A History of Bankruptcy Preferences
Written by:
Scott Blakeley
Blakeley & Brinkman
Los Angeles, California
SEBLAKELEY@aol.com
Web posted and Copyright ©1997, American Bankruptcy
Institute and Blakeley & Brinkman.
Introduction
A fundamental principle of bankruptcy law since its advent in
the sixteenth century is equality of distribution. This principle
disfavors transfers that benefit one creditor at the expense of other
creditors. [ FN: See, e.g. ,
Charles Segilson, The Code and the Bankruptcy Act, 42 N.Y.U. L. Rev.
292, 292 (1967): A cornerstone of the bankruptcy structure is the
principle that equal treatment for those similarly situated must be
achieved. It would be highly inequitable to disregard what transpires
prior to the filing of the bankruptcy petition; to do so would encourage
a race among creditors, engender favoritism by the debtor, and result in
inequality of distribution. At bankruptcy, the bankrupt would be left .
. . with only tag ends and remnants of unencumbered
assets.] Preference laws are central to this principle
and they are the primary instrument in achieving equality of
distribution. The preference laws have evolved as an offshoot of
fraudulent conveyance law, thus containing broad ethical pronouncements
of sixteenth century English bankruptcy law and to standardized,
technical rules of twentieth century American bankruptcy law. The focus
of preference laws has shifted from the culpability of the debtor, to
the culpability of creditors, to the present day standard of strict
liability.
Preference laws seek to deter individual creditor action by
threatening recapture of transfers made during the debtor's period of
vulnerability. Closely associated with the tenet of equality of
distribution is the bankruptcy policy of maximization of the bankruptcy
estate. A larger distribution might be achieved through rehabilitation
rather than liquidation. Preferential transfers result in diminishment
of estate assets, thus frustrating decisions that would achieve
maximization. [ FN: See, e.g.,
Thomas H. Jackson, Avoiding Powers in Bankruptcy, 36 Stanford L. Rev.
725, 759 (1984): Such eve-of bankruptcy asset-grabbing may be
detrimental to the collective interests of the creditors. By reaching
back to undo the actions of the creditors, preference law deters such
grabbing, thereby protecting the creditors = bargain. Therefore,
preference law essentially prevents individual creditors from opting out
of the transitional period before bankruptcy. It enforces the
hypothetical creditors = bargain that justifies a collective proceeding
in the first place.]
English Bankruptcy Law:
Creation of the Preference
Since 1570, English law has prohibited transfers by a debtor for the
purpose of defrauding creditors. The penalty imposed for the crime of a
forfeiture of the property transferred and imprisonment of the debtor.
[ FN: 8 William Scarle Holdsworth, A
History of English Law , 240 (1922); 3 Halsbury's Laws of England (4th
ed. 1973).] The emergence of preference law was closely
tied to the law of fraud. Although the concept of pro rata distribution
appeared in the first comprehensive bankruptcy statute, The Statute of
13 Elizabeth, [ FN: 13 Eliz., ch. 5
(1571).] the Statute was silent as to preferences. Early
preference law developed through case authority. In 1584, equality of
distribution was introduced as a fundamental principle of bankruptcy law
in the The Case of Bankrupts. [
FN: 76 Eng. Rep. 441 (K.B. 1584).] In his
pronouncement, Lord Coke stated that "[T]here ought to be an equal
distribution. . .; [for] if, after the debtor becomes bankrupt, he may
prefer [a creditor] and defeat and defraud many other poor men of their
true debts, it would be unequal and unconscionable, and a defect in the
law." [ FN: Id . at
473.] This principle of equality advanced by Lord Coke
viewed preferential transfers as defeating the principle of
fairness.
Later cases further developed the doctrine of equality of treatment
of creditors. Lord Mansfield held that the debtor must not set himself
up as the law-giver in bankruptcy distribution. [ FN: Alderson v. Temple, 96 Eng. Rep.
384, 385 (K.B. 1768).] Therefore, transfers on the eve of
bankruptcy were void [ FN: See id
.] where creditors had not demanded payment or threatened
to bring suit. [ FN: See Thomason v.
Freeman, 99 Eng. Rep. 1026, 1028 (K.B. 1786).] Payments
to creditors, on the eve of bankruptcy, who had threatened to
collect their debts were not considered preferential.
