Volume 42 | Number 3 Summer 2007
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II. The Evolution of Preference Law and Policy
A. The Debtor Deterrence Rationale
Broadly speaking, a preference is a payment of money or a transfer of property made by a debtor to a creditor on the eve of the debtor’s bankruptcy, representing more than the amount the creditor would recover in the debtor’s bankruptcy distribution. Early preference law developed through case authority. In The Case of Bankrupts (Smith v. Mills), Lord Coke stated the rationale for the avoidance of preferences in terms of the need to preserve the principle of equal distribution underlying the bankruptcy laws: “there ought to be an equal distribution . . . [for] if, after the debtor becomes a bankrupt, he may prefer [a creditor] and defeat and defraud many other poor men of their true debts, it would be unequal and unconscionable, and a great defect in the law.”6 Lord Mansfield expressed a similar view in Alderson v. Temple.7 According to Dickson J. in Hudson v. Benallack, this is still the policy of Canadian preference law:
The object of the bankruptcy law is to ensure the division of the property of the debtor rateably among all his creditors in the event of his bankruptcy . . . . The Act is intended to put all creditors upon an equal footing. Generally, until a debtor is insolvent or has an act of bankruptcy in contemplation, he is quite free to deal with his property as he wills and he may prefer one creditor over another but, upon becoming insolvent, he can no longer do any act out of the ordinary course of business which has the effect of preferring a particular creditor over other creditors. If one creditor receives a preference over other creditors as a result of the debtor acting intentionally and in fraud of the law, this defeats the equality of the bankruptcy laws.8
The following statement from Re Norris, an Alberta Court of Appeal decision, makes the point even more clearly:
. . . [the fraud lies in] the accompanying intent of the insolvent debtor who in the face of imminent bankruptcy is moved to prefer or favor, before losing control over his assets, a particular creditor over others who will have to wait for and accept as full payment their rateable share on distribution by the Trustee in the ensuing bankruptcy. It is called fraudulent because it prejudices other creditors who will receive proportionately less, or nothing at all, and upsets the fundamental scheme of the Act for equal sharing among creditors.9
Although these explanations are all framed in terms of equal distribution in bankruptcy, they cannot mean that the objective of preference laws is to ensure equal distribution per se. The emphasis on the debtor’s state of mind and the reprehensibility of the debtor’s conduct is inconsistent with the objective of preserving equality of distribution per se. All transactions having the effect of favouring a particular creditor disrupt the equal treatment of creditors in bankruptcy, regardless of whether the debtor intended that result and regardless of the moral character of the transaction. Lord Coke’s statement discloses the real concern, namely that it is wrong for the debtor to play favourites among creditors in defiance of the bankruptcy laws: paying out friends,10 relatives and business connections ahead of other creditors is wrong because, given the debtor’s impending bankruptcy, it deprives “other poor men of their true debts.” This is where the fraud lies. Another way of making the same point is to say that the debtor may not “set himself up as the law-giver in bankruptcy distribution.”11 That is how Lord Mansfield expressed it in Alderson v. Temple.12
In summary, according to the old cases the rationale for the preference laws is “debtor deterrence.” Under this model, it is the debtor’s conduct that is viewed with suspicion.13 The debtor deterrence rationale presupposes sanctions against the preference-giving debtor. The main burden of the preference laws falls on the creditor rather than the debtor. What penalty does the debtor suffer? In former times, the giving of a preference was a criminal offence for which the bankrupt would be pilloried and have an ear cut off.14 This, along with other barbaric features of the bankruptcy laws, has long since disappeared, but there are vestiges of a penal strategy in the modern law. For example, in Canada the giving of a preference is a ground for denying or suspending the debtor’s right of discharge.15
B. The Creditor Deterrence Rationale
