Bankruptcy Outline Focus on commercial insolvency not consumer area

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Bankruptcy – Outline

Focus on commercial insolvency not consumer area

He assuming we will all become business lawyers of some kind, not bankruptcy lawyers

Course designed for business lawyers – transactional or litigators

Not policy oriented really – mostly dealing with the code

A lot of time spent on code method
Open book exam so it is about understanding how things work

Basic course – he is assuming we know nothing

Participation points are given
Bring a name card
Final is four hours long – essay

One hour is for reading, three hours is for writing

Allows for emailed questions – uses the email listserv
What would it be like if there was no bankruptcy?

The judgment against you continues forever, and people become very risk averse

Bankruptcy discourages grabby behavior, in theory it also preserves the going concern value of the entity, especially Chapter 11 (this is for everyone’s benefit, the creditors and employees)

Grabby behavior – not only on the art of the creditors, but also on the insiders, the people running the company  they steal basically

Timeline of bankruptcy

Debtor entity (dr) starts to fail over time  bankruptcy petition is filed  voluntary and involuntary petitions (do not file involuntary petition unless you know they are really bankrupt = if you are wrong, you could be liable for damage). Chapter 7 and Chapter 11 voluntary petitions

Chapter 7 is a liquidation  most companies should file this

Chapter 11 petitions  reorganization (90% of these all fail). Why do companies file this when they shouldn’t = false hope (good faith but just false) but really it is filed strategically, the company knows it cannot get back on its feet, but it is a long drawn out affair. Creditors hate Chapter 11.

Third party trustee is appointed for Chapter 7

Debtor in possession, administers the reorganization on behalf of the creditors while also reorganizing itself – Chapter 11.

The trustee and the DIP have to engage in all kinds of conduct

Duties of the trustee and DIP

Avoidance  undoing the bell, nullify certain transactions

Preferences  pay offs of old debts

Fraudulent transfers  stealing

Strong-arm powers  secret unrecorded liens

Objections to claims  potentially bogus claims – limit the number of folks trying to get paid by the debtor

Automatic stay  everything is supposed to come to a halt, the estate could be a plaintiff and defendant in some lawsuits, the trustee may have to prosecute or defend those actions.

Executory contracts  there are provisions in the bankruptcy code that allow the estate to get out of contracts, assume or reject

Process of reorganization under Chapter 11 – how to put together a plan, obtain confirmation of the plan, voting rights, distributions after Chapter 11.
Preference statutes

Operative statute is § 547(b) – trustee or DIP may avoid any transfer of an interest of the debtor in property:

(1) To or for the benefit of the creditor (indirect preference)

Ex – personal guaranty by shareholders of company to a supplier, becomes secondarily liable to the supplier, so shareholder has a contingent right of reimbursement by the corporation, just before going bankrupt, the company pays the supplier, should extinguish the guaranty – so for the benefit of the shareholder who was a creditor. Trustee would try to go after the shareholder, to get back the value of the guaranty, even though the shareholder didn’t get any money.

  1. For or on account of an antecedent debt owed by the debtor before such transfer was made (was this a payment on an old debt)

  2. Made while the debtor was insolvent (were your debts greater than your assets)

  3. Made
    1. Within 90 days of bankruptcy filing

    2. Between 90 days and one year before the date of filing if such creditor was an insider

  4. that enables such creditor to receive more than such creditor would have received – preferential – if

    1. the case were a case under Chapter 7

    2. the transfer had not been made

    3. and such creditor received payment of such debt

    4. if yes, then 5 is satisfied – Ex: oversecured creditor  dr has a 1 million debt to the lender, lender has a lien on the assets, assets are worth 1.5 million so the creditor is oversecured. Then the dr makes a payment of 100k. what result? Could that be preferential? Probably not because if we have an oversecured creditor, it would have been paid anyway, so who cares  NO HARM NO FOUL, THEY WERE NOT MADE BETTER OFF – this is scenario under which (b)(5) was written.

Problem p. 325

  1. Part A = march through 5.47(b) of the code. Plod through each step, be systematic. There are six (five plus preamble) requirements under the section – (1) transfer of debtor’s property  YES. (2) benefit directly to creditor  YES. Section 101.10. Creditor has a claim against the debtor. Well claim is a defined term as well. (3) antecedent debt  YES. (4) insolvent – defined under 101.32 Insolvent – means with reference other than partnership, sum that debts are greater than sum of entities property, balance sheet test. Who has the burden to prove that Smith was insolvent? 547(f). there is a presumption of insolvency, not an irrebuttable. If debtor was solvent when you got preference, then maybe trustee will go away. (5) time line – no facts in indicate that person was an insider. Figure out date of bankruptcy. Every month has thirty days – so preference window opens on 4/15. Satisfied here because made within 90 days of filing. (6) fantasy world – if this were a Chap 7, undo the transfer, and creditor got the dividend. Did the creditor get more than it should have received by getting the payment, than otherwise if it has been a liquidation and got the dividend?  YES. Trustees case in chief has been satisfied. Can the amount be recovered? See 550(a)(1). Puts teeth on 547.