In 1746 Parliament created a bona fide creditor law, intending to
protect innocent creditors from avoidance payments. [ FN: See 8 William Scarle Holdsworth, A
History of English Law , 237 (2d ed. 1937).] Courts
distinguished between good and bad transfers. In a good transfer:
(1) the claim had to arise in a bona fide credit transaction and in
the ordinary course of trade; (2) the payment had to be made in the
ordinary course of trade; and (3) the creditor had to not know or have
notice that the debtor at the time was bankrupt or insolvent
circumstances. [ FN: See Charles
Jordan Tabb, Rethinking Preferences, 43 S.C. L. Rev. 981, 998
(1992).]
A bad transfer required debtor intent to benefit a creditor to the
detriment of other creditors. [ FN:
See John C. McCoid, Bankruptcy, Preferences, and Efficiency: An
Expression of Doubt, 67 Va. L. Rev. 249 (1981).] The
ethical inquiry under English preference law focused principally on the
state of mind of the debtor, not on the actions of the
creditor. Under this analysis the aggressive creditor was rewarded:
[I]f a bankrupt, in a course of payment pays a creditor, this is a
fair advantage in the course of trade; or, if a creditor threatens legal
diligence, and there is no collusion; or behind the sue a debtor; and he
make an assignment of part of his goods; it is fair transaction, and
what a man might do without having any bankruptcy in view . . . if done
in the course of trade, and not fraudulent may be supported. [ FN: 96 Eng. Rep. 384, 385 (K.B.
1768).]
The statute advanced a central theme in preference legislation:
Preferential payments are contrasted with some sense of ordinary
commercial practice. The goal of preference laws was to capture fraud
and not unwind a transaction in the ordinary course. The focus of
English bankruptcy law was not ensuring a mathematical pro rata
distribution of assets, but rather, to prevent a debtor from creating
his own form of distribution to creditors.
In 1869 Parliament drafted a preference provision into its bankruptcy
legislation. The preference law provided that any payment made within
three months of bankruptcy, for the purpose of giving the creditor a
preference, was void. [ FN: 32 &
33 Vict., ch. 71, sect. 92 (1869); Vern Countryman, The Concept of a
Voidable Preference in Bankruptcy , 38 Vand. L. Rev. 713, 718
(1985).]
American Bankruptcy Preference Law
Switching continents, a central consideration in American preference
legislation is the review of changing relationships (1) between debtor
and its creditors, and (2) among debtor's creditors.
Early American Bankruptcy Law
1. The State's View
State regulation of preferential transfers began in the late
eighteenth century. Under these laws, the debtor's state of mind was
essential in determining a preference.
2. The Bankruptcy Act of 1800
The first American Bankruptcy was the Bankruptcy Act of 1800 [ FN: 2 Stat. 19-21 (1800) ; Countryman,
Supra note 14, at 718.] While fraudulent conveyances were
included in the Act of 1800, preference actions were not.
3. The Bankruptcy Act of 1841
The Bankruptcy Act of 1841 [ FN:
Bankruptcy Act of 1841.] was the first to define and
prohibit preferences. Any transfer by the debtor, within a two month
reach back period, [ FN: Bankruptcy
Act of 1841, ch. 9, section 2, 5 Stat. 440.] was illegal
if made for the purpose of benefitting a particular creditor. As a
result of an illegal preference, the debtor would lose his discharge .
[ FN: See Id.]
The Act of 1841 did not consider "state of mind" as an element in
finding an illegal preference.
4. The Bankruptcy Act of 1867
The Act of 1867 [ FN: 14 Stat.
517 (1867).] made it easier to find a preference.
In addition to extending the reach back period to four months, [ FN: 14 Stat. 517, section 35
(1867).] it changed the "debtor's contemplation of
bankruptcy" condition to the "debtor's insolvency or contemplation of
insolvency." Insolvency, however, was not defined. The Supreme Court
defined insolvency as a debtor's inability to meet debts as they come
due. [ FN: See
Id.] The 1867 Act also added the "state of mind"
condition requiring the creditor to have reasonable cause to believe the
debtor was insolvent. [ FN: See
Id.]
A Technical Approach to Preferences
1. The Bankruptcy Act of 1898
The Act of 1898 [ FN: 30 Stat.
