As a creditor, the news of a debtor who owes you a substantial sum of money filing bankruptcy is often the most alarming news you can learn—that is, until you seek advice of counsel and learn that payments the debtor made to you within 90-days prior to the bankruptcy will be the subject of a lawsuit and likely recoverable by the bankruptcy estate as a “preference.” This is usually the point I offer soothing chamomile tea to the client.
Recovery of “preference” transfers in bankruptcy cases, though seemingly unfair to the individual creditor, serve an important role and offer a degree of protection to the creditors as a whole. The primary elements of a preference transfer are relatively straightforward: a debtor who is insolvent, makes a payment or payments to a creditor, within 90 days prior to the bankruptcy filing, to satisfy at least a portion of a pre-existing debt, and the creditor receives more than it would have had the debtor filed a chapter 7 (liquidation) bankruptcy case. Though the “don’t rob Peter to pay Paul” concept appears clear enough, the Ninth Circuit has recently illustrated how complicated the matter can become in In re Tenderloin Health where the court addressed the often overlooked final element to a preference—the “greater amount” test.
As the Ninth Circuit noted, the “greater amount test … ‘requires the court to construct a hypothetical chapter 7 case and determine what the creditor would have received if the case had proceeded under chapter 7’ without the alleged preferential transfer.” Id. at *7. This task of creating a hypothetical chapter 7 liquidation grows ever more daunting as a case grows more complex, leading to uncertainty for a creditor client, especially when unresolved legal issues come up within the hypothetical bankruptcy.