Part B – debtor did not transfer anything – it is a prejudgment attachment lien. Debtors will often file bankruptcy petitions within time, to avoid the prejudgment debt. So it is a transfer and everything else is the same as above

  1. Problem 2. Why undo preference if bank would have gotten that much in bankruptcy. So undo the payment in full.

Case came down last year – u/s on date of payment, o/s on date of bank, yet payment was still preferential  why? Added 300 k to 900 K – Falcon Products case (8th Cir)

547(e)(2)(a) – “made” is a defined term  the moment it becomes enforceable, attachment – when interest becomes enforceable.
(e)(1)(b)  “perfected”  when under state law you can beat out a subsequent judicial lien creditor, you are federally perfected.
But this leaves us at loose ends – well gosh, when could our creditor have beat out a subsequent judicial lien creditor. Go back to UCC handout.
Steps to answering this fact pattern:
547(b)  547(e)(2)(a)  547(e)(1)(b)  9203  9308  9317
July 25 – loan is made, security agreement executed by both parties (creates the lien on the assets)
August 1 – bell rings
Aug 3 – secured creditor files UCC 1 financing statement
Nov 1 – we have bankruptcy
Question: whether creation of lien (transfer of collateral is preferential)?

Transfer = yes, the lien is a transfer (101.54)

To a creditor = yes, the bank is a creditor

On account of an antecedent debt, owed before transfer was made = “made” is a defined term  547(e)(2)(a) = made when takes effect between parties (moment of delivery for real property, arises between the parties = look at 9203 for personal property – moment of attachment – when creditor gives value, debtor has rights in collateral, security agreement signed by debtor), and if perfected within 30 days

So under 9203 – this date is July 25 – when transfer took effect

IF perfected within 30 days (e)(b)(1) – perfected when you (the transferee) can beat a subsequent judicial lien creditor  so go 9317 (a) = if you are unperfected under state law, then you lose to a judicial lien creditor  so if you are perfected under state law, then you do beat out a jlc. So – as soon as you are state law perfected, you can then beat a jlc. If you can beat a jlc, then you are federally perfected.

So when are you state law perfected = 9308  perfect if attached and procedural requirements have been met (filing UCC -1) = attachment plus filing

Transfer was made – July 25, as long as perfection occurred within 30 days. Filing occurred on August 3 – this is when perfection occurred. Perfection ocurred within 90 days of bankruptcy. But deemed to have taken effect on July 25  as long as perfection took place within 30 days.

Need to distinguish moment of attachment, moment of perfection, moment of debt, moment the bell rings

So no preference here**

Lien = right to seize and sell property in order to satisfy an obligation

Two kinds = consensual and nonconsensual

Nonconsensual  attachment

Consensual  personal (Article 9 – security agreement – creates a security interest) and real (mortgage or trust deed)

What if the UCC-1 is not filed until August 26?

July 25 – loan is made, security agreement executed by both parties (creates the lien on the assets)
August 1 – bell rings
Aug 26 – secured creditor files UCC 1 financing statement
Nov 1 – we have bankruptcy

Go thru all of the steps  not filed within 30 days so deemed to have been made on Aug 26 = preferential (UCC-1 needs to be filed right away – this is a real world problem)

Figure out when it was made  then that answers whether on account of an antecedent debt (can still be preferential if loan and s/a made on the same day)

Change facts again

6/1 debtor takes out a loan – executes promissory loan and s/a

august 1 – bell rings

august 2 – UCC 1 is filed

11/1 – we have bankruptcy

we know when debt was occurred, when s/a – we can assume this was also date of attachment. If transfer took effect on 6/1, and more than a 30 day gap from attachment and perfection, then transfer not made until august 2. Still within 90 days so we have a preference. Similar to last hypo, just the gap is stretched out.

6/1 UCC-1 filed

8/1 bell rings

8/3 executes s/a, bank makes a loan to the debtor

11/1 bankruptcy
Is there a transfer on account of an antecedent debt

debt incurred on aug 3, s/a incurred on aug 3

e2a  deemed to be made when it takes effect, if perfected within 30 days – took effect on aug 3, was it perfected within 30 days  perfected when you can beat a jlc, if attachment and filed  both of the requisites for 9308 were present on Aug 3, so within 90 day window but not made on account of antecedent debt because it is a contemporaneous debt – everything happened on the same day = no preference, creditor wins.
8/1 bell

8/11 s/a, loan

8/18 UCC-1 filed

11/1 bankruptcy

everything within 90 days of bankruptcy – so looks preferential but it is NOT

transfer is made when takes effect – if perfected within 30 days

when you can beat jlc, can beat jlc as soon as there has been attachment plus a perfection step, when is that – aug 18. Therefore, the transfer is made on aug 11, but not on account of an antecedent debt. Contemporaneous debt. So no preference.

If UCC -1 was filed on Sept 13, is there a preference?

Real world stuff
Most article 9 transaction involve after-acquired property, most have after acquired property clause (AAPC)

Ex: Debtor grants creditor a lien, in all inventory hereafter acquired

So the property subject to the lien is constantly changing
On June 1, loan incurred, s/a has AAPC, and UCC-1 is filed

August 1 – bell rings

August 15 – debtor gets another piece of equip

This makes the creditor LESS undersecured

Question: what result?
Gut says no preference – everything happened on June 1 but what about the new asset  when was the transfer of that asset made? 9203(b) attachment occurs when the creditor has given value, when the debtor has rights in the collateral, when the security agreement was signed. When did debtor get rights  not until Aug 15 – s/I did not attach until aug 15, so the transfer was NOT made until aug 15. Not perfected until aug 15. So it is made on account of an antecedent debt  and meets other steps so it is a PREFERENCE

 shortcut is 547(e)(3)

 the original collateral property would not have been preferential
***look at transfer on an item by item basis
After acquired property clauses  AAPC
June 1 – s/a which contains AAPC, loan, UCC 1

8/1 – bell rings

8/15 – debtor gets additional equipment

11/1 – bankruptcy

Is acquisition of this equipment preferential? Yes, debtor did not receive rights in the goods until 8/15. There is also the shortcut: 547(e)(3).


