When a borrower files for bankruptcy, it would be natural for lenders to feel relieved if their bank received loan repayments, collateral pledges, or proceeds of a property sale in the weeks or months before the bankruptcy filing. The bank would have seemingly avoided a potentially larger loss by receiving such a paydown or additional collateral for the debt shortly. But under federal bankruptcy law, a court may unwind such payments and transfers made in the months leading up to a bankruptcy, even those that appear routine, thus forcing a bank to return money or release collateral that it has legitimately received. The bank may have to defend against claims that the borrower gave such payments or collateral to the lender as a preference over other creditors.
This is the power of the preferential transfer avoidance action, a misunderstood and underestimated risk lenders face when debtors file for bankruptcy. Bankruptcy trustees and debtors-in-possession have broad authority to unwind transfers made to creditors before a bankruptcy filing and demand payment from such creditors. Lenders, who often maintain close, long-term relationships with their borrowers, are frequently targeted in this way precisely because those relationships may have led to what the Bankruptcy Code (U.S.C. Title 11) deems “preferential treatment.”
The preferential transfer avoidance power (codified at 11 U.S.C. § 547) is designed to ensure the equitable distribution of assets among similarly situated creditors. It is common for debtors in financial distress to favor certain creditors over others, in order to keep their operations going. An aggressive lender might pressure the debtor for repayment; a well-connected vendor might receive full payment while trade creditors go unpaid. Even debtors contemplating bankruptcy may pay certain creditors first, in order to preserve credit relationships that might be needed in the future. As a result of this preferential treatment, similarly situated creditors might receive disparate distributions, undermining the bankruptcy system’s goal of fairness. The Bankruptcy Code allows a bankruptcy trustee, or at times a Chapter 11 “Debtor-in-Possession” (when the bankrupt debtor retains control of its assets), to recoup these payments through court action.
To establish a preference claim under 11 U.S.C. § 547(b), a bankruptcy trustee or debtor-in-possession must prove five elements. First, there must have been a transfer of an interest in property of the debtor. Second, the transfer must have been made to or for the benefit of a creditor. Third, the transfer must have been made for or on account of an antecedent debt, meaning that the debt pre-existed the payment. Fourth, the transfer must have been made while the debtor was insolvent. Fifth, the transfer must have been made within the applicable lookback period and must have enabled the creditor to receive more than it would receive in a Chapter 7 liquidation had the transfer not been made.
The length of the lookback period is critical. For ordinary creditors, the lookback period is 90 days prior to the bankruptcy filing date. For insider creditors (e.g., officers, directors, and certain relatives of the owners of the debtor), the lookback period extends to one year. The distinction is a significant benefit for banks, which are almost never classified as insiders, but should be alert to situations where loan transactions are structured through or alongside insider relationships.
With regard to non-insider transfers, insolvency is presumed during the 90-day period immediately preceding the bankruptcy filing. This means the bankruptcy trustee does not have to prove that the debtor was insolvent at the time of the transfer. Rather, the burden shifts to the creditor to prove that the debtor was solvent at the time of the transfer.
Payments On Term Loans Or Revolving Lines Of Credit
A common scenario is one where a commercial borrower makes regularly-scheduled principal and interest payments to a lender on a term loan within 90 days of the bankruptcy filing. Those payments are facially preferential, because they were transfers of property from the debtor to the lender, made for an antecedent debt, during the preference period, and allowed the bank to recover more than it would have as an unsecured creditor in a liquidation. In this situation, after the business files for bankruptcy, the bankruptcy trustee reviews all payments made within the previous 90 days and will make demand on the lender for return of the preferential payments and, absent a negotiated resolution between the trustee and the lender, the trustee may sue the lender to recover such payments.
In this scenario, the bank may invoke the so-called “ordinary course of business defense” under
11 U.S.C. § 547(c)(2). This defense protects transfers made in the ordinary course of business of both the debtor and the bank. A court will examine whether the payments deviated from the historical pattern of dealings between the parties. For example, a borrower who always paid on the 15th of each month and continued to do so during the preference period presents a strong ordinary course of business defense. Whereas, a borrower who received repeated default notices and then made a large lump-sum payment at the bank’s insistence presents a weak one. The key to a successful ordinary course of business defense is the ability of the bank to show a continuous pattern of conduct starting before the preference period and continuing until the bankruptcy filing. It requires careful documentation on the part of the bank, including regular statements and written communications with the debtor.
