Bankruptcy 101— The Impact Of Section 547 Of The Bankruptcy Code (11 U.S.C.§547) On Secured Creditors.  

Most lenders who take liens on the assets of a borrower are aware that they must perfect their liens under State Law. Many lenders are aware that the Bankruptcy Code gives a Trustee in Bankruptcy and a Debtor In Possession under a Chapter 11 Reorganization some extraordinary powers called “Avoiding Powers”. This post is just a refresher on how the concept of a Preference under the Bankruptcy Code (11 U.S.C. §547) creates some important challenges for secured creditors.First off—What is a Preference and why does it exist in the Bankruptcy Code. Congress when it enacted the Bankruptcy Act of 1898 and in each iteration of the Bankruptcy Act and now the Bankruptcy Code has always had the concept of a Preferential Transfer. The basic philosophy is to set a period of time during which transfers to creditors of the Debtor prior to the filing of Bankruptcy can be recovered by the Trustee in Bankruptcy to create a “level playing field” for creditors, hence the name Preference to prevent one creditor being preferred over another creditor.

In Its Current Form A Preference Is:

  • A transfer of property by a Debtor to a Creditor;
  • In payment of an existing debt (called an antecedent debt);
  • Made by the Debtor to the Creditor during the 90 days prior to filing of bankruptcy[1];
  • While the debtor is insolvent[2];
  • That allows the Creditor to receive more than the Creditor would have gotten in the liquidation of the Debtor.

There is a presumption of insolvency of the debtor in the 90 days prior to Bankruptcy, which means it is up to the Creditor receiving the transfer to prove the Debtor was not insolvent when the Creditor received the transfer.

What Happens If The Creditor Receives A Preference. If the elements of the Preference are proven in a proceeding in the Bankruptcy Court, the Creditor has to return the transferred property or the value of the transferred propertym if not cash, to the Trustee in Bankruptcy or if a Chapter 11 Reorganization the Debtor in Possession. The Trustee or Debtor in Possession must bring an action in the Bankruptcy Court to recover and the Creditor has the right to raise one of the many defenses set out in 11 U.S.C. §547.[3]

What Does This Have To Do With Secured Creditors Such As ABL Lenders?
Here is the big catch–the grant of a lien or security interest is considered a transfer under the Preference statute. Therefore, the Unsecured Creditor who is granted a lien by the Debtor during the 90 days prior to the filing of bankruptcy to secure a debt incurred prior to the grant of the lien is likely to be a preferential transfer. Naturally as with most laws, there are a number of exceptions to this rule.

Most Common Exception That Applies To Secured Creditors. The most common exception arises if the Lender has advanced funds to the debtor during the 90 days prior to the filing of the bankruptcy and received a lien in exchange for that advance. As long as the lien only secures the so-called new money and not an older debt, then it is not a preference. The lender also gets credit for advances made in the period after the grant of a lien within the 90 days before the filing of a Bankruptcy. However, if the lien covers older debt that was unsecured, the lien would be a Preference as to that older unsecured debt (even though secured under the new security agreement).

The Impact of Failing to “Perfect” A Lien. One of the biggest problems for Secured Creditor is the timing of the “perfection” of a lien granted to secure a Loan. In all 50 states, in order for a lien to be effective against a third party creditor certain rules have to be followed (such as filing a Financing Statement or recording a Lien). If the lien is not perfected under state law, the Lender is just an unsecured creditor after the filing of the Bankruptcy and cannot fix the problem. In addition, if a loan is made and the lien is perfected within the 90 days prior to the filing of the Debtor’s Bankruptcy, it may be a preference unless the lien was perfected within 30 days of making the loan. I had a situation in which the debtor’s counsel volunteered to file the necessary lien (before the days of online filing) and the debtor promptly filed for bankruptcy after only 60 days. At first I thought, my client was sunk, fortunately, the debtor’s counsel had filed 19 days after the Loan was made and the preference was avoided.

Another situation may arise if the Lender either fails to perfect the lien or does not perfect the lien properly. If the 30 days grace period has passed from the date of the original Loan, if the Lender perfects or corrects the perfection of the lien within 90 days prior to the Debtor filing for Bankruptcy the lien can be avoided. This is the kind of situation that should not exist in this day of on line filing, but it still occurs from time to time.

Just To Make It Interesting A Special Rule For ABL Lenders And Certain Factors. Just to be even more confusing, there is a special section of the preference statute just for Asset Based Lenders or Factors that are lending to the Debtor under a Borrowing Base Formula (and not buying the accounts outright with each advance).

  • Lets assume the ABL Lender perfects its lien under a Revolving Line Of Credit secured by receivables and inventory more than 90 days before the filing of Bankruptcy by the Debtor. No problem with your security interest per se.
  • However, under Section 547(c)(5) of the Bankruptcy Code (11 U.S.C. §547(c)(5)), the Trustee in Bankruptcy or the Debtor in Possession in a Chapter 11 Reorganization may still be able to claim a Preference under the following circumstances:>

If the value of receivables and inventory securing the loan on 90th day prior to the date the Bankruptcy is filed exceeds the Loan outstanding (not the advance rate, but rather the actual value of such collateral) then no Preference exists.

If the value of such collateral does not exceed the Loan outstanding on that date (a real deficiency not just an overadvance under the Borrowing Base Formula) and on the date of the filing of the Bankruptcy the value of the receivables and inventory securing the Loan exceeds the Loan outstanding, then the amount by which the Lender “improved its position” is a preference and must be disgorged, but only if it allows the Lender to receive more than the Lender would have gotten in liquidation of the Debtor.

Confusing So Here Is An Example:

  • On the 90th day prior to bankruptcy the loan was $1,000,000 and the real value of the collateral was $900.000 therefore there was a $100,000.00 actual deficiency.
  • On the date of filing the loan is $900,000 and the real value of the collateral is $800,000. Since the Lender’s deficiency is still $100,000 there is no preference.
  • But if on the date of the filing of the Bankruptcy the loan is $800,000 and the real value of the collateral is $800.000, then there is a $100,000 preference, because the Lender’s overall position has improved by $100,000 by wiping out the deficiency that existed on the 90th day prior to Bankruptcy.
  • If the lender makes a loan within the 90 days then the time to measure the deficiency is the date the loan was first made and hopefully a lender will not start with collateral and the loan amount being upside down.

IMPORTANT ADVISE. This Blog Post is meant to alert Lenders to a potential problem and Debtors to a potential avenue for recovery, BUT UNDER NO CIRCUMSTANCES SHOULD EITHER LENDER OR BORROWER TAKE ANY ACTION BASED SOLELY ON THE SUMMARY CONTAINED IN THIS BLOG POST. IF YOU THINK ANY OF THE FORGOING APPLIES TO YOU, CONSULT YOUR BANKRUPTCY ATTORNEY AS SOON AS POSSIBLE. THE FORGOING IS ONLY THE HIGHLIGHTS AND AS WITH ALL BANKRUPTCY ISSUES, THE DEVIL IS IN THE DETAILS. WITH THAT SAID I HOPE YOU FIND THIS BLOG POST HELPFUL.

This period is extended to 1 year for insiders, but more on that in a later post.
Generally, the Debtor has less assets then liability or an inability to pay its creditors in the ordinary course of business.
[3] To keep this post under 100 pages I am not going to discuss all of the defenses just a few that apply to secured creditors.


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