Under federal law – when you can beat a jlc

Go to state law – you can beat a jlc when you attach and when you have taken the requisite perfection step

Change of facts:

Equipment shipped to debtor on july 31, but still did not arrive until August 15

Look at 547(e)(3)  possible that the debtor received rights on july 31 – if so, the transfer was outside the window period and could not have been preferential.
When was the transfer made:

Made when takes effect IF perfected within 30 days

Attachment  value, rights in the goods, debtor signed s/a

Rights in goods – 2501 – identification of existing goods -

So made on July 31, perfected on July 31

August 2 – s/a containing AAPC, loan, dr owns some equipment at that time

Equipment 1

August 9 – dr gets equipment 2

August 20 – bell rings

September 5 – UCC -1 filed

11/10 – bankruptcy
What result as to these two pieces of equipment?
Equipment 1
Attachment occurred on Aug 2 – takes effect so made on that date IF perfected within 30 days

Federal perfected if you can beat out a jlc. You can beat out a jlc if sate law perfect. You are state law perfected if attached and UCC 1 filed. So transfer was deemed to be made on 9/5  so preferential because of delayed perfection.

Equipment 2
Attachment occurs on the 8/9. Takes effect so if perfected within 30 days. Perfected within 30 days, so deemed to have been made on 8/9. = not preferential

Real estate

2/25 loan, TD signed

3/1 bell

3/3 TD recorded

6/1 bankruptcy

Is the granting of the lien preferential?
Made – date it takes effect  moment of delivery  if perfected within 30 days = (e)(1)(a)

When you can beat a bona fide purchaser  when properly recorded

So look at state recording statute
So when it is recorded – that is the moment at which our TD holder is federally perfected, so we now that the information under e1a – and plug into e2a – here took effect on 2/25, perfection took place within 30 days, so made on 2/25. Before the bell and no transfer on account of an antecedent debt  not preferential
Race notice – CA

O  A unrecorded

O  B sbfp for value – records

An unrecorded conveyance is void vs. a bfp for value who first records

What if recording had happened on April 1. More than 30 days after date of delivery – e2b  after the bell  preferential
When transfer takes effected under e2a  when TD is executed or when funding of the loan takes place = a lot of courts have said when the funding takes place
Problem of foreclosure as preferential
Suppose we have a TD that was never properly recorded –then our secured party forecloses within 90 days of bankruptcy. Some cases have held that this is preferential. Other cases have said where there is a properly recorded TD, then foreclosure right before bankruptcy, most courts have said not preferential because there was already a valid lien – the foreclosure does not make you better off. (547b5).
CA has two kinds of foreclosure: judicial and non-judicial

Judicial foreclosure

Complaint, sale of property is ordered, sale price determined, deficiency liability is determined (debt minus sale price)

This is fairly uncommon

Non-judicial foreclosure

Notice of default

Notice of sale

Sale – auction

Private auction – not conducted by court (much more common)

But since no court overseeing, you will see where the deed was not properly recorded – but no one says anything. Sale goes off without proper recording – this could well be a preference.

If the TD was already recorded long ago, then we have to think about if the foreclosure is a transfer. Is it a transfer that would have made the creditor better off, no. foreclosure would not be preferential – fails (b)(5).
Ordinary commercial situation – lien on property – deficiency posture – debt is greater than value of the assets

Debtor has a bifurcated claim

Section 506(a) – if you are secured creditor and you are undersecured, you hold a secured claim for the collateral and an unsecured claim for the amount of the deficiency
So in the bankruptcy, you will get the collateral and then have an unsecured claim for the rest of the money. But as a secured creditor, you got the collateral already. Your deficiency claim comes from that collateral judgment.
Change of facts
Debt – 2 million

Fair market value of collateral – 1.5 million

Creditor judicially forecloses – someone pays creditor 1.5 million, at auction.

Creditor gets ½ million deficiency judgment

If go into bankruptcy court, unsecured creditor

So what if you get paid on your deficiency judgment before bankruptcy, you levy execution and you get paid on your judgment right before bankruptcy  likely preferential  foreclosure would NOT be preferential – did not alter economic status because you were always going to get that amount, but the transfer of the deficiency would be.

Foreclosure law plays into preference law

Lawyers can get sued too – malpractice

Debtor – also a D

Plaintiff file suit – judgment entered on March 1

Bell rings on 3/15

On 3/20 – judgment is filed and abstract is obtained and recorded.

