Consider the following scenario: A financially struggling consumer borrows cash from a friend and deposits the cash into his bank account. He uses this cash to make a purchase at a retail store and later pays his friend back. Subsequently, he files for bankruptcy. In this scenario, few would argue that the payment to the retail store and paying back the friend were not separate, avoidable preferences (assuming that no § 547(c) defenses applied). However, what if, instead of borrowing the cash from a friend, the consumer used his credit card to make the purchase and subsequently makes a payment on the account to his credit card company?
Similar to the first scenario, few would argue that the payment on the account to the credit card company was not an avoidable preference (assuming that no § 547(c) defenses applied). However, what about the funds paid by the credit card company to the retail store representing the use of the debtor’s available credit? Should the consumer’s use of credit be treated differently from the cash that was borrowed from the friend? Would this result in a double recovery to the estate, with one recovery from the credit card company and one recovery from the retailer? When considering the prevailing view that the use of available credit can constitute a preference as well as the underlying purpose of preference law, it is likely that courts faced with this situation will determine that the credit transaction and the payment to the credit card company are two separate preferences that would not result in a double recovery to the estate.
Avoidance of Preferential Transfers
Under § 547(b) of the Bankruptcy Code, trustees can avoid certain transfers of the debtor’s property made within the 90-day period (or one-year period for insiders) preceding the debtor’s bankruptcy filing.[1] Such transfers are considered “preferential” and are “avoidable because they allow the favored creditor to receive more than if he had to wait in line with other creditors and share ... what is usually rather slim pickings from the debtor’s estate.”[2]
Congress enacted the preference statute to serve dual purposes. First, the statute discourages creditors “from racing to the courthouse to dismember the debtor during his slide into bankruptcy.”[3] Second, and most important, § 547(b) “facilitates the prime bankruptcy policy of equality of distribution among creditors of the debtor.”[4] To that end, a creditor who receives “a greater payment than others of his class is required to disgorge so that all may share equally.”[5] In order to avoid a transfer of a debtor’s interest in property as preferential, a trustee must prove the following elements:
(b) Except as provided in subsections (c) 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; and
(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.[6]
The Crucial Element for Payments by Credit Card: An Interest of the Debtor in Property
In most cases involving preferential transfers made with borrowed funds (cash or credit), the central issue is whether the transfer constitutes an interest of the debtor in property. The majority of courts that have presided over this issue have determined that a debtor’s use of available credit constitutes an interest of the debtor in property for preference purposes; thus, it follows that the same courts permitted the avoidance of payments made with credit.
In Beiger v. IRS, the U.S. Supreme Court explained that property that would not have been available for distribution to creditors in a bankruptcy proceeding is not property of the estate for avoidance purposes.[7] About 15 years later, the U.S. Bankruptcy Court for the District of Utah became the first court to preside over the issue of whether payments made by credit card were property of the debtor’s estate.[8] Relying on the Beiger holding, the Perry court held that a debtor’s credit card payment to a vendor was not property of the estate under § 541(a)(1)[9] of the Bankruptcy Code because credit is “merely potential wealth” that serves “no immediate benefit” to the debtor’s estate.[10]
About two years after the Perry decision, the U.S. Bankruptcy Court for the Middle District of Georgia was faced with a similar set of facts in Flatau v. The Walman Optical Company d/b/a X-Cel Contacts Inc. (In re Werner).[11] After considering the Perry court’s reasoning, the Werner court compared it with the U.S. Bankruptcy Court for the Western District of Kentucky’s holding in Reisz v. Napus Federal Credit Union (In re Anderson)[12] and the U.S. Bankruptcy Court for the District of Maine’s holding in Growe v. AT&T Universal Card Services (In re Adams).[13] In both cases, the debtors paid off their balances due to the defendant credit card issuers by way of balance transfers to new credit cards. The defendants asserted earmarking[14] defenses on the grounds that there was no diminution of the debtors’ estates.
