Making Sense of Preferential Transfers

By: Zachary McKay

Your oilfield service company provided $300,000.00 worth of goods and services to a struggling oilfield customer on credit. You billed the customer and about 45 days later, the customer paid in full. A month following payment, you find out that the customer filed for chapter 11 bankruptcy. It’s time for high fives all around, right? Not only did you get your company paid, but you also avoided the potential expense of navigating through a complex bankruptcy case with the ever-present possibility of little or no recovery. You close the file and move on. Almost two years later, you receive a letter in the mail:

Dear Sir or Madam:

This law firm represents the Trustee of the above-referenced Debtor’s bankruptcy estate. Pursuant to the United States Bankruptcy Code, the Trustee may avoid and recover certain payments made to or for the benefit of a creditor within 90 days of the Debtor’s bankruptcy petition date—in this case July 1, 2013. The Trustee believes that certain payments made to you by the Debtor are avoidable as preferential transfers pursuant to applicable bankruptcy law. The records of the Debtor reflect that you were paid the sum of $300,000.00 during the 90-day preference period. The Trustee hereby makes demand for payment of $300,000.00, which equals the amount the Trustee believes are avoidable preferential payments.

“What?” Your company did the work! There were no disputes! You took a risk working with a struggling entity! Isn’t that something we want to promote at a time like this? On top of that, you neither filed a mineral lien nor participated in the bankruptcy case in any way. Now, almost two years later, some “bankruptcy trustee” is telling your company that you have to pay the $300,000.00 back? This all seems unfair. All of these admittedly logical hair-trigger responses begin running through your head and you call your attorney, seeking an explanation. Your attorney is forced to give you the dreaded preferential transfer discussion.

We are having the preferential transfer discussion with more and more clients these days, and the explanation is becoming increasingly grim as the state of the oil and gas industry remains stagnant. In a time where every penny counts, your company may be liable to pay hard-earned funds back to a bankruptcy estate. It’s a hard pill to swallow. It will be equally hard to explain to your management, and it is sometimes near impossible to reconcile the apparent intent of the preferential transfer laws with the often-harsh outcome for creditors like you.

So what is a preferential transfer? Section 547 of Title 11 of the United States Code defines the type of transfer that is avoidable (recoverable) as a preferential transfer by the bankruptcy trustee:

…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…on or within 90 days before the date of the filing of the petition…and (5) that enables such creditor to receive more than such creditor would receive if…the case were a case under chapter 7 of this title….

11 U.S.C. § 547(a). Each of these elements and the corresponding preferential transfer defenses could be headliners of their own blog post, so I won’t get into them in too much detail.

In a broad, quick-hitting sense, a preferential transfer is a transfer of the debtor’s property (usually funds transferred via check or wire transfer), made when that debtor was insolvent, to a creditor for a pre-existing debt (think credit, as opposed to a cash in advance transaction), made within the 90 days prior to the filing of a petition commencing a bankruptcy case (or 1 year for debtor insiders), and which enables that creditor to obtain more than it would have otherwise received in a chapter 7 liquidation bankruptcy case. Since unsecured creditors are generally paid pennies on the dollar in chapter 7 bankruptcy cases, virtually any payment allows a creditor to receive more than they would have received under a chapter 7. Any transfer that meets all five elements in § 547 can be avoided and recovered from your company by the bankruptcy trustee.

Why does bankruptcy law allow this? The main purpose of recovering a preferential transfer is to support one of the basic and fundamental tenets of the United States bankruptcy system, which is to encourage and enforce equality of distribution among similarly situated creditors. The drafters of the Bankruptcy Code have determined that certain pre-bankruptcy transfers disturb this theme.

Among these are preferential transfers. In an effort to avoid transfers which are deemed to travel against the grain of creditor equality, the preferential transfer law allows bankruptcy trustees to recover money that was transferred just prior to the bankruptcy filing that should have been shared by all similarly situated creditors equally.