Judgment lien arises that this point – encumbers the debtors real property

6/15 debtor files bankruptcy.
Judgment lien is a preference – so when you are a Plaintiff and about to obtain to a judgment, have all your ducks in a row to get everything filed fast – your failure to move quickly could be malpractice
Enforcing judgments – we will discuss more later
Finding out where the debtor has real property

force debtor to tell you  judgment debtor exam

Belated perfection of real estate liens – a lot of problems like this today
Jan 1 – TD 1 is recorded on the debtors property

July 1 – refinanced loan (new lender, old obligations extinguished); new TD executed but NOT recorded

Aug 1 – bell rings

Sept 1 – new TD is finally recorded

Nov 1 – bankruptcy

Belated perfection so preferential but the argument is that the new lender is somehow perfected

Theory 1 – perfected when you can beat out a bfp; holder of the second TD, says that first holder put everyone on notice so the second bfp was always perfected – so there could have been no subsequent bfp. But the problem with this is that the subsequent person would not know about TD 2. This argument is overbroad and has been largely discredited.

Theory 2 – sort of works  doctrine of equitable subrogation = holder of TD 2 since he paid off TD 1 takes the place of TD 1, therefore you jump into the shoes the lien you paid off. The problem is most wont recognize this but it provides an argument. Courts tend to be going in favor of the trustee and against the refinanced lender.

If same party did the refinancing – then likely they would have been on notice
Earmarking doctrine

Some people call it a defense but more of a threshold question

We need to have a transfer of property under 547

So suppose we have an old creditor. New creditor steps in and gives money directly to old creditor. Now debtor incurs new debt to new creditor. Some courts hold that if we simply have a swat, the payment to the old creditor would not be preferential. Others say it is a preference. Some say if debtor has any control, then earmarking will not apply. If debtor has no say, then earmarking may apply.

Rights of guarantors – we have a guarantor who issues a personal guaranty in favor of a creditor – there is now a contingent right of reimbursement.

Suppose the guarantor actually pays the creditor. No longer a contingent right of reimbursement. Not a preference because not a transfer of the debtor’s property. But sometimes the guarantor acquires a security interest in the debtors assets – usually occurs at the moment of payment. At this moment, the old creditor has received a preference – the value of the assets used to collateralize the reimbursement – transfer to the guarantor for the benefit of the creditor – not a transfer directly to the creditor. Courts have then get back the value of the assets from the creditor that was paid off.

If there was no security agreement, then not a preference.  note – this is the mirror image of the hypo we did on the first day – where that was a preference (payment from debtor to the creditor – here from guarantor to the creditor)

Might be preferential to more than one person – guarantor and creditor

Negative pledge clauses

Forbids the debtor from giving anyone a security interest in its assets other than you – have power over the debtor

You want to be able to do what you want without interference from other creditors when you foreclose on a debtor

Forbids junior lien holders from coming into existence

If there are junior creditor, then they confine your freedom
The sandbag – you have a debtor who is planning to go into bankruptcy, the debtor will step up preferences that don’t look like preferences. Then once bankruptcy is filed, debtor says hahaha give it back and it gives a war chest to the debtor’s counsel.
A case came down over the weekend – all you can go is avoid the lien, you cannot recover the amount. Bremmer case – prof wrote up an article about why this is wrong.
Pre-petition debtor vs. post-petition debtor
If the creditor were oversecured during this entire analysis, the 547(b)(5) would not be satisfied.
Defenses under 547(c) – creditor has the burden of proof – affirmative defenses
To the extent = only to the extent

Contemporaneous exchange

Intended to be contemporaneous and in fact substantially contemporaneous

How far does substantially go  about 10 days (some courts have gone farther)

Problem on page 329
(c)(1) is Not satisfied – not intended to be contemporaneous
(c)(2) – ordinary course payments

if the debtor is targeting specific creditors, no point in bringing in all of these payments

so Congress enacted this defense – two and a half part test

has to be an ordinary course debt

method of payment – made according to ordinary business terms (trade usage) or the way the parties have always done business (course of dealings)
Even if not in parties ordinary affairs, if the industry as a whole does it this way, then it is also OK.
How do you get a competent witness = if a lot of money involved, get a real expert witness

Judges also know that preference recovery is the mother’s milk of attorney’s fees

There is a bias in favor of preference recovery so bankruptcy lawyers can make a living

90% of jurisprudence here has to do with whether it is regular course of dealings or trade usage, not whether ordinary debt – this has been decided already
Enabling loan exception: (c)(3)

if you lend money to a debtor to enable the debtor to acquire an asset, you will get special protection

Business reality – suppose the following scenario:
We have a debtor and a vendor of an asset

Debtor buys this asset on time (worth 1 million)

D pays 100k down and executes a note for 900k

Security interest in the asset – secures the balance of the purchase price of that asset

D uses the credit extended by the vendor to purchase the asset

Purchase money security interest = PMSI

This is an example of a two party PMSI
Three party PMSI

debtor and a vendor who wants cash

lender present as well

debtor makes a 100k down payment

lender gives vendor 900 k in cash

lender extends credit to the debtor to enable the debtor to acquire a specific asset

the asset acquired secures the loan
Where the asset acquired secures the loan that was given to purchase the asset** that is what a PMSI is
That was the background for 547(c)(3)

security agreement

given by or on behalf of the secured party

enable the debtor to acquire the property

actually used by the debtor to acquire

perfected on or before 30 days after the debtor receives possession

“in fact so used” = when the creditor funds the acquisition, either put the money in a special bank account or make check payable to both debtor and vendor

march 20 – bell rings

april 1 – PMSI in specific item of collateral, s/a AAPC, loan is made, UCC-1 is filed

april 7 – debtor buys an item of equipment

june 20 – debtor files bankruptcy

apply 547(b) to this item of collateral then walk through any other defenses that apply (c)(1) might apply and (c)(3) does apply

