Treatment of Preferential Transfers in Bankruptcy

Otten Johnson Alert January 2010

In the current economy, business bankruptcies have become more commonplace. When doing business with a company that is a bankruptcy risk, there is a possibility that the company's pre-bankruptcy payments will be deemed a "preference" by a bankruptcy court, meaning that such payment can be reversed or unwound.

What Is a "Preference"?

To be considered a "preference," a transfer of property or money must meet the following criteria: (a) it is made by an insolvent debtor, (b) for the benefit of an existing creditor, (c) on account of a pre-existing debt, and (d) occurring within 90 days before the filing of bankruptcy (one year for a transfer to or for the benefit of an "insider").

To be considered a "preference," the creditor must have received more than it would have received under a hypothetical Chapter 7 liquidation plan had the transfer not been made. If a transfer is designated as a preference, then the bankruptcy trustee can avoid it (i.e., unwind the transfer) and recover the property or money, and use that property or money for the benefit of unsecured creditors as a whole. There are exceptions to the preference rules, the two most common exceptions being (a) payments made to creditors in the ordinary course of business, such as monthly loan payments, and (b) payments made by the debtor in exchange for "new value," a term often the subject of complicated analysis and factual disputes.

Preferences in the Real Estate Context

Below are three common examples of preferences in the real estate context:

Loan Restructurings: In workouts, lenders often request additional collateral or a partial pay-down of the loan. If the borrower goes into bankruptcy within 90 days, then the additional collateral or payment can be avoided as a preference.

Deeds in Lieu of Foreclosure: The value of property transferred by deed in lieu of foreclosure is often less than the outstanding balance of the loan and will not constitute a preference. However, a trustee may still challenge the transfer if s/he believes the property was not properly appraised or if values have increased since the transfer occurred.

Guarantors: Real estate loans are often guaranteed by a principal of the borrower, making the guarantor both a conditional creditor and an insider of the debtor. A transfer by a borrower to a lender indirectly benefits the guarantor. If the guarantor is an insider of the debtor the transfer may be considered a preference if made within the one year period prior to bankruptcy. Under this scenario, the insider guarantor could be required to pay the bankruptcy estate any excess of the preferential payment over the amount that the lender would have received in a liquidation.

Navigating the rules surrounding preferential payments is complicated and these issues can arise in a number of different scenarios. The Troubled Credits practice group has substantial experience in navigating the potential pitfalls of workout transactions that occur prior to bankruptcy and in defending preference claims in bankruptcy. For more information on this Client Alert or for help evaluating your current situation, contact any of the attorneys in the Troubled Credits practice group (for a listing, click here).

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