544 (1898).] promulgated an elaborate scheme for
regulating preferences. It is viewed as the key which ensured ratable
distribution. Section 60a provided:
[A debtor] shall be deemed to have given a preference if, being
insolvent, he has procured or suffered a judgment to be entered against
himself in favor of any person, or made a transfer of any of his
property, and the effect of the enforcement of such judgment or transfer
[would] be to enable any one of his creditors to obtain a greater
percentage of his debt than any other such creditor of the same
class.
The 1898 Act reflects a shift in preference philosophy from the
debtor's moral duty to his creditors to the preferred creditor's moral
duty to fellow creditors. The debtor's state of mind in making the
preference become irrelevant. The focus was now on to state of mind of
the creditor. A transfer was avoidable provided the preferred creditor
has reasonable basis to believe that the payment would cause a
preference. [ FN: Section 3, 30
Stat. 544 (1898).] The preference laws were intended to
punish bad creditors, i.e. those that know of the debtor's
insolvency. The Act's shortfall was that it included an abstract
definition of preference giving the courts too much flexibility in its
application. [ FN: See, e.g.
, Kennard v. Behrer, 270 F. 661 (S.D.N.Y. 1920). Preferred creditor who
assists the debtor in financial straits by restructuring notes is immune
from attack notwithstanding the creditor's state of mind. Distinction
made to preferred creditors who know there is insufficient money to go
around for fellow creditors.]
The Act of 1898 also addressed the secret lien, whereby a debtor who
provide a creditor with a security interest well before the reach back
period but who did not perfect the lien until the eve of filing, would
fall within the relation back doctrine. Under this doctrine, liens were
viewed as arising during the four month reach back period and could
thus, be avoided. A number of courts, however, refused to avoid the
secret liens. These counts held that such creditors deserved to be paid.
Congress amended the preference laws in 1910 and 1926 to strictly apply
the relation back provision. Moreover, until recovery of the
preferences, the creditor's claim would be disallowed.
2. The Chandler Act of 1938
The Chandler Act continues the trend to a more technical application
of preference laws. The Chandler Act re-emphasizes that ratable
distribution is the essence of bankruptcy laws and preference laws are
the vehicle to achieve this. As with the Act of 1898, the focus of the
legislation was avoidance of secret liens and last-minute liens, and its
purpose was to prevent rewards to preferred creditors, insiders and
creditors exerting economic pressure.
3. The Bankruptcy Reform Act of 1978
The Bankruptcy Reform Act fundamentally changed American preference
law. [ FN: See Thomas M. Ward &
Jay A. Shulman, In Defense of the Bankruptcy Code's Radical Integration
of the Preference Rules Affecting Commercial Financing , 61 Wash. U.
L.Q. 1, 4 (1983).] The drafters of the Bankruptcy Reform
Act created a preference law, section 547 of the Bankruptcy Code, [ FN: A preference consists of a transfer
of the debtor's property: 1. To or for the benefit of a creditor; 2. For
or on account of an antecedent debt owed by the debtor prior to such
transfer; 3. Made while the debtor was insolvent; 4. Made on or within
90 days before the date of the filing of the petition (one year for
insiders); 5. That enables such creditor to receive more than such
creditor would receive if the case were a case under chapter
7.] which was a precise, technical rule of definitions
and numbered exceptions intended to avoid transfers that upset ratable
distribution. Congress sought to simplify the preference laws and
restrict court interpretation of these provisions through technical
drafting and on rule-oriented approach. [
FN: Barash v. Public Fin. Corp., 658 F.2d 504, 510 (7th Cir.
1981).] The rule shifts the onus of preference litigation
from debtor to creditor.
The principle objective section 547 is:
[T]wo-fold. First, by permitting the trustee to avoid prebankruptcy
transfers that occur within a short period before bankruptcy, creditors
are discouraged from racing to the courthouse to dismember the debtor
during his slide into bankruptcy. The protection afforded the debtor
often enables him to work his way out of a difficult financial situation
through cooperation with all of his creditors. Second, and more
important, the preference provisions facilitate the prime
bankruptcy policy of equality of distribution among creditors of the
debtor. Any creditor that received a greater payment than others of his
class is required to disgorge it so that all may share equally. The
operation of the preference section to deter the "race of diligence" of
creditors to dismember the debtor before bankruptcy furthers the second
goal of the preference section-that of equality of distribution. [ FN: Barash v. Public Fin. Corp., 658
F.2d 504, 510 (7th Cir. 1981). Does this really promote equality?