make sure it is preferential BEFORE you walk through the defenses

march 20 – bell rings

april 1 – PMSI in specific item of collateral, s/a AAPC, loan is made, UCC-1 is filed

april 7 – debtor buys an item of equipment

june 20 – debtor files bankruptcy
apply 547(b) to this item of collateral then walk through any other defenses that apply (c)(1) might apply and (c)(3) does apply

make sure it is preferential BEFORE you walk through the defenses


transfer can be avoided if 6 requirements are met:

transfer of property – lien (lien is a transfer under 10154)

directly to a creditor

made on account of an antecedent debt  debt was incurred on 4-1 but when was it made  same day as when it took effect if perfected within 30 days

takes effect when value has been given by creditor, debtor has rights in the property, and signature of the security agreement = seems to have taken effect on april 7 – that’s when all three are met.

If perfected within 30 days  attachment and UCC filing – so this all occurred on the 7th. So perfection occurs on april 7.

Takes effect and perfection on same day – deemed to have been made on april 7. Debt was incurred on April 1 – so there is a gap – antecedent debt

(b)(5) is satisfied

so there is a PREFERENCE


(c)(1)  intended to be contemporaneous and sufficiently contemporaneous

but this could be poisoned because of the AAPC – so this shows that they may not have intended for contemporaneous transfers – they intend for there to be other later transfers – destroys the intent requirement
(c)(2)  not a payment so this CANNOT apply (it is a lien here)
(c)(3) 

security interest acquired by the debtor = yes

secures new value

given at or after the signing of the s/a

on behalf the secured party

given to enable the debtor to acquire such property

in fact used by the debtor

that is perfected on or before 30 days

so (c)(3) applies – so even though it is preferential still cannot be avoided

if this had been a general business loan, then (c)(3) would not have applied

new facts
4/1 loan, s/a, aapc

4/10 debtor orders equipment, shipped

4/12 bell rings

4/15 debtor gets equipment

5/12 UCC-1 filed

7/12 bankruptcy

Question: do we have a preference and can our creditor invoke 547(c)(3)?

We know it’s a transfer – lien

Transfer to a creditor

Obligation was incurred on april1

Figure out when takes effect  moment of attachment  creditor gives value, debtor has rights in the collateral (2501  has rights when shipped), security agreement signed = april 10

Perfection  attachment and perfection step = may 12

So deemed to have been made on may 12 – so on account of an antecedent debt

So the delay in perfection means this was preferential

security interest acquired by the debtor

secures new value

given at or after the signing of the s/a

on behalf the secured party

given to enable the debtor to acquire such property

in fact used by the debtor

that is perfected on or before 30 days (need perfection within 30 days of possession)

so (c)(3) applies  comes to the rescue
If the goods have been received on april 11, then (c)(3) would NOT have been met so no defense.
547(c)(4) – subsequent advance rule

provides a consolation prize to creditors

2/1 shipment of 100k worth of shoes – sent to debtor

4/1 bell rings

4/5 debtor pays for the 100k in shoes

4/15 creditor ships 70k worth of socks

7/1 bankruptcy
Is the preference a preference  yes

The terms of 547(c)(4) – even if liable for 100k, be gets to offset that by 70k  he gave money back = encourage creditors to do business with struggling debtors

If the rule were different, as soon as the debtor starts slow paying, you would start starving the debtor on credit.
So after you get a preference, if you give new value back to the dr, you get to offset the value for the value you gave back
Problem comes with the next two clauses:

  1. and (b)

Illustrations to understand (a) and (b)

2/1 shipment for 100k of shoes

4/1 bell

4/5 100k preference

4/15 70k worth of socks, shipped with a security interest in the socks, AAPC

5/3 UCC 1 is filed, PMSI in socks

This is a secured subsequent advance – under (c)(4) it has to be unsecured

In other words, if your subsequent advance is validly secured, then you cannot use it as an offset.**

This is a valid PMSI because perfected within 30 days

Needs to be perfected within 30 days of possession – here that seems obvious

So cannot be used as an offset
In contrast to the following:
What if the debtor got possession on 4/15 and the UCC 1 was filed 5/18 – perfection was more than 30 days, so creditor cannot invoke (c)(3) to save the PMSI, so the PMSI is invalid, but since the PMSI is invalid under (c)(3), it is an avoidable security interest – with a subsequent advance, so we get an offset.
So either the creditor gets the value of the PMSI OR the creditor gets to use the invalid PMSI as an offset***

We actually have two preferences here – the 100k and the PMSI

(c)(4)(b)  suppose you got paid for the new value (pays for the socks), not preferential because of 547(c)(2) – so therefore it is a valid payment, then you cannot use those paid for goods as an offset against your preexisting preference liability.
There is a glitch:

Debtor, parent corp, seller

Seller sells 100k worth of goods, debtor pays for those goods in a preference

Seller ships 70k worth of new goods = subsequent advance and goes to the debtor

Parent corp the pays 70k to the seller

Debtor goes bust – trustee goes after the seller

Seller says he gave new value to the debtor so that’s an offset

Trustee says no, parent corp paid seller  courts are split here

But look at the language = did the debtor pay for the 70k?? NO, paid for by a third party, so some courts have held that if Congress had wanted anybody to e able to pay then they would have said that. So since debtor did not pay, you get the offset  you get to double dip.


