Bankruptcy Update Blog

Non-Monetary Preferences

Most everyone who has been around the business and legal worlds for even a little while is familiar with the clawback by bankruptcy trustees of money that was paid by the debtor to creditors on the eve of bankruptcy.  We bankruptcy lawyers know this as the avoidance of preferential payments under Section 547 of the Bankruptcy Code.  Good credit and collection folks at our clients have developed an aversion to the word “preference” because they think the Code was deliberately designed to punish the diligent and reward the lazy (and, in a sense, they’re right).

Far less familiar, even to many lawyers, is the risk of avoidance of a preferential transfer of property other than money.  Section 547(b) of the Code targets “any transfer of an interest of the debtor in property” that is made “for or on account of an antecedent debt” and satisfies the other criteria of subsection (b) and is not protected by one of the defenses provided in subsection (c).  “Property” is far broader than money and can include virtually anything.

So when is property other than money transferred “for or on account of an antecedent debt” that could be at risk of avoidance in the event of a bankruptcy?  Here are two examples:

(1)  B Company and S Company enter into an asset acquisition agreement pursuant to which, at closing, B Co. will purchase an asset from S Co.  At the time of the signing of the agreement, B Co. makes a down payment of 50% of the agreed price and is obligated to pay the balance at the closing.  The down payment creates a debt of S Co. that is intended to be satisfied at the closing by the transfer of the asset to B Co.  When the closing occurs at some time thereafter and the asset is conveyed to B Co., a transfer on account of an antecedent debt has occurred (to the extent of the down payment) that is at risk of avoidance in a subsequent bankruptcy of S Co.

(2)  S Corp., a widget wholesaler, sells a large quantity of widgets to B Corp., a retailer, on 30-day credit.  On the payment date, B Corp. is unable to pay, so B Corp. and S Corp. agree that B Corp. will return the widgets to S Corp. for a credit against the unpaid price.  The return of goods for credit against the account payable for those goods is a transfer of property on account of an antecedent debt that is at risk of avoidance in a subsequent bankruptcy of S Corp.[1]

An example of the first kind of transaction is found in Thompson v. McMaster (In re Fritz-Mair Manufacturing Co.), 16 B.R. 417 (Bankr. N.D. Tex. 1982), in which the defendant prepaid the debtor for an oil-field pump jack, the subsequent delivery of which the bankruptcy trustee attacked as a voidable preference.  The defendant escaped with its pump jack, but only after proving at trial that it was protected by one of the defenses provided in Section 547(c).  In Danning v. Bozek (In re Bullion Reserve of North America), 836 F.2d 1214 (9th Cir.), cert. den. 486 U.S. 1056 (1988), the defendant was not so fortunate.  The defendant thought that he had purchased gold bullion from the debtor in exchange for a simultaneous payment of the cash purchase price long before bankruptcy.  However, due to the debtor’s fraud, the bullion was not acquired and delivered to the defendant until shortly before the commencement of the debtor’s bankruptcy case, and the defendant’s payment for the bullion had in fact been a prepayment.  The delivery of the bullion to the defendant was a transfer on account of an antecedent debt that had arisen at the time of the defendant’s prepayment to the debtor to which none of the defenses provided in subsection (c) applied, and the defendant was out of luck.

A return-of-goods preference is illustrated in Active Wear, Inc. v. Parkdale Mills, Inc., 331 B.R. 669 (W.D. Va. 2005), in which the debtor returned a large quantity of yarn it couldn’t pay for to the defendant, its supplier, shortly before bankruptcy.  The defendant’s liability was open-and-shut, and the only thing worth fighting over with the trustee was the amount of damages.[2]

The risk of avoidance of the conveyance of assets at the closing of a purchase (and related risks arising from transacting with a financially troubled counterparty) can be greatly reduced by careful transaction planning and document drafting, and the risk of avoidance of a return of goods can be controlled by measures taken at the time of the initial extension of credit and delivery of the goods or, much less effectively and certainly, at the time of the return of the goods.  Inattention to these risks until the trustee serves his summons and complaint is likely to result in litigation risk and expense that could have been prevented or substantially diminished.

 

[1]  Section 546(c) of the Bankruptcy Code creates a safe harbor of limited value for goods that are recovered pursuant to a reclamation notice that meets the conditions of that subsection and non-bankruptcy commercial law.  Other longstanding bankruptcy principles exempt a return of goods that are the seller’s collateral securing a fully secured debt.

[2]  The same outcome generally prevailed under the old Bankruptcy Act that was replaced in 1978.  Marks v. Goodyear Rubber Sundries, Inc. (In re M&R Plastic Co.), 238 F.2d 533 (2d. Cir. 1956)