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Avoiding Powers of Debtor in Possession

Cite this article as: Jason Mance Gordon, "Avoiding Powers of Debtor in Possession," in The Business Professor, updated January 21, 2015, last accessed April 8, 2020, https://thebusinessprofessor.com/knowledge-base/avoiding-powers-of-debtor-in-possession/.
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Avoiding Powers of Debtor in Possession
This video explains what are the powers of a debtor in possession to avoid or undue prior payments or transfers for estate assets that are deemed preferential.

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What is the authority of the debtor in possession?

Avoiding Powers – The DIP exercises the avoiding powers of a bankruptcy trustee. This is known as the “strong-arm” powers. The strong-arm authority allows the DIP to:

⁃    Avoid Preferential Conveyances – The DIP may seek to undo any preferential conveyances or payments made by the company and certain statutory liens placed on the debtor’s assets by creditors. Generally, a payment is considered preferential if it made while the debtor was insolvent and it enables the recipient creditor to receive more than such creditor would receive if the case were a case under Chapter 7. Further, a preferential conveyance must meet the following elements:

⁃    any transfer of interest in the debtor’s property;

⁃    within 90 days of filing for bankruptcy (or one year if the transfer is to insiders of the business);

⁃    to or for benefit of a creditor on account of an existing debt.

If these elements are present, the DIP may undo the transaction by making a claim against the preferred creditor for return of the transferred assets. There is an assumption that a debtor is insolvent in the 90-day period prior to the filing of bankruptcy. This period is extended to one year if any payment benefits an insider of the business (such as an owner of the business, officer, director, third-party guarantor, etc.). The longer time period for insiders rests upon the presumption that companies may siphon off funds to insiders upon signs of financial distress. The term “transfer” is broadly defined to include any payment, transfer of property, creation of a lien on property, or recording of a security interest. The requirement that the transfer benefit the creditor is also construed very broadly. Even a payment on a debt that somehow reduces a third-party guarantor’s liability for the debt may be considered preferential.

There are several exceptions or defenses that protect conveyances that may otherwise qualify as preferential, including:

⁃    Contemporaneous Exchanges of Value – This exception allows a debtor to make payment to a creditor who simultaneously provides value to the debtor. The theory behind this exemption is that a supplier should not worry about creating an “antecedent debt” based upon the timing of the exchange of money (or property) for goods or services.

⁃    Example: A business could purchase goods or hire services and make immediate payment for those goods or services without payment being considered preferential.

⁃    Payment in the Ordinary Course of Business – If a payment is recurring or is part of the ordinary course of the employer’s business, it may not be deemed preferential. To determine if such a payment is truly in the ordinary course of business, a court will examine the length of account, relationship history, whether the amount or form was different from past payment, any unusual collection or payment activity, and whether creditor took advantage of debtor’s deteriorating financial condition.

⁃    Example: A recurring financing payment made each month on assets or recurring services would not be considered a preferential payment.

⁃    Purchase Money for Collateral – A transaction that creates a security interest in property acquired by the debtor will not be considered preferential if done pursuant to a security agreement that describes the collateral and is given to allow the debtor to purchase the collateral. Generally, the debtor must file the security interest within 20 days of taking receipt of the collateral or the security interest loses priority to other secured creditors.

⁃    Example: The debtor purchases equipment from a dealer who finances the deal. If the dealer takes a security interest in the equipment within 20 days, the security interest is not deemed to be a preferential payment.

⁃    Enabling Loans – If a debtor receives an enabling loan to continue operations, payments on that loan may not be considered preferential.

⁃    Example: A debtor receives funds on a new line of credit. Payment on this credit agreement is not considered preferential.

⁃    Extending New Value  – If a debtor makes payment to a creditor on account or existing debt, but later receives new value in a transaction (such as an extension of credit or purchasing goods on account), that payment or any lien taken on goods or payment made toward those goods or services would not be preferential.

⁃    Example: The debtor owes a seller of inventory who finances the sale to the debtor. If the debtor makes a payment on the debt in order to receive new inventory financing, this would not be considered preferential.

⁃    Floating Liens – If a debtor acquires and finances new assets or is subject to a prior lien specifically covering after-acquired collateral (such as inventory or receivables), the attachment of a floating lien will not be considered preferential. An important limitation with this defense is that the creditor cannot materially improve her position as a result of any payment.

⁃    Note: Inventory and receivables financiers are protected when the debtor acquires property, but they are not permitted to enhance their positions during the 90-day period.

⁃    Example: Fred makes a loan to ABC Corp. The loan is secured by all of ABC’s assets and includes an after-acquired property clause. If ABC acquires new property, it will be subject to Fred’s security interest. The attachment of this floating lien to the newly acquired equipment is generally not considered a preferential payment.

⁃    Avoid Fraudulent Conveyances – The Bankruptcy Code allows for state fraudulent-transfer laws to remain in effect during a bankruptcy. The bankruptcy code allows the DIP to reclaim any fraudulent conveyances by the debtor. The DIP may look back two years to challenge any fraudulent transfers made with the “intent to hinder, delay or defraud” creditors, or made without “reasonably equivalent value”. A failure of reasonably equivalent value may include situations where a debtor transfers corporate assets to a creditor or purchaser for an extremely low value.

⁃    Example: ABC Corp transfers assets to the CEO’s brother-in-law for one-tenth of the value of the assets. If ABC files for bankruptcy within two years of this transaction, the DIP would likely be able to recover the assets (or equivalent value) as a fraudulent transfer.

If the DIP successfully challenges and avoids a transfer, she may recover the actual property transferred or the value of the property transferred. There are limits on the ability of the trustee to recover from a transferee who receives the property in exchange for value (such as payment of a preceding debt) and in good faith without knowledge of the voidability of the transfer.

⁃    Discussion: Why do you think the bankruptcy law allows a DIP to avoid preferential and fraudulent transfers by the debtor? How do you feel about the default position that a transfer within 90 days of bankruptcy filing is a preferential payment? What do you think about the exemptions of certain types of otherwise preferential payments? Are there any exceptions you would add or exclude? Why? How do you feel about the 2-year look-back period for fraudulent transfers?

⁃    Practice Question: Martin is CEO of ABC Corp. ABC is going through financial problems and files for Chapter 11 bankruptcy. Two months before filing for bankruptcy, Martin directed ABC to repay an outstanding debt owed to 123 Corp. 123 Corp is owned by a close friend of Martin. Under what provisions might a DIP challenge this transfer?

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