Payments by check – problem with a check is that it is not cash

Because the date of delivery of a check is hard to figure out and may also be meaningless, the SC has held that 547(b) the date of honor of a check is the date of transfer

But trial courts have drawn a distinction between 547(b) and (c)

3/39 – seller ships 100k worth of shoes

4/1 – bell rings

4/5 – debtor delivers 100k check

4/8 – seller ships 70k worth of socks

5/1 – debtors 100k check is honored

so do we have a preference and how does this al weave together?

We clearly have a preference – check is honored on may 1, that is the date the transfer is made – on account of an antecedent debt

But the advance of new value was not subsequent to the preference

Trial courts have said that if we adopt the date the honor controls, they are going to withhold the goods until the check is honored – everyone is going to be hurt. So instead lets deem the check to have been paid when it has been delivered, for purposes of 547(c). If the date of delivery controls, then we do have a subsequent advance.

need some background

debtor – processes raw materials from the supplier

dr creates inventory and sold to customers called account debtors – accounts receivable, eventually collected as cash. Cash goes back to the debtor. Cycle starts anew.

In the real world, there is a problem. The debtor has to pay for raw materials before the account debtors pay.

Lender loans money to the debtor – dr executes a note, gets a security interest in the accounts receivable

Unlike other forms of collateral, accounts receivable and inventory is always changing.
Under (c)(5), if we look at every item of inventory (undersecured lender), if you think of each new item and joining the collateral package, we have a creditor that is less undersecured

Opening up too much preference exposure – so nobody would ever loan money to the debtor if they had this exposure – the collateral would be wiped out

Hence 547(c)(5) – get out of jail free card for lender
Golden rule – receivables and inventory and their proceeds are NOT vulnerable to attack; they are NOT preference property.
The rest of (c)(5) is difficult:

Lender – you are golden except if the collateral package grew in value during the 90 days before bankruptcy making you better off, less undersecured. Sometimes called the fattening of the cow. (c)(5) makes you give that back.

Go through (c)(5) – you could easily construct hypos


payments in the ordinary course on debts incurred in the ordinary course

We have mostly been talking about secured transactions – not payments, they are transfers

Has to be a payment under (c)(2) – manner of payment has to occur in the ordinary course and debt incurred in ordinary course = 3 parts

Courts have mostly said payments are ordinary course – even if kind of unusual

Only where it is completely weird would a court say not incurred in ordinary course

1/1 1 million loan, s/a aapc, UCC-1 filed, a/r and inventory

3/1 bell rings

3/10 debtor sells 700k item

so there is a 1 million debt and 700k collateral has been sold

creditor was nominally fully secured before then – now the creditor is really undersecured. Creditor is in a bad deficiency posture – not enough collateral to cover the debt.

3/15 debtor gets item 2 worth 300k. SO now there is more collateral for the creditor – less undersecured.

3/20 debtor sells that item for 300k

4/1 debtor gets item 3 worth 400k

6/1 bankruptcy

Creditor is still undersecured, applying 547(b) literally – we look at each transfer in isolation. Did each item make creditor more well off – Yes, as to items 2 and 3. As each item comes in, the creditor becomes less undersecured. It is conceivable that the secured party could have a huge preference liability because each item in the aggregate probably have 700k in preference liability.
So creditor has received a preference due to the simple turning of inventory – every time there is a new item, there is a potential preference.
The solution is 547(c)(5)

If inventory or receivables – no preference = golden rule

But there is an exception:

Suppose on the 90th day before bankruptcy, the debt is 1 million. Stays constant all the way to bankruptcy. Now assume the collateral is at 600k at the 90th day – all inventory, receivables and proceeds. On day of bankruptcy, 900k in collateral. So the deficiency is 100k. On the 90th day, deficiency was 400k. in the aggregate, if we look at this, then we see that the increase in the collateral package reduced the deficiency posture. So although C5 begins with the olden rule, it is NOT true to the extent that the collateral has increased during th 90 days and to the extent that the increase has decreased the deficiency  creditor has been made better off.

This is a two point test

  1. look at collateral package on 90th day

  2. look at collateral package on date of bankruptcy

Except to the extent that the sum of all transfer reduced the deficiency during the 90day period  IN ENGLISH

Debt minus collateral – two point test

Note: ignore intermediate fluctuations; also 547(b)(5) and (c)(5) comparison  they are very different

B5 says did this transfer make you better off in a chap 7

C5 says it is already understood that B5 has been satisfied, but now because we are talking about a special collateral, we see if you were made better off during the 90 days before bankruptcy.

(1) Debt is 10 million on the 90th day before bankruptcy and the date of bankruptcy
Collateral goes from 6 million to 9 million, we have a deficiency of 4 million on the 90th day and 1 million on the date of bankruptcy. So preference liability is 3 million.
(2) Assume we have no change in the value of the collateral

90th day debt is 10 and collateral is 6. Bankuptcy debt is 7 and collateral is 6. The pay down of the debt itself will be a preference but C5 is not implicated, the exception to C5 does not apply – no increase in collateral. The preamble to C5 does apply to insulate the inventory and receivables from preference liability. (that’s being hypertechnical)

Maybe a C2 defense if in the ordinary course
(3) 90th day = we have a debt of 10 million and collateral is 16 million

date of bankruptcy – debt is 7 and collateral is 16 million.

