Last week I wrote about stockholders in GMX Resources who were being sued as part of its bankruptcy for the recovery of dividends that they received prior to the bankruptcy filings. There are a ton of those cases filed. I haven’t spent a lot of time with the consolidated docket, but it looks like there were just under 200 Adversary Proceedings filed to recover property or payments of some kind in this Bankruptcy. About half of those were filed against owners of Preferred Stock, and I wrote about those last week. It appears that the other half were filed against people, or more frequently companies, who had received what are called Preferential Transfers; and I thought I this would be a good excuse to explain preferential transfers.

Preferential transfers are the product of two policies: 1. To make sure that when someone files for bankruptcy all creditors who have similar legal rights wind up getting treated essentially the same way; and 2. To encourage creditors to give debtors a bit of room to get back on their feet when they start to show signs of financial trouble.

Here are two examples of that. There is a natural inclination when you know you are sinking fast to want to repay loans from people you care about rather than those you might not. So, when that tax refund comes in, and you know you need to file for bankruptcy, are you going to repay the loan from your Mom or a credit card account? Well, yea, of course you are; but in terms of good policy, it isn’t fair for Mom to get better treatment than any other creditor.

This leads us directly into the next reason. If one creditor can get paid when no one else does and that creditor gets to keep the money, then at the first sign of trouble there will be a rush to squeeze money out of the Debtor – a virtual feeding frenzy if you will. Now, consider this in the context of a small business. Something bad happens. The business falls behind on paying its bills. At the first sign of trouble, all of its creditors take immediate steps to make sure that they get paid. The business collapses, because it lacks sufficient cash flow to keep the doors open.

Whereas, if the creditors had given the business 60 or 90 days to find its feet, the business might have stabilized, paid all its creditors, stayed in business, and continued providing an income for its employees and its owner. When you think about it, this kind of thing happens in the life of virtually all small businesses; and as it happens, creditors usually do give businesses time to get back on their feet – but they aren’t doing that at the risk that someone else will be less understanding and wind up with all the money and no one else will get anything. No. Creditors give debtors a chance to get back on their feet, because they know that if someone else doesn’t and the business files for bankruptcy, the money the greedy creditor got will be taken back and distributed out equally.

The tool for recovering those funds? Why an avoidance action to recover a preferential transfer, of course. This is a tool that bankruptcy trustees use frequently. If a Debtor’s wages are garnished in the 90 days before a bankruptcy? Well, that is one creditor getting paid and making sure no one else does. The trustee can take that money back. This is actually kind of nice when a debtor is being garnished and he owes recent taxes. When the trustee takes the garnished wages back, the first creditor he pays is the taxing authority.

There are defenses to preferential transfers, just like there are to fraudulent transfers. There are also times when it can be in a debtor’s best interests to have a Trustee recover preferential transfers. The nice thing about preferential transfers from the Debtor’s perspective is that the window for the transfer is generally quite short. Unless the transfer was made to (or benefited) an insider (like family), the transfer has to have been made within 90 days of the bankruptcy filing. That is a time period that can usually be waited out if necessary. Of course, if the transfer was to a family member, then the look back period is a year. That can be harder to wait out, although I have done it twice in the recent past.

The worst thing you can do about any type of transfer if you are getting ready to file for bankruptcy is to not tell your lawyer about it. I promise you, what he doesn’t know will hurt you.

Elaine