Undoing the Payments a Company Made on Its Way Down
A bankruptcy estate can recover money the debtor paid out before filing, including ordinary payments to suppliers and transfers made for inadequate value. The purpose is equal treatment, and the effect surprises recipients.
The Principle Underneath
Bankruptcy distributes a limited pool among creditors according to priority, with creditors of equal rank sharing proportionally. That principle is meaningless if a debtor can decide in the weeks before filing which creditors get paid in full.
Nor does it work if a debtor can move valuable assets to friends and family for nothing shortly before losing everything else.
Avoidance actions address both. They let the estate recover transfers made before the filing and redistribute the money according to the rules that should have applied.
Preferences
A preferential transfer is a payment to a creditor on an existing debt, made while the debtor was insolvent, within ninety days before filing, that enabled the creditor to receive more than it would have in a liquidation.
The lookback extends to one year for insiders, meaning officers, directors, and affiliates.
The element that surprises people is what is absent. There is no requirement of wrongdoing by anybody. A supplier that delivered goods, invoiced normally, and was paid in the ordinary course can be sued to return the money.
| Element | Requirement |
|---|---|
| Transfer of debtor property | Cash, goods, or granting a lien |
| To or for a creditor | On account of an existing debt |
| While insolvent | Presumed in the 90 days before filing |
| Within the lookback | 90 days, or one year for insiders |
| Improved the creditor position | Received more than in liquidation |
A preference claim is not an accusation. It says the payment was fine when made and the outcome is inconsistent with equal treatment among creditors, so the money goes back into the pool and the supplier takes its share alongside everybody else.
The Defences That Do the Real Work
Because the rule as stated would make trade credit unworkable, the code provides defences that most legitimate suppliers can use.
The ordinary course of business defence protects payments consistent with the historical dealings between the parties, or with ordinary terms in the industry. A supplier that was always paid in about forty days and continued to be paid in about forty days is protected.
The new value defence protects a creditor to the extent it supplied further goods or services after receiving the payment, on the reasoning that it replenished the estate.
A contemporaneous exchange for new value, meaning cash on delivery, is not a preference at all, because it was not a payment on an existing debt.
The practical consequence is that suppliers who tightened terms as the debtor deteriorated are the most exposed. Moving a customer from sixty day terms to cash in advance is prudent credit management and is exactly the pattern that defeats the ordinary course defence.
Fraudulent Transfers
The second category reaches further back and is more serious in character.
An actual fraudulent transfer is one made with intent to hinder, delay, or defraud creditors. Intent is proved through circumstantial indicators traditionally called badges of fraud: transfers to insiders, retention of control after transfer, concealment, transfer of substantially all assets, and timing near a threatened claim.
A constructive fraudulent transfer requires no intent at all. It occurs where the debtor received less than reasonably equivalent value and was insolvent, or was rendered insolvent, or left with unreasonably small capital.
That second branch is the one with commercial consequence, because it reaches transactions nobody thought of as fraudulent.
Where Constructive Fraud Reaches Real Deals
The most significant application is to leveraged buyouts. In a typical structure the target company grants liens and incurs debt, and the proceeds go to selling shareholders rather than to the company.
From the target perspective it has taken on substantial obligations and received little in return. If it fails afterward, creditors can argue the transaction was a constructive fraudulent transfer, seeking to recover from the selling shareholders.
Courts have addressed this in major cases, and a statutory safe harbour protecting certain securities transactions from avoidance has been central, with its scope narrowed by the Supreme Court in a 2018 decision that clarified the protection does not apply merely because a financial institution acted as a conduit.
Dividend recapitalisations and large distributions to owners raise the same question, which is why solvency opinions are commissioned before such transactions and why those opinions are examined closely afterward.
What It Means Commercially
For a supplier, exposure is manageable and requires attention. Maintaining consistent payment terms with a deteriorating customer preserves the ordinary course defence, while tightening terms destroys it. Continuing to ship after receiving payment builds the new value defence. And receiving a demand letter years after a customer bankruptcy is normal rather than alarming, since these claims are frequently pursued in bulk near the limitation deadline.
For anyone structuring a transaction that moves value out of a company, contemporaneous solvency analysis is the protection, and its quality is what a court will examine if the company fails.
The Bottom Line
Avoidance actions exist so that a debtor cannot choose its winners in the weeks before filing, and so that value cannot be moved beyond the reach of creditors before the door closes. Preferences reach ordinary payments made in good faith and are defended by consistency of dealing. Constructive fraudulent transfer reaches transactions that were never fraudulent in any ordinary sense, including leveraged buyouts and dividend recapitalisations, and it is the reason solvency opinions exist at all.