Preferential Transfer Actions

The bankruptcy lawyers at Mark Anchor Albert and Associates are well-versed in prosecuting and defending against preference actions.

Under section 547(b) of the Bankruptcy Code, the trustee, debtor-in-possession, or other authorized plaintiff must provide undisputed evidence establishing the debtor’s interests in the property transferred and that the transfers of those interests 1) were for the benefit of a creditor; 2) were on account of an antecedent debt; 3) were made while the debtor was insolvent; 4) were made within 90 days of debtor’s bankruptcy petition; and 5) would allow the receiving creditor to receive more than it would under a chapter 7 liquidation without the transfer. 11 U.S.C. § 547(b). To succeed on preferential transfer avoidance claims, the trustee, debtor-in-possession or other authorized plaintiff must provide evidence establishing each element of a preferential transfer under section 547(b) of the Bankruptcy Code.

Section 547(e) of the Bankruptcy Code governs whether or not a transfer is made within the 90 day preference period. According to its terms, for avoidance purposes, a transfer is made:

(A) at the time such transfer takes effect between the transferor and the transferee, if such transfer is perfected at, or within 30 days after, such time;

(B) at the time such transfer is perfected, if such transfer is perfected after such 30 days.

11 U.S.C. § 547(e)(2)(A) and (B).

Under this definition, a transfer is not necessarily “made” at the time that the debtor completes an effective transfer to the intended transferee. Instead, the Bankruptcy Court must also consider when the transfer is perfected to determine whether the effective date or the perfection date will control. Under Section 547, perfection depends on whether the transfer involves real property or not. A transfer of real property is perfected when “a bona fide purchaser of the property cannot acquire an interest that is superior to the interest of the transferee.” Id. at § 547(e)(1)(A). The transfer of something other than real property is perfected when “a creditor on a simple contract cannot acquire a judicial lien that is superior to the interest of the transferee.” Id. § 547(e)(1)(B). State law determines when it is no longer possible to gain a superior interest. See In re Lewis W. Shurtleff, Inc. (9th Cir. 1985) 778 F.2d 1416, 1420.

The determination of whether a debtor is insolvent at the time the disputed preferential transfers were made typically is made using three interrelated tests: (1) an adjusted balance sheet test (the “Balance Sheet Test”) to determine whether the sum of the debtor’s debts exceeds the value of its property (assets), at fair valuation; (2) an inability to pay debts as they become due test (the “Cash Flow Test”) to determine whether the debtor incurred debts that were beyond its ability to pay as the debts matured; and (3) an insufficient capital or assets test (the “Capital Adequacy Test”) to determine whether the debtor incurred debts that were beyond its ability to pay as the debts matured.

The Balance Sheet Test, which seeks to determine whether the Debtor was insolvent at the time of the transfers or as a result of such transfers, is reflected in Bankruptcy Code sections 548(a)(1)(B)(ii)(I) and 101(32), which define insolvency as a financial condition such that the sum of a Company’s debts is greater than all of such Company’s property at a fair valuation, exclusive of any property fraudulently transferred. Under the Balance Sheet Test, as the name implies, courts have made the insolvency determination simply by reviewing and analyzing a corporation’s balance sheets placed into evidence.

The Cash Flow Test, sometimes also called the “Equity Test,” is reflected in Bankruptcy Code section 548(a)(1)(B)(ii)(III), which defines a form of financial distress where a company intended to incur debts that would be beyond a company’s ability to pay as such debts matured. The Cash flow test also is reflected in California Corporations Code section 501, which states that a corporation is insolvent when it is “likely to be unable to meet is liabilities ... as they mature.” The Bankruptcy Code employs the same test in determining grounds for an involuntary bankruptcy under 11 U.S.C. § 303(h)(1).

Finally, the Inadequate Capital Test is reflected in Bankruptcy Code section 548(a)(1)(B)(ii)(II), which defines a form of financial distress where a company is left with unreasonably small capital to conduct future business.

Bankruptcy litigation issues involving preferential and fraudulent transfers often turn on the question of whether the debtor actually was insolvent during the applicable transfer period under the Cash Flow Test, the Balance Sheet Test, or the Capital Adequacy Test. The debtor’s internal financial and accounting records, particularly its balance sheet, income statement, and statement of cash flows, should be examined during the relevant time period to assess the debtor’s financial strength. Expert testimony may be required.