No reduction in deficiency and the pay down of the debt is NOT preference because he was oversecured at ALL times – no improvement in position.
(4) 90th day = debt of 10 million collateral is 16

bankruptcy = debt of 10 million collateral is 18

increase in collateral does not affect – no deficiency = NO preference, oversecured at all times, and exception to C5 does not apply
Case – Qumetc

90th day before bankruptcy = debt was 12, collateral was at 9

date of bankruptcy = debt went to 14, collateral was at 10

court says there was an increase in collateral but the increase did not cause a decrease in the deficiency – creditor was in a WORSE position because the debt increased faster than the collateral

Counter – increase in the receivables did makes the creditor better off, so an equitable argument would be give it back. But the statute does not say that in C5.
Note – all we have been talking about so far is receivables and inventory – so preamble to C5 applies. Not talking to mixed collateral yet.
90th day = debt is 10, collateral is 6 = 4
bankruptcy = debt is 8, collateral is 7 = 1 (Debt goes down and collateral goes up)
faces preference liability in the amount of the pay down = 2

pay down of debt does not implicate C5 – only applies to transfers of inventory and receivables – maybe C2 applies but not C5.

increase in the collateral caused a decrease in the deficiency = 1

so total is 3 = preference

exception to C5 does apply – increase in collateral caused a decrease in the deficiency

so the reduction in debt is simply 547(b)

the increase in the collateral is 5467(c)(5)
so if the debt goes down, have to separate it out. It is NOT 4-1. Don’t treat it like the other C5 hypos.

Qumetc case is almost the inverse of this question – there the increase did not create a decrease.

No good deed goes unpunished – this rule was designed to sweep back the increase

Affect of the rule in the real world has been different however

Creditor monitors the state of debt and the collateral – lets assume there is more collateral than debt

Debt continues to mount and collateral starts to drop

Suddenly we are in undersecured posture

You are really worried

If collateral does not go back in value, you may be killed in bankruptcy. If collateral does go up, you have a big problem under C5. It is very common for the creditor to be holding the guaranty of an insider (shareholder).

So creditor could take the guarantors house – what does guarantor do. Guarantor goes and gets ore inventory – goes to suppliers – order volumes increase.

So collateral package goes back UP and debt stays constant. Now no longer in deficiency posture, so obviously if we have a bankruptcy filing, we have a problem.

Creditor says to guarantor, don’t file bankruptcy for at least another 90 days. We are in an oversecured position, debt is down, now we have bankruptcy filing, 90 days or more, and we now have a situation where the creditor was oversecured during the 90 days before – so no preference liability. This is called manipulating the two-part test.

The truth will come out. The whole goal on the part of the guarantor is to bump up the collateral and then stall the bankruptcy. The injuries go to the unsecured creditors – the suppliers.

If you can prove this sort of control by the creditor, then the creditor can face all kind of tort liability.

Look for the criss cross pattern – can show control by the creditor and the manipulation
We have a corp and we have trade creditors, then the trade creditors owe them money. And we have a lender with the security interest. President of corp issues a guaranty – pres has no liability to the trade creditors unless they get a personal guaranty

The SHs would not be liable to the unsecured creditors – try to squeeze the suppliers for more inventory and screw them over

Same scheme took place in the Casablanca fan bankruptcy – people do bad things to try to manipulate the system

As the lawyer, don’t get involved in the scheme.

As to the guarantor, the bell rings one year. Lender, the bell would ring at 90 days. If the lender is an insider, then one year would apply.

Probability of call on the guaranty comes into question here as well – will talk about later

Problem of valuation

You could have a situation where you are a creditor, there looks like there has been an increase in the amount of receivables – company becomes a basket case on bankruptcy. On the 90th day, the account receivables has gone up from 6 to 7 – company was shaky was OK. The argument is yes it has gone up. But lets look beyond the face value, says the creditor. Lets look at real value. Because of intervening events, have to be valued at a liquidation basis – all of the assets become garage sale assets.

Receviables crash in value of there has been a liquidation – so don’t look at face value in the real world. Think about the real value of the assets – the difference between going concern and liquidation value.

It is going to be tough to show that different valuation methods should be applied on the 90th day and the date of bankruptcy.

In most cases, the company is either OK at both dates or really shaky on both dates.

Look for a severe intervening event – like Northridge quake, 9/11

Some companies file a Chap 11 even if the company is unsalvageable

Delay the date of reckoning

Strung out process

Induces creditors to settle with the guarantors so they can foreclose

So don’t let the chapter determine the method of valuation – it is relevant but not determinative
Back to C5 – there is some odd language
To the prejudice of unsecured creditors – what does this mean?

On one hand, whenever a/r increase, it is to the prejudice of the other creditors. = superfluous language

On the other hand, has to mean that the value to cause the increase has to be derived from the other creditors = gives the language more meaning

Increase in value prejudicing the other creditors

Hog example – has babies within the 90 day period – has tis increase in value prejudiced the other creditors  YES because without the help of other creditors, this would not have happened. Feeding of the hogs, veterinarian services, etc.

Ripening of blue cheese or other cheese – no third party intervention to make the cheese more valuable. But somebody has to tend to the cheese – to the prejudice of the other creditors YES

Common theme – if increase is attributable to efforts or value of unsecured creditors, then the increase in value ought to be recapturable.