The Anderson court disagreed with the defendant and focused on the fact that the debtor had “dispositive control” over the funds that were used to effectuate the balance transfer.[15] It also emphasized that its holding furthered the Bankruptcy Code’s “equitable distribution principles” because if the defendant had not been preferred, the funds that the defendant received could have been distributed equally among the unsecured creditors.[16] The Adams court came to a similar conclusion and held that the balance-transfer payment “negatively impacted equal distribution of assets” because the debtor could have used those funds to “pay all creditors equitably.”[17]
The Werner court found the reasoning of the Anderson and Adams courts to be more persuasive than the Perry court’s reasoning, holding that the debtor could not have “initiated and directed” the transfer of funds from his credit card account if he had no interest in the funds.[18] The Werner court further emphasized that there was no reason to distinguish a debtor paying with a credit card from a debtor obtaining a cash advance and using the funds to pay a creditor.[19]
After the Werner court’s decision, Perry was abrogated by the Tenth Circuit in Parks v. FIA Card Services NA (In re Marshall),[20] another balance-transfer case. At the outset of the decision, the Tenth Circuit explained that if a debtor deposits the proceeds from a credit card cash advance into his bank account and then writes a check to pay off the balance of another credit card, a preference has clearly occurred.[21] Thus, in holding that a balance-transfer payment was a property interest of the debtor, the Tenth Circuit opined that technology should not mask the process and that the debtor’s ability to control who received the funds was the key.[22] Further, the Tenth Circuit reconciled its holding with the Supreme Court’s holding in Beiger by explaining that regardless of “how fleeting[ly]” an asset is present in the debtor’s estate during the 90-day preference look-back period, the asset should be “ratably apportioned among qualified creditors.”[23] Thus, at the moment that the debtor’s new credit card issuer approved the debtor’s balance-transfer request, the funds used to make the balance-transfer payment became assets of the debtor’s estate, even if they were preferentially transferred to the defendant “only a nanosecond” later.[24]
When considering the courts’ holdings in these cases, it is clear that a debtor’s credit constitutes property of the estate. Thus, for preference purposes, it follows that a debtor’s use of credit to make a purchase should not be treated any differently than if a debtor borrowed money from a friend to make a purchase.
The Next Step: Recovery of Avoided Preferential Transfers
Even though credit transactions can be avoided as preferential under § 547(b), § 550 of the Bankruptcy Code must still be satisfied in order to recover the value of the credit used for the estate. Congress enacted § 550 in order “to restore the estate to the financial condition it would have enjoyed if the transfer had not occurred.”[25] Under § 550(a), “the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from ... (1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or (2) any immediate or mediate transferee of such initial transferee.” However, “[s]ection 550(d) limits the recovery authorized by Section 550(a) by restricting the trustee to a ‘single satisfaction’ under that subsection.”[26]
Section 550(d) usually “arises in scenarios where Section 550(a) enables the trustee to recover from more than one transferee, possibly allowing the trustee to recover more than the value of the avoided transfer.”[27] At first glance, the scenario of a debtor making a credit card purchase at a retail store and subsequently making an on-account payment on his/her credit card bill seems like it would fall within the § 550(d) prohibition on multiple recoveries. However, this scenario is actually two distinct transfers of the debtor’s interest in property. The first transfer is the debtor’s use of his/her available credit to make the purchase at the retail store. As the debtor’s credit is property of the estate, the retail store is an initial transferee under § 550(a)(1). The second transfer is the debtor’s on-account payment to the credit card company, which is also an initial transferee under § 550(a)(1). Thus, despite appearing to result in a double recovery for the estate, these are two separate preferences, and avoidance of both results in an equitable distribution to all of the debtor’s unsecured creditors.
[1] DeRosa v. Buildex Inc. (In re F & S Cent. Mfg. Corp.), 53 B.R. 842, 846 (Bankr. E.D.N.Y. 1985).
[2] Kleven v. Household Bank FSB, 334 F.3d 638, 641 (7th Cir. 2003).
[3] Union Bank v. Wolas, 502 U.S. 151, 161 (1991).
[4] Id.
[5] Id.
[6] 11 U.S.C. § 547(b).
[7] 496 U.S. 53 (1990).
[8] Loveridge v. The Ark of Little Cottonwood Inc. (In re Perry), 343 B.R. 685 (Bankr. D. Utah 2005) (abrogated by Parks v. FIA Card Services NA (In re Marshall), 550 F.3d 1251 (10th Cir. 2008)).
[9] Section 541(a)(1) provides that a debtor’s bankruptcy estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case.”
[10] Perry, 343 B.R. at 688.
[11] 365 B.R. 283 (Bankr. M.D. Ga. 2007).
[12] 275 B.R. 264 (Bankr. W.D. Ky. 2002).
[13] 240 B.R. 807 (Bankr. D. Me. 1999).
[14] The earmarking doctrine provides that when a new creditor pays a debtor’s existing debt to an old creditor, the funds used to pay the debt do not become property of the debtor’s estate. See Manchester v. First Bank & Trust Co. (In re Moses), 256 B.R. 641 (B.A.P. 10th Cir. 2000).
[15] Anderson, 275 B.R at 266.
[16] Id.
[17] Adams, 240 B.R. at 813 (citing Lewis v. Providian Bancorp (In re Getman), 218 B.R. 490, 493 (Bankr. W.D. Mo. 1998)).
[18] Werner, 365 B.R. at 287.
[19] Id.
[20] 550 F.3d 1251 (10th Cir. 2008).
[21] Id. at 1256-57.
[22] Id. at 1256.
[23] Id. at 1258.
[24] Id.
[25] Feltman v. Warmus (In re Am. Way Serv. Corp.), 229 B.R. 496, 530-31 (Bankr. S.D. Fla. 1999).
[26] Dobin v. Presidential Financial Corp. of Del. Valley (In re Cybridge Corp.), 312 B.R. 262, 268 (D.N.J. 2004).
[27] Id. at 268.