The COVID-19 pandemic and extraordinary governmental response in hopes of containing it, including the forced closure of tens of thousands of “non-essential” U.S. businesses, have inflicted unprecedented harm on our economy. Some analysts project double-digit contractions of U.S. gross domestic product over each of the next two quarters, with unemployment rates and unemployment insurance claims spiking to levels unseen since the Great Depression.

Despite equally unprecedented emergency relief measures—e.g., the newly enacted $2 trillion Coronavirus Aid, Relief and Economic Security Act and the Families First Coronavirus Response Act hurried to President Trump’s desk just two weeks before—in the absence of “cool heads” and general marketplace cooperation, it seems inevitable many businesses will fail. A spike in commercial and personal bankruptcies will surely follow.

Given this grim reality, many creditors will likely do all they can to aggressively collect debts thinking, like hoarders dashing through Costco, to get what they can while they can. However, once a squeezed debtor declares bankruptcy the question soon will follow … did this really help?  In many instances, the answer will be a resounding “no.” This is because the aggressive creditor who successfully jumps ahead of others waiting to be paid will likely find itself served with a complaint or “mini-lawsuit” in the debtor’s bankruptcy action.  In that mini-lawsuit, the bankruptcy trustee or Chapter 11 debtor-in-possession will demand that the creditor give back, or “disgorge,” some or all of the money it received as a “avoidable” preferential transfer.  

Here’s why:  

When a bankruptcy petition is filed, a bankruptcy estate is created, consisting of all of the debtor’s nonexempt property as of the time of the bankruptcy filing. In a bankruptcy proceeding under Chapter 7, a bankruptcy trustee is appointed to “marshal” the debtor’s assets – that is, identify, gather and collect them for equal distribution among creditors.  (In a Chapter 11 bankruptcy proceeding, the debtor itself may function similarly to a trustee.)

The Bankruptcy Code serves two basic functions: to afford honest but unfortunate debtors a chance for a “fresh start,” and to promote an equal distribution of a distressed debtor’s assets among similarly situated creditors.” (5 Resnick & Sommer, Collier on Bankruptcy, ¶541.01; see In re Arnold, 471 B.R. 578 (Bankr. C.D. Cal. 2012).) “Bankruptcy is designed to provide an orderly liquidation procedure under which all creditors are treated equally.  A race…by creditors for the debtor’s assets prevents that.” (Benedor Corp. v. Conejo Enterprises (In re Conejo Enterprises), 96 F.3d 346 (9th Cir. 1996).)

One mechanism the Bankruptcy Code uses to avoid a “race” among creditors to get paid is the power to “avoid,” or invalidate and require the return to the estate of, “preferential transfers.”  Under Section 547 of the Bankruptcy Code, a bankruptcy trustee has the power to invalidate as “preferential” any transfer made by a debtor within 90 days (or up to one year, in the case of transfers to insiders) of the bankruptcy petition date, when the transfer is made to or for the benefit of a creditor, for or on account of an antecedent (pre-existing) debt, and the transfer resulting in the creditor receiving more than it would have otherwise received, in a Chapter 7 liquidation, had the transfer not been made. (11 U.S.C. § 547(b).)

The purpose of Section 547 is to discourage creditors from racing to dismember a debtor during its slide into bankruptcy and to further the prime bankruptcy directive of equal distribution among similarly situated creditors. (Valley Bank v. Vance (In re Vance), 721 F.2d 259, 260 (9th Cir. 1983). In plain English, this means when a distressed debtor’s bankruptcy is imminent, creditors can’t push to the front of the line at other creditors’ expense; all creditors must be treated alike and, if there are insufficient exempt assets to pay all the creditors in full, each must share equally in the reduction of their claims. 

There are defenses to preference, including contemporaneous exchange (for example, when a supplier of goods who is owed money from prior transactions is paid for a later shipment at the time of delivery), new value (such as when a creditor who is owed money advances additional credit after receiving an otherwise-avoidable payment within the 90 day window), and ordinary course of business.

This last defense is probably the most important, as it is what shelters ordinary trade credit transactions. If a payment by a debtor is made in the ordinary course of business or financial affairs of the debtor and transferee, or according to ordinary business terms, the trustee may not avoid it. (11 U.S.C. § 547(c)(2).) To give a simple example, if it is customary for a particular debtor to pay a particular creditor on 30-day terms, and a bill was made within 30 days as usual, the payment will not be deemed a preference even if the money changed hands less than 90 days before the debtor filed bankruptcy. 

Even, however, if a creditor has a legitimate defense, the creditor bears the burden of proving it. Generally, this means to fight a preference claim the creditor must pay for competent legal counsel to marshal proof of that defense, attend court proceedings and be prepared to “go to trial.” Depending on the size of the claim, sometimes this “cure” can be more costly than the money at stake.

Bankruptcy trustees are compensated by fixed fees and a “commission” on a debtor’s assets distributed to creditors. In practice, therefore, the first thing trustees often do is carefully review the debtor’s financial records over the 90 days before bankruptcy. If any particularly large or unusual payments stand out, the creditors who received them are likely to find itself embroiled in costly legal proceedings.

In summary: When a debtor shows signs of financial distress, it may be tempting to race to collect past-due debts, and even ask for advance payments, while the getting is good. However, this approach may be counterproductive. A “run on the debtor” by multiple creditors thinking the same thing, particularly in a time of crisis, may push it over the brink into bankruptcy when the debtor might have otherwise survived to pay another day. If this occurs within 90 days of a payment, the creditor who thought it got “a leg up” is apt to get a nasty legal surprise.

Author: Thomas J. Eastmond, Associate, Enterprise Counsel Group