Helping Suppliers Make Sense of the Bankruptcy Preference Law

By David Shaiken

Suppliers are very unhappy when they receive a demand from a bankruptcy estate to repay a preferential transfer. Here’s the scenario. A supplier sells to a customer who pays, but slowly. Then the customer files for Chapter 11 bankruptcy. The customer’s creditors’ committee is demanding that the supplier pay back the money it received from the customer during the 90 days before bankruptcy or else the committee is going to sue to get it back. How can this be when the supplier did nothing wrong and was paid for goods or services it supplied? This brief post won’t make the supplier happy, but it explains the rationale for the preference law.

We often think of bankruptcy as a debtor’s remedy, a way for insolvent companies to get protection from creditors. But the truth is that bankruptcy also protects creditors from each other. For example, once a company goes into bankruptcy all creditors are automatically stayed from taking collection action. One reason for the automatic stay of collection efforts is to prevent the piecemeal liquidation of the debtor, and to facilitate creditors’ sharing of the debtor’s assets and future income.

One purpose of the bankruptcy law is to treat creditors who are similarly situated the same in terms of the percentage that each recovers on its claims. So if there are $1 million dollars of unsecured nonpriority claims, and there are $100,000 of assets after paying secured and priority claims, each unsecured nonpriority creditor would get 10% of its claim paid.

The preference law is designed to answer the question, “As of what date should we look at what creditors are owed to determine how bankruptcy estate assets and future income are shared among the creditors?” One obvious choice is the date the debtor files for bankruptcy. For some purposes the bankruptcy filing date is precisely the choice Congress made. For example, claims are determined as of the bankruptcy petition date.

But choosing the petition date has some problems. If we use the bankruptcy petition date for all purposes, then creditors who are aggressive in the months leading up to the bankruptcy filing get rewarded, because they get more than those who were lenient and worked more cooperatively with the debtor. If you imagine 2 suppliers owed equal amounts of money, the aggressive creditor will be owed less on the bankruptcy petition date than the lenient creditor because the aggressive creditor collected more and maybe sold less to the debtor during the 90 days before bankruptcy.

Think of it this way: the aggressive creditor receives 100-cent dollars in the 90 days before bankruptcy, while the lenient creditor almost always is paid less than 100-cents on the dollar – often far less – and, as a result of the bankruptcy process, has to wait a long time to be paid.

To solve the problem of the disparity between the aggressive and lenient creditor, Congress created the preference statute (11 U.S.C. § 547). The purpose of the preference statute is to make it possible to determine the sharing of the debtor’s assets and future income as of 90 days before the bankruptcy petition date. The hope is that the preference law discourages suppliers from hounding a debtor into bankruptcy.

Under the preference law, a creditor who receives a preferential transfer must pay back what it received in the 90 days before bankruptcy, and then add that amount to the claim it files for what it is owed by the debtor. So, instead of collecting 100 cents on the dollar during the 90 days before bankruptcy, the supplier returns to the bankruptcy estate the 100-cent dollars it collected, and receives the same percentage on those dollars that all the other creditors receive.

Why make the determination as of 90 days before bankruptcy? Why not 100 days or 60 days? Under the Bankruptcy Act of 1898, the look-back period was 120 days. Congress shortened the preference period to 90 days when it passed the Bankruptcy Reform Act of 1978. The answer is that 90 days is arbitrary, but that is what the law has been since 1978.

There, didn’t that make you feel better? I thought not!