When preference claims involve revolving lines of credit, the bank’s defenses become more challenging. With a revolving line of credit, the borrower often draws down on the line of credit and then may make intermittent repayments of the advances as part of normal business operations, but not pursuant to a set payment schedule that would be required for a term loan. In such cases, some courts apply a “net result rule”, looking at whether the bank’s position improved on a net basis during the 90-day period compared to the bank’s and debtor’s prior course of dealing. If the debtor drew down the line of credit multiple times and repaid multiple times, the alleged preference amount would be the net increase, if any, in such repayments made during the preference period rather than the gross repayments made during such time. However, in some jurisdictions, the courts focus on each individual transfer, making revolving facilities a frequent source of litigation. Unfortunately, although the net result rule appears favored in Massachusetts, the absence of applicable precedent in Massachusetts means that an aggressive bankruptcy trustee may nonetheless seek to recover preferential payments if the net result rule would result in no recovery from the lender.
In applying the net result rule, a bankruptcy trustee would consider whether the lender demanded a full or partial paydown or refused to allow new draws while accelerating repayments during the preference period. Those actions would be seen as occurring outside the ordinary course of business, triggering increased scrutiny and likely a demand by the trustee. What appears at the time to be a prudent reduction in the lender’s exposure, may lead to litigation or disgorgement later.
Preference Claims Involving Collateral
A “transfer” under the Bankruptcy Code is broadly defined to include both the voluntary and involuntary movement of property or assets of the debtor. The granting of a lien and its perfection, setting off cash on deposit, or the foreclosure or repossession of collateral all constitute transfers that may be unwound if undertaken during the lookback period.
Whether a transfer of property is deemed to be preferential turns on the relationship between the value of the collateral recovered and what the bank would have received in a Chapter 7 liquidation. If a foreclosure or repossession recovers more than what would have been recoverable by the lender in a Chapter 7 case, the transfer is deemed preferential and avoidable. An example of this would be if a lender has two loans, one secured, another unsecured. If the lender sells property at auction for more than the secured loan’s balance, any funds retained to pay the unsecured loan constitute a preferential payment because the unsecured loan would not have been repaid from those proceeds (i.e., such proceeds would instead have been allocated to other secured creditors, or divided amongst unsecured creditors, etc.) if the sale was conducted in the context of a Chapter 7 liquidation.
Another type of transfer subject to unwinding and which is unique to banks is a setoff of funds on deposit to pay down a loan. If a bank sweeps deposit accounts, freezes and sets off balances, or exercises contractual setoff rights within the 90-day lookback period, a bankruptcy trustee will often demand turnover of the funds. In fact, bank setoffs are often the triggering event that forces a company into bankruptcy, because the debtor no longer has working capital to continue operations. Although it is a powerful tool to recover funds with minimal effort, a bank setting off accounts needs to understand that such recovery may only be temporary if the debtor files bankruptcy within 90 days thereafter.
One of the more technical but significant preference claims involves the late perfection of a security interest. Under the Bankruptcy Code, a transfer not involving real estate is deemed to occur not when the debtor signs its security agreement, but when the UCC financing statement is properly filed. If the lender files a financing statement within the 90-day preference window, the security interest may be voided as a preference even if the security agreement was signed months or years earlier. The trustee recovers the collateral or its cash equivalent, and the bank is left with an unsecured claim. This also applies when a lender discovers an error in its UCC filing and tries to correct it during the lookback period or after the bankruptcy filing.
How To Minimize Risk
Lenders can take meaningful steps to reduce their preference exposure and strengthen their litigation position if a preference claim is ever asserted.
First, banks should maintain comprehensive payment history records for all commercial borrowers including how payments are applied. The ordinary course of business defense relies on the ability to demonstrate consistent payment patterns over time. Banks should retain sufficient historical data to establish the baseline against which preference-period payments will be compared.
Second, UCC financing statements should be filed promptly, ideally on the date of loan closing. Banks should also perform periodic audits of their UCC financing statements to identify errors and discover any lapses in perfection.
Third, lending officers and workout personnel should know how to recognize potential preference exposure as they manage distressed borrower relationships. The instinct to accelerate repayment, freeze lines, and collect collateral is understandable, but each of those actions may increase the risk of potential preference liability if a borrower subsequently files for bankruptcy. In cases where agreements are entered into requiring payments outside of the ordinary course, or waivers by the bank, claw-back provisions should be added to ensure that any funds lost because of a preference claim are restored to the loan balance.
Lastly, banks should consult with bankruptcy counsel early in any workout situation, not after a bankruptcy filing has occurred. Early legal advice can help structure workout arrangements to maximize available defenses and minimize exposure.
This communication is for informational purposes only and is not legal advice on any specific facts or circumstances. In addition, the firm undertakes no obligation to update the information discussed in the foregoing article.