Mixed Collateral Problems
What happens if a/r goes down in value and the value of the equipment goes down

Debt is 100 on both 90 and bankruptcy

a/r is worth 60 on 90 day

goes to 90

equipment starts at 30 and goes to 0

looks like a preference under C5 – look for increase in a/r

then look at the debt by which exceeds all collateral

even if there is an increase in a/r, and a corresponding decrease in other collateral, when we don’t have a decrease in the amount by which the debt secured by such security exceeds the value of all security interests = aka no decrease in the deficiency

**This is the mirror image of the Qumetc problem
Different outcome
a/r goes down in value but the equipment goes up in value

debt is 100 at all times

collateral starts out at 60 and goes to 30

equipment starts at 30 and goes to 60

different outcome – we are not within C5 exception because there is NOT an increase in a/r.

increase in the equipment would be preferential – 30  amount of the increase in the collateral pool

the argument is that equipment should not be protected the same as C5 – does not fluctuate like inventory and a/r

There is another exception here

what if this new equipment was purchased with the proceeds of the a/r

if the secured party can trace this progression of funds, then the equipment would be swept up in C5.  because of the predicate in C5. = then no preference likely.

Real world question
How would you avoid the specter of having your inventory converted into cash proceeds and you don’t know where it has gone?

Solution – thing called a lockbox – this avoids commingling, dissipation, etc.

Wont be tested on this**

Debtor – account debtors – secured party (this is your client)

Debtor sells to account debtors – generates a/r

Collections go into lockbox

Secured party takes money from lockbox and pays down the debtors loan obligation – used to retire the debtor’s loan obligation = routine payments

Secured party has a security interest in the a/r

As the money is used to pay off the debt, that means that the secured party has plenty of collateral

So the secured party readvances new money to the debtor  this is called a revolving credit facility or revolver – kind of like a credit card

We will see where the nature of this will become important in the context of cross-corporate guarantys

Most commercial finance is done under this type of system

This could be the way the creditor avoids a huge preference problem – secured party could trace origin of the money from the lockbox – no doubt about what the money was used for

More than an accounting technique, it is a control technique

Creditors always want more collateral – always better to be oversecured than undersecured = even if given in the last 90 days it will have to be given back – this is a risk they are willing to take
Lockbox trick avoids all questions about where the money came from – if it was proceeds to buy more equipment – would qualify under C5 because proceeds of the receivables.
Is the lockbox the debtor’s property – probably – there is some level of ownership
Related Chap 11 issues

Debtor is going to need financing during the reorganizaton = post petition financing = DIP financing

As the post petition lender, you are entitled to all kinds of protections – debtor owes you FDs.

Big problem

DIP lender who provides money to the DIP

DIP deposits the money in his general bank account – which is a separate entity than the lender

DIP overdraws his bank account

Bank provides overdraft protection – goes into the general bank account

DIP writes check to third parties, attorneys

One morning, everyone wakes up and the DIP has no money. Going to stroll into a Chap 7

DIP lender comes into court and wants money back – court says so sorry

DIP commingled into the his own bank account

The attorneys are holding money from the bank

DIP lender gets stiffed

Moral of the story – don’t be ashamed to insist on a lockbox – verifiable auditable protection.

We are essentially done with preferences except for some stuff dealing with letters of credit

Note: C5B – don’t worry about that

Fraudulent Transfers
(1) Debtor is getting ready to go bust – right before he goes bust debtor gives away car to his brother right before filing bankrupt petition = this sounds wrong, his creditors expect the debtor to not give away his assets before going bankrupt
(2) Debtor sells his car to his brother for 10k though it is worth 50k = this is a sale, but not an arms-length sale – is it for reasonable equivalent value but it is wrong too
Both of these examples are fraudulent**
REV = reasonable equivalent value – means close enough

If small disparity, possibly OK. If huge disparity, maybe a problem.

The goal of these statutes is to undo actually fraudulent transfers – if there is actual fraud, the code will go after the parties to the fraudulent transfers – the third party might not be a party to the fraud, just the debot
Another prong

Constructive fraud – court looks at the circumstances without reference to actual intent  the court deems the transfer to be fraudulent

Ex = situation with brother, transfer car while insolvent, code say we don’t care if your motives were pure. If you transfer while insolvent and you get less than REV, you are going to be deemed to have engaged in a fraudulent transfer.
Two major avenues for the trustee in bankruptcy to prosecute FTs

  1. under the bankruptcy code = 548

    1. once asserts claims here, then can assert remedies under 550

    2. problem – only 2 year SOL – have to have occurred within two years of bankruptcy

  2. state law
    1. 544(b) of the code – trustee may avoid any transfer of an interest or obligation that is voidable under applicable law by a debtor holding an unsecured claim

      1. if there is an unsecured creditor who could have voided, then the trustee is empowered to use STATE LAW

      2. this is the window that gets us into state law

What if we have a FT more than two years before bankruptcy  have to use state law to void the transfer – so how do we get to state law = 544(b)

State law has longer SOL
So trustee will try to use 548, if not, then uses 544(b) to state law
548 (2 yr)  550 recovery phase
544(b)  state law  550 recovery phase (usually a SOL that ranges from 4-7 yrs)
almost every state, the state FT law is the Uniform Fraud Transfer Act = UFTA
CUFTA – California version

We will talking about the structure of CUFTA – there are some important differences between 548 and CUFTA

Trustee will have to ID a triggering creditor for purpose of 544(b)

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