pension plans, health insurance plans and life insurance plans as the type of employee-benefit plan intended to be included within the scope of the priority.”[16] “Employee-benefit plans eligible for priority generally fall into two categories. The first are self-insured plans where employees are reimbursed for expenses incurred by them that are covered by the employee benefit program….The [second] common category of employee-benefit plans is that in which the employer maintains insurance programs for the benefit of the employees.”[17] Claims relating to pension plans (whether they are a single- or multi-employer plan) may be entitled to priority status of § 507(b)(5) provided that all the requirements are met.[18]
The Intersection of §§ 507(a)(5) and 547(b)(5)
Given that the Bankruptcy Code explicitly requires that distributions from the estate are to be made in accordance with the priority-distribution scheme,[19] this means that in the event that any distribution is to be made to general unsecured creditors, then, by law, the priority claimants will necessarily have their claims paid in full. This means that if the employee-benefit provider had not been paid during the preference period, it would have had a priority unsecured claim against the debtor's estate pursuant to 11 U.S.C. § 507(a)(5), which would have been fully paid in a hypothetical chapter 7. This also means that if the transfers had not been made during the preference period, the employee-benefit provider still would have fully received those same amounts in a chapter 7 liquidation given its priority-claim status above that of other general unsecured creditors.
In short, employee-benefit providers are not run-of-the-mill creditors who receive allegedly preferential transfers from a debtor. They are instead in a unique position by virtue of § 507(a), which prohibits a trustee from avoiding pre-petition payments to them in cases where general unsecured creditors will receive a distribution from the debtor’s estate.
[1] See 11 U.S.C. § 547(c)(9).
[2] See 11 U.S.C. § 547(c)(1), (2) and (4). In addition to these three subsections, there several other defenses in the other subsections under § 547(c) that may apply in certain circumstances.
[3] See e.g., 11 U.S.C. §§ 546 and 550.
[4] 11 U.S.C. § 547(b).
[5] 11 U.S.C. § 547(g).
[6] Hager v. Gibson, 109 F.3d 201, 210 (4th Cir. 1997); see also In re LCO Enterprises, 12 F.3d 938, 941 (9th Cir. 1993) (section 547(c)(5) “requires the court to construct a hypothetical chapter 7 case and determine what the creditor would have received if the case had proceeded under chapter 7”).
[7] In re LCO Enterprises, 12 F.3d 938, 941 (9th Cir. 1993) (emphasis added); see also In re Public Access Technology.com Inc., 307 B.R. 500, 504 (E.D. Va. 2004); In re Pameco Corp., 356 B.R. 327, 337 (Bankr. S.D.N.Y 2006) (“[I]n making a determination under § 547(b)(5), a Court does not focus on other [the] sources of recovery [that are] available to a transferee, but rather what such transferee would receive vis-à-vis other creditors within such creditor’s class.”); In re Griffith, 194 B.R. 262, 267 (Bankr. E.D. Okla. 1996).
[8] Alan N. Resnick and Henry J. Sommer, 5 Collier on Bankruptcy ¶ 547.03[7] (15th ed.).
[9] In re El Paso Refinery LP, 171 F.3d 249, 254 (5th Cir. 1999).
[10] In re Smith’s Home Furnishing Inc., 265 F.3d 959, 964 (9th Cir. 2001).
[11] In re Pameco Corp., 356 B.R. 327, 336 (Bankr. S.D.N.Y 2006).
[12] In re Smith’s Home Furnishing Inc., 265 F.3d 959, 964 (9th Cir. 2001).
[13] As a practical matter, a partially secured creditor is an entity that might be able to generally avail itself of the benefits of the § 547(b)(5) element. “To determine whether an undersecured creditor received a greater percentage recovery on its debt than it would have under chapter 7 the following two issues must first be resolved: (1) to what claim the payment is applied and (2) from what source the payment comes.” In re El Paso Refinery LP, 171 F.3d 249, 254 (5th Cir. 1999). An undersecured creditor who applies the payment to the secured portion of its debt does not receive more than it would otherwise receive in a chapter 7 liquidation because the secured debt has been paid down by the amount received. Id. In contrast, application of the monies to the unsecured portion of the debt will likely result in a preferential transfer. Id. However, even if the monies are applied to the unsecured portion of a claim, there will not be a preferential transfer if the source of the monies is the creditor’s collateral. Id. This is because the creditor has simply received assets that it otherwise would have received in a hypothetical Chapter 7 liquidation.
[14] 4 Collier on Bankruptcy ¶ 507.07 (Alan N. Resnick and Henry J. Sommer eds., 16th ed.).
[15] Id.
[16] Id. See also Howard Delivery Service Inc. v. Zurich American Insurance Co., 547 U.S. 651 (2006) (noting as stated in syllabus that "group health, life, and disability insurance … undisputedly are covered by § 507(a)(5).")
[17] 4 Collier on Bankruptcy ¶ 507.07[1] (Alan N. Resnick and Henry J. Sommer eds., 16th ed.).
[18] 4 Collier on Bankruptcy ¶ 507.07[4] (Alan N. Resnick and Henry J. Sommer eds., 16th ed.).
[19] See 11 U.S.C. §§ 726(a), 1129(a)(7), 1225(a)(4) and 1325(a)(4)