Creditors may hold on to the money knowing that so long as the debtor
does not file 90 days after the filing they will be able to keep it. At
worst, a preferred creditor will simply have to return the
money.]
The significant additions and revisions to the preference law under
the Bankruptcy Reform Act include the following.
a. Reasonable cause to believe
The Bankruptcy Reform Act made it easier to establish the existence
of a preference by eliminating the requirement that the creditor have
reasonable cause to believe that the debtor was insolvent (except for
insider creditors). [ FN: While
Congress eliminated the creditor's state of mind, this did not prevent
courts from looking to the nature of the transaction and the
relationship of the parties. See, e.g. , Wyle v. C.H. Rider &
Family ( In re United Energy Corp.), 944 F.2d 589, 595 (9th Cir.
1991).] The state of mind element is eliminated, in part,
out of concern that the innocent creditor exception conflicts with the
policy of equality among creditors. [
FN: See, e.g. , H.R. Rep. No. 595, 95-595 at 178 (1978),
reprinted in 1978 U.S.C.C.A.N. 5787 (1978) To argue that the creditor's
state of mind is an important element of a preference and that creditors
should not be required to disgorge what they took in supposed innocence
is to ignore the strong bankruptcy policy of equality among creditors.
Finally, the requirement that the trustee prove the state of mind of his
opponent is nearly insurmountable, and defeats many preference actions.
The amount of litigation it causes is too great when the requirements
itself does not further any necessary bankruptcy policy. It also defeats
the policy of the preference section by limiting recoveries to only the
most egregious cases.]
b. Vulnerability period shortened
The reach back period is shortened from 120 days to 90 days.
c. Presumption of insolvency
To aid the trustee in establishing a prima facie case of preference,
the drafters added the provision the debtor is presumed insolvent
within 90 days prior to the bankruptcy filing.
d. Bankruptcy court jurisdiction
All forms of preference actions may be commenced in the bankruptcy
court where, presumably, the action will proceed more swiftly. [ FN: 11 U.S.C. ' 105.]
e. Secret liens
Aimed at the secret lien, the Bankruptcy Reform Act also requires
creditors to timely perfect their security interests. [ FN: See Ray v. Security Mutual Fin.
Corp. ( In re Arnett), 731 F.2d 358, 363 (6th Cir. 1984): One of
the principal purposes of the Bankruptcy Reform Act is to discourage the
creation of > secret liens = by invalidating all transfers occurring
within 90 days prior to the filing of the petitions. Thus, creditors are
discouraged from waiting until the debtor's financial troubles become
all-too-manifest before recording its security
interests.]
f. Exceptions
The elimination of the creditor's state of mind element and the
addition of the presumed insolvency of the debtor element broadens to
scope of a preference. The drafters seek to limit the broadened scope
with defined exceptions. Other than the "subsequent advance" exception,
[ FN: See 60c of the Bankruptcy Act
of 1898.] exceptions are new to preference law. The
exceptions are intended to leave intact those transactions that do not
diminish the size of the estate.
The drafters enumerated seven exceptions from section 547. [ FN: Those seven exceptions are commonly
referred to as: (1) contemporaneous exchange; (2) ordinary course of
business; (3) enabling loan; (4) subsequent advance; (5) improvement in
position; (6) statutory lien; and (7) consumer's small
business.]
Courts have struggled with the application of the law, especially the
exceptions, spending much time analyzing the ordinary course
exception.
The drafters continued the rule disallowing a creditor's preferenced
claim until the creditor surrenders the preference. [ FN: See 11 U.S.C. '
502(d).]
4. The 1984 Bankruptcy Amendments and Federal Judgeship
Act ("BAFJA")
BAFJA eliminates the Areasonable cause to believe" standard for
insider creditors. The 45-day rule contained in the ordinary course of
business exception is eliminated. BAFJA is contrary to the trend of more
precise, bright line-rules promulgated under the Bankruptcy Reform Act.
For example, the elimination of the 45 day reoccurrence rule now allows
any creditor to argue the transfer was not in the ordinary course of
business.
|
