It Cuts Both Ways: How Preference Avoidance Actions Can Harm Business Relationships Between Debtors and Creditors

Abstract

It is no secret in the bankruptcy community that creditors hate so-called “preference” actions, which permit a debtor to recover payments made to creditors on the eve of bankruptcy for the benefit of the estate. This resentment is particularly palpable among trade creditors, which tend to be unsecured businesses providing the debtor goods and services on credit terms. Nominally, preference actions are intended to equalize the extent to which each unsecured creditor must bear the loss of a bankruptcy discharge, or to discourage creditors from rushing to collect from the debtor in such a way that will push an insolvent debtor into bankruptcy. But empirical evidence strongly suggests that, at least in chapter 11 reorganization proceedings, preference actions do not fulfill either of these stated goals. Interviews with debtors, trade creditors, and attorneys involved in small-and medium-sized chapter 11 bankruptcy cases establish both that creditors are not deterred from collecting by preference actions, and that preference actions are not applied equally in a system where debtors are able to choose which preferential transfers to avoid and how much to accept in settlement of preference actions. Instead, these interviews suggest an alternative justification for preference law in chapter 11, one more consistent with promoting a debtor’s ability to exercise strategic leverage over its creditors in an effort to reorganize. In this way, the law of preference avoidance is actually one of preference perpetuation, in the interest of preserving valuable relationships within bankruptcy proceedings.