A preferential transfer is a transfer made (1) to or for the benefit of a creditor, (2) during the preference period (90 days or, in the case of insiders, one year) preceding the filing of the petition,(3)on account of an antecedent debt, (4)at a time when the debtor was insolvent, and (5) that permits the creditor to receive more than the creditor would receive from a distribution made in a chapter 7 liquidation in the absence of such transfer [§ 547(b)]. Analysis of preferential transfers requires one to look at all five elements.

Section 547(e) defines when a transfer occurs. For real property, the transfer occurs when a BFP can not acquire an interest superior to the interest of the transferee [§ 547(e)(1)(A)], i.e., the transfer instrument is recorded. For other property, a transfer occurs when a creditor on a simple contract can not acquire a judicial lien superior to the interest of the transferee [§ 547(e)(1)(B)]. For transfers by check, the transfer is completed when the drawee bank honors the check [Barnhill v. Johnson, 503 US 393 (1992)]. Under § 547(e)(2) transfers perfected within 10 days of the time the transfer takes effect between the debtor and the transferee relate back to the effective date, otherwise the transfer is made at the time of perfection. However, no transfer is deemed made until the debtor has acquired rights in the property [§ 547(e)(3)].

Insiders are defined in § 101(31) and, in the interests of editorially imposed brevity, those definitions are not repeated in this article.

A debt is a liability on claim [§101(12)], a claim in turn is a right to payment, whether liquidated, unliquidated, contingent, matured, unmatured, disputed, undisputed, legal, or equitable and any right to an equitable remedy if the breach gives rise to a right of payment [§ 101(5); Matter of Southmark, 88 F3d 311 (CA5 1996) cert den. 117 SCt 686 (1997)]. In an interesting twist on the definition of a "debt" involving a "check kiting" scheme, it was held that granting provisional credit by a bank for deposited but uncollected funds is deemed an advance on a debt from the bank to the depositor that will come due when the deposit clears the other bank and is not, therefore, a debt owed the bank by the debtor [Laws v. Missouri Bank of Kansas City, N.A., 98 F3d 1047 (CA8 1996)]. An antecedent debt is any debt then in existence, including an obligation that is not yet matured, e.g., future support obligations or installment loans [In re Futoran, 76 F3d 265 (CA9 1996)]. It has been held that a claim arising out of an executory contract does not "arise" until such time as the contract is breached, thus, a payment made contemporaneously with the "breach" is not on account of an antecedent debt [Matter of Southmark Corp., 62 F3d 104 (CA5 1995) cert. den. 116 SCt 815 (1996)].

A debtor is insolvent when the sum of the debtor's debts exceeds the aggregate value (at fair valuation) of the debtor's property, excluding fraudulently conveyed and exempt property [§ 101(32)]: the balance sheet insolvency test. If the debtor is a partnership, the non-exempt property of the general partners, to the extent it exceeds the partners' nonpartnership debts, is considered part of the debtor's property [§ 101(32)(B)(ii)].

A debtor is rebutably presumed to be insolvent during the 90-day period preceding filing [§ 547(f); In re Koubourlis, 869 F2d 1319 (CA9 1989)]. Presumption of insolvency during the 90 days immediately preceding the petition does not shift ultimate burden of proof, but merely shifts the initial burden of going forward with evidence. Once the transferee comes forward with substantial evidence of solvency, the presumption vanishes and plaintiff must come forward with sufficient evidence to meet its burden of proving insolvency [In re Sierra Steel, Inc., 96 BR 275 (BAP9 1989)]

Disputed and contingent claims against the debtor are considered in determining insolvency of the debtor at time of transfer. Contingent liability must, however, be reduced to its present or expected amount before insolvency can be determined, and, to determine contingent liability, one must discount it by the probability that the contingency will occur and liability will become real [id].

The fifth element, the "greater amount test," requires the court to construct a hypothetical chapter 7 case and determine what the creditor would have received in a distribution, taking into consideration the facts of the case as they actually exist, including claims actually filed and administrative costs necessarily incurred postpetition [In re LCO Enterprises, 12 F3d 938 (CA9 1993)]

Classification of the creditors' claim on the date the petition is filed is an important initial step. In an ordinary case, the amount and priority of an unsecured creditor's claim is fixed on the date of filing. Similarly, a secured creditor's claim is fixed in amount and the value of the security ascertained as of that date -- the claim may be either fully or partially secured.

