This is the second in a series of blog posts I am writing here about preference lawsuits (I have a 50 page research treatise that I wrote, from which I am pulling to create these posts!). I will try to make the subject matter as interesting as possible.
Does the motive of a debtor a creditor matter in a preference law suit?
Scenario One: I know our business is not going to make it another 30 days. I have one $10,000 receivable that we can expect to receive. We owe our trade creditors about $100,000 and we owe my Aunt Molly $50,000 that she lent to us on an unsecured basis. We have been making monthly payments in the amount of $500 to her for the past three years. I want to take the $10,000 once we get it and pay her all of it because she is my favorite Aunt, I feel bad we are going to stiff her, and she use to buy me pink marshmallow peeps for every Easter.
Scenario Two: My critical supplier knows that we have been in distress. He knows that we lost our biggest customer and we are barely making ends meet. He just recently shortened my payment terms from net 30 to net 7, he has told me he doesn’t care if I cannot pay my electric bill or payroll and that he wants me to pay his aged account receivable now! He sends me threatening letters, emails, and nasty voicemail messages. I don’t even answer my phone anymore.
As set forth in my prior blog post, there are the five basic elements of a preference; basically, a transfer must be made (1) to or for the benefit of a creditor, (2) on account of an antecedent debt, (3) while the debtor is insolvent, (4) within ninety days before bankruptcy (for non-insiders) or 1 year (for insiders); and (5) the transfer must enable the creditor to receive a greater amount had the transfer not occurred and had the creditor received payment in a hypothetical Chapter 7 liquidation.
What is absent from that list is mental state of mind, motive, or intent. Under the predecessor statute to Bankruptcy Code § 547 (§60 of the Bankruptcy Act of 1898), a plaintiff had to establish that the creditor had “reasonable cause to believe” that a debtor was insolvent before a preferential transfer could be avoided. But, importantly, a creditor’s state of mind is no longer an element to the preference cause of action. See Barash v. Public Finance Corp., 658 F.2d 504, 510 (7th Cir. (Ill.) 1981). In the Barash case, the Seventh Circuit Court of Appeals held that voluntary payments by a debtor to creditor on an installment contract were preferential transfers, and the fact that the creditor had no way of knowing that the debtor was having financial difficulties was irrelevant. The Barash Court quoted the legislative notes regarding Bankruptcy Code § 547: “A creditor’s state of mind has nothing whatsoever to do with the policy of equality of distribution ….”. H.R.Rep.No.95-595, supra, at 178, 5 U.S. Code Cong. & Admin. News at 6139.
Collier on Bankruptcy, the most authoritative secondary authority on bankruptcy law, acknowledges this change as well. “Intent or motive is not a material factor in the consideration of an alleged preference under §547. Generally speaking, it is the effect of a transaction, rather than the debtor’s or creditor’s intent, that is controlling.” See 4 COLLIER ON BANKRUPTCY, ¶547.01 at 547.12.
Some courts, however, have attached a significance to the intent, motive or state of mind of either the debtor or a creditor, even though intent is not a “material” or a basic element of a preference,. In the Eleventh Circuit, for example, see In re Craig Oil Co., 785 F.2d 1563 (11th Cir. (Ga.) 1986)). The Craig Oil Court held that a pre-Petition payment was a preference, attaching significance to fact that debtor’s motive for making a payment to a creditor was to forestall an involuntary petition and to prevent personal liability on guaranteed debt, but observing that state of mind of the debtor alone, would not establish unusual or extraordinary actions by the debtor, but merely would go to explain unusual payment actions by debtor. Also, in the First Software Corp. v. Micro Educ. Corp. of Amer., 103 B.R. 359 (D. Mass. 1988), the United States District Court for Massachusetts held that payments made by a debtor under an agreement with a creditor were not preferences. The debtor agreed to make larger weekly payments to a creditor until the balance on the account was reduced to zero. The Court held that the transfers were within the ordinary course of business (and not preferences), where there was no evidence that indicated that the creditor knew that the debtor was on the verge of bankruptcy when the payments at issue were agreed upon and made.
I have had cases in which my creditor clients were guilty of making dunning phone calls to the debtor prior to company’s slide into bankruptcy. I have also had cases in which my client was a critical supplier and it wanted to keep servicing the debtor during the time of distress. Often, at moments like that, new deals are struck in order to keep the debtor afloat and the supplier still dealing with the debtor. Perhaps, the supplier is owed a substantial amount of money from the debtor and the supplier is willing to do anything to keep the debtor as a going concern; otherwise, the supplier faces the threat of its own bankruptcy.
Although the intent, mens rea, state of mind, motive of either the debtor or the creditor is no longer a prima facie element to a preference action, when I conduct diligence surrounding an alleged preferential transfer I always ask the necessary questions to get a better understanding of what was really going on in the business relationship as the debtor became unable to pay its debts as they came due. Asking these questions is important in order to paint an accurate picture of the course of dealing between the parties and how such dealing may have changed prior to the filing of the case.
I often advise the credit risk groups of all of my clients always to have a pulse on the financial condition of their clients, especially if a client generates revenue from only a handful of customers. I even advise my clients to put “google alerts” on each such client so that they can catch wind of any distressed circumstances.
Without a doubt, a business should be strategic when dealing with a distressed client, especially if there is a significant amount owed, and especially if you are striking a new deal with the debtor with changed terms. Even if you are paid in the year or 90 days prior to your customer’s bankruptcy filing, you always run the risk that the payment will be clawed back post-Petition. You should be prepared for what defenses you will mount in the event that happens.
MAZURKRAEMER represents debtors and creditors in bankruptcy courts all over the country. The information, comments and links posted on this blog do not constitute legal advice. No attorney-client relationship has been or will be formed by any communication(s) to, from or with the blog and/or the blogger. For legal advice, contact an attorney at MAZURKRAEMER or an attorney actively practicing in your jurisdiction.