Seventh Circuit: No Avoidance Of Preferential Or Fraudulent Transfer Absent Diminution Of The Estate

• Jurisdiction: United States,Federal
• Law Firm: Jones Day
• Subject Matter: Criminal Law, Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy, White Collar Crime, Anti-Corruption & Fraud
• Author: Patrick Lombardi
• Published date: 02 October 2023

In Mann v. LSQ Funding Group, L.C., 71 F.4th 640 (7th Cir. 2023), reh'g denied, 2023 WL 4684702 (7th Cir. July 21, 2023), the U.S. Court of Appeals for the Seventh Circuit affirmed the entry of summary judgment by a Wisconsin bankruptcy court dismissing litigation commenced by a chapter 7 trustee seeking to avoid as a fraudulent and preferential transfer a pre-bankruptcy payment made by a third party to satisfy the debtor's obligation under a factoring agreement because the transferred funds were never "an interest of the debtor in property." The Seventh Circuit reasoned that the transferred funds did not diminish the amount available for distribution to the debtor's creditors because the funds were not estate property.

Avoidance of Preferential and Fraudulent Transfers

In bankruptcy cases, a trustee has the "paramount duty ... to act on behalf of the bankruptcy estate, that is, for the benefit of the creditors." In re Cybergenics Corp., 226 F.3d 237, 243 (3d Cir. 2000). In furtherance of this duty, the Bankruptcy Code provides trustees with an array of tools that they can wield to fulfill this mandate. Among these tools are the "statutorily created powers, known as avoidance powers, which enable trustees to recover property on behalf of the bankruptcy estate." Id. Each avoidance power has a specific application. Two of the most commonly invoked avoidance powers are the ability to avoid preferential and fraudulent transfers made (or obligations incurred) by debtors prior to filing for bankruptcy.

Preferential Transfers. A preference generally "exists when a debtor makes a payment or other transfer to a certain creditor or creditors and not others." Kenan v. Fort Worth Pipe Co. (In re George Rodman, Inc.), 792 F.2d 125, 127 (10th Cir. 1986). Section 547(b) of the Bankruptcy Code establishes the trustee's power to avoid preferential transfers, providing in part:

Except as provided in subsections (c) and (i) of this section, the trustee may, based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses under subsection (c), avoid any transfer of an interest of the debtor in property ....

11 U.S.C. ' 547(b) (emphasis added). A preferential transfer may be avoided under section 547(b) only if:

1. The transfer was made to or for the benefit of a creditor (' 547(b)(1));

2. The transfer was for or on account of an antecedent debt owed by the debtor (' 547(b)(2));

3. The transfer was made while the debtor was insolvent (' 547(b)(3));

4. The transfer was made either: (i) on or within 90 days before the date of filing of the petition; or (ii) between 90 days and one year before the filing of the petition if the creditor at the time of the transfer was an insider (' 547(b)(4)); and

5. The transfer enables the transferee to receive more than it would have received in a chapter 7 liquidation had it not received the transfer (' 547(b)(5)).

Section 547(c) contains nine defenses or exceptions to avoidance. These include, among other things, contemporaneous exchanges for new value, ordinary course business transfers, transfers involving purchase-money security interests, and transfers after which the transferor subsequently provides new value to the debtor.

There are also certain other nonstatutory defenses to preference liability. One of these is the judge-fashioned "earmarking doctrine," which provides that the debtor's new borrowing of funds to satisfy a preexisting debt is not deemed a transfer of property of the debtor and therefore is not avoidable as a preference. That is, if a third party provides funds for the specific purpose of paying a creditor of the debtor, hence "earmarking" them for that purpose, the transfer of the funds to the creditor may not be recoverable as preference. The doctrine rests on the idea that the funds are not within the control of the debtor, and because one debt effectively is exchanged for another, there is no diminution of the debtor's bankruptcy estate. See generally Collier on Bankruptcy ("Collier") '547.03[2][a] (16th ed. 2023).

Fraudulent Transfers. Section 548(a)(1) of the Bankruptcy Code empowers a bankruptcy trustee to avoid pre-bankruptcy fraudulent...