If a creditor is fully secured, a prepetition transfer is not preferential because the secured creditor is entitled to receive 100% of its claim [Laws v. United Missouri Bank of Kansas City, N.A., supra; In re Powerine Oil Co., 59 F3d 969 (CA9 1995); see In re World Finance Service Center, Inc., 78 BR 239 (BAP9 1987) aff'd 860 F2d 1089 (CA9 1988)]. However, it is important to note that it is the value of the collateral at the time the petition is filed that controls, not the time of transfer [In re Sufolla, 2 F3d 977 (CA9 1993)]. Thus, if at the time the petition is filed the value of the collateral has deteriorated to an amount less than the creditor's claim (adding back in the amount of the transfer), the creditor is undersecured.

With respect to unsecured claims, the rule is quite different. In determining the amount that the transfer "enables [the] creditor to receive," the creditor must be charged with the value of what was transferred plus any additional amount that the creditor would be entitled to receive from a chapter 7 liquidation. The net result is that, as long as the distribution in bankruptcy to the creditor's class (as determined under 726) is less than 100%, any payment "on account" to an unsecured creditor during the preference period will enable that creditor to receive more than he would have received in liquidation had the payment not been made [In re Lewis W. Shurtleff, Inc., 778 F2d 1416 (CA9 1985)].

What about the undersecured creditor? The answer depends on (1) to what claim the payment is applied (application aspect) and (2) from what source the payment comes (source aspect). In bankruptcy, an undersecured creditor holds two different claims, each of which is entitled to different treatment in bankruptcy: (1) its claim against the collateral and (2) the amount of debt that exceeds the value of that property, which is by definition "unsecured." If payment is applied to the unsecured claim of the creditor, then in the usual situation the creditor will have received more than it would receive in a chapter 7 liquidation, meeting the greater amount test and satisfying the trustee's burden on the fifth element. By the same token, if the source of the payment is the creditor's own collateral, then the creditor will have received no more than it would receive in chapter 7 anyway, so that the greater amount test will not be met, and the trustee will have failed to sustain her burden on the fifth element. Even a payment that has been applied to the unsecured claim of an undersecured creditor will not trigger the test if the source of the payment is the creditor's own collateral. Both aspects of the test must be examined before a court can safely conclude that the greater amount test has or has not been satisfied in the case of an undersecured creditor.

Turning first to the "application" aspect, if a payment received by an undersecured creditor is applied to the unsecured portion of the debt, the effect of the transfer is similar to the effect on the ordinary unsecured creditor who receives such a payment. Like the unsecured creditor, the undersecured creditor who applies a transfer to the unsecured portion of its debt will have recovered a greater amount on this claim if the estate cannot pay 100% of the unsecured claims.

If the creditor applies the payment to the secured portion of the debt, on the other hand, the creditor effectively releases a portion of its collateral from its security interest (i.e., its secured claim is reduced, freeing up an equivalent amount of collateral). Now, the effect of the transfer is quite like that received by a fully secured creditor. The payment will not have enabled the creditor to receive any greater amount than it would have received in bankruptcy anyway, because, when payment was applied, a corresponding amount of collateral was released from the security interest, becoming at least theoretically available for bankruptcy distribution to unsecured creditors. If the creditor does not actually release collateral upon application of the payment, the payment is ipso facto a payment on the unsecured portion of the claim.

However, even if the payment in question is applied to the unsecured portion of an undersecured creditor's claim, the creditor will not be deemed to have received a greater amount as a result of the payment if the source of the payment is the creditor's own collateral. A creditor who merely recovers its own collateral receives no more as a result than it would have received anyway had the collateral been retained by the debtor, subject to the creditor's security interest. Upon bankruptcy, the collateral would simply be returned to that creditor by the trustee as part of the chapter 7 administration. When an undersecured creditor is paid from the proceeds of its collateral pre-petition, it has received precisely what it was entitled to receive anyway in the chapter 7 liquidation -- the value of its collateral. Thus, the undersecured creditor receives no more from a receipt of the proceeds of the collateral than it would have under a chapter 7 liquidation. [In re El Paso Refinery, L.P., 178 BR 426 (Bank.W.D.Tex. 1995); see In re Castletons, Inc., 990 F.2d 551 (CA10 1993)]

Certain transfers are specifically excluded from being classified as preferential. These will be covered in the next article.

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