This is a harsh rule, but if your company were the unsecured creditor in a bankruptcy who expects to make pennies on the dollar in the final distribution, wouldn’t you want the trustee to go after an entity who was paid $300,000.00 just prior to the bankruptcy filing? Shouldn’t that money have gone into the bankruptcy estate, forcing that transferee entity to file an unsecured claim next to yours? The answer to both of those questions is likely, “Yes!” This is the public policy behind allowing and promoting the recovery of preferential transfers.

But what if I wasn’t favored or “preferred” by the debtor when it made the payment? Interestingly, the debtor’s intent when it made the transfer is not material in establishing a preferential transfer action. In fact, the debtor’s intent is nearly irrelevant. Instead, it is the actual effect and assumed impact of the transfer that is controlling when deciding whether or not a payment is deemed preferential and recoverable by the bankruptcy trustee.

Whether the debtor overtly or intentionally favored you or your company over other creditors (to maintain or cultivate a positive business relationship, for example), or you just happened to be the unlucky creditor to get paid during the 90-day preference period, the resulting bankruptcy effect was that other similarly situated creditors were not able to share in those funds. As you can imagine, that is a result that the Bankruptcy Code painstakingly seeks to avoid.

This sure generated a huge mess for me. Next time, should I reject a payment that I think will turn out to be a preferential transfer? Absolutely not! But this is a common question. The service company often attempts to weigh the effects of accepting a preferential transfer with the alternative of being able to file a mineral lien and participate in the bankruptcy as a possible secured creditor.

This one is simple. The best choice is always to accept the payment—preference or not. If you don’t, you are assuming the following things, several of which are inevitably false: (1) that the payment actually is a preferential transfer; (2) that the trustee will find out about it; (3) that the trustee will discover the correct amount that was transferred; (4) that the trustee will deem that amount worthy and economic enough to pursue; (5) that the trustee will follow up on the initial demand; (6) that the trustee will be unwilling to settle for less than a full repayment (almost always false); (7) that you will have absolutely no preferential transfer defenses available for you to further lower your exposure; and (8) that the mineral lien and bankruptcy claim will eventually hold value, among other things.

Those are a lot of assumptions. Let’s discuss an alternative. When and if the trustee shows up later, you can usually settle for much less than what is demanded even if all preferential transfer defenses are out of reach. The trustee will sometimes make an initial offer to settle the preferential transfer claim for as low as 80%, no questions asked. After all, this is a matter of efficiency and economics for the trustee as well. All of the sudden your $300,000.00 exposure has been lowered to $240,000.00, which generates a much smaller realized loss for your company. Plus you were free to use those funds to invest into other projects over the past two years, possibly generating further profits. These pros don’t completely eliminate the sting of getting burned by 80% of a preferential transfer claim, but in a time where every penny counts, taking the money can pay off big for you and your company.

Wait. There are defenses? Of course there are defenses available to you. We are definitely not implying that you should settle for 80% and be happy with it. When you bring your preferential transfer matter to us, we will be analyzing every defensive angle available, including the subjective and objective prongs of the ordinary course defense, the new value defense, and all other defenses provided under 11 U.S.C. §§ 547(c) and 550. It would be a near impossible task to cram all of those defenses into this single blog post, but I will be writing about each one in turn in the future. So be sure to check back in the future.

So what are the takeaways? Accept the money, preferential transfer or not. Remember that you might have generated some preference exposure, keep detailed records and invoices, and when the time comes to evaluate your defenses, give us a call.

Legal Tips for Startup Companies in Houston

By: Carl Doré

In a recent survey by Thumbtack, Houston was rated as one of the top cities in the nation for “friendliness to small businesses”. Accordingly, it’s no wonder Houston is such a popular place for startup companies.

We frequently have clients come to us with legal questions as they’re in the initial stages of starting their businesses, so we’ve compiled this “Legal Tips for Startup Companies” PDF to help. This brief guide for startups gives tips on what type of organizational entity to choose, available options for financing and funding, and what legal documents it’s important to have.

Check out the legal guide below and let us know what startup tips you’d recommend in the comments below!

Legal Tips for Startup Companies – Doré Law Group