Jackson offers a quite different justification for the preference laws.16 In his view, the debtor’s insolvency creates a common pool problem. In the absence of bankruptcy laws, once individual creditors learned about the debtor’s insolvency, each creditor would have an incentive to engage in a race for the debtor’s assets both to make sure of being paid in full and also because, if a creditor does not race and the other creditors do, it will be left with nothing. This self-interested behaviour is against the interests of the creditors collectively because it is likely to result in the piecemeal dismemberment of the debtor’s estate, and it is often the case that the debtor’s estate will be worth more if it can be sold intact. Moreover, the prospect of a race to judgment would require creditors to engage in costly monitoring of not only the debtor’s financial situation but also other creditor’s activities to make sure they did not gain a head start if a race were to eventuate. Bankruptcy law addresses theses concerns by substituting a mandatory system of collective debt collection for the individual, winner-take-all collection system that operates outside bankruptcy. The preference laws are an integral part of the transition from one system to the other. This is because, in the absence of the preference laws, creditors who find out about the debtor’s impending bankruptcy may take advantage of the information to have their own claims satisfied, thereby opting out of the collective proceeding altogether. “By the time the bankruptcy petition is actually filed, those creditors that remain would have to share in the ‘tag ends and remnants’ of the [debtor’s] assets.”17 In short, preference law is “part of the attempt to ameliorate the effects of a common pool problem that justifies a collective proceeding in the first place.”18
Lord Coke’s justification for the preference laws looks to the debtor’s conduct in giving the preference. By contrast, Jackson’s justification looks to the creditor’s conduct in receiving it. While Lord Coke’s approach provides a debtor deterrence rationale for the preference laws, Jackson’s approach provides a creditor deterrence rationale.19 Under the creditor deterrence model it is the creditor’s conduct that is viewed with suspicion.20 In the United States over the years, “the focus of the preference laws has shifted from the culpability of the debtor, to the culpability of creditors, to the present day standard of strict liability.”21 These changes all reflect different ways of thinking about the preference laws: debtor culpability is consistent with the debtor deterrence rationale; creditor culpability is consistent with the creditor deterrence rationale; strict liability is consistent with the idea that the purpose of the preference laws is to promote equality of distribution per se.
C. The Equal Sharing Rationale
In 1978, the United States moved away from a creditor culpability model. Congress eliminated the requirement that the creditor recipient have reasonable cause to believe that the debtor was insolvent and, in its place, introduced a strict liability regime. The move was justified in the following terms:
Whether or not a creditor knows or believes that his debtor is sliding into bankruptcy is important if the only purpose of the preference section is to deter the race. However, a creditor’s state of mind has nothing whatsoever to do with the policy of equality of distribution, and whether or not he knows of the debtor’s insolvency does little to comfort other creditors similarly situated who will receive that much less from the debtor’s estate as a result of the prebankruptcy transfer to the preferred creditor. To argue that the creditor’s state of mind is an important element of a preference and that creditors should not be required to disgorge what they took in supposed innocence is to ignore the strong bankruptcy policy of equality among creditors.22
In other words, strict liability supports a policy of equal sharing. The reference to equality cannot be taken literally because the principle of equality, as embodied in the pari passu rule, is largely a myth in modern bankruptcy law. The exceptions (insolvency set-off, preferential claims, deferred claims and so on, in conjunction with the prevalence of secured credit) are so extensive that they all but swallow the rule. The only claimants subject to the pari passu rule are the general unsecured creditors, but in the overwhelming majority of bankruptcy cases there is nothing left to distribute among the general unsecured creditors once secured and preferred creditors have been paid out. Bearing these considerations in mind, the equal sharing rationale presumably means that creditors should share in accordance with the overall scheme of distribution provided for in bankruptcy laws.23
In any event, contrary to the impression the quoted passage creates, the current United States preference provisions do not unequivocally embrace the equal sharing rationale (whatever equal sharing might mean). The Bankruptcy Code, § 547(c)(2) creates an exception to preference liability for transfers in the ordinary course of business. The purpose of the ordinary course exception has been explained in the following terms:
The purpose of this exception is to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor’s slide into bankruptcy.24
In other words, “only extraordinary behavior by creditors who are seeking to ‘opt out’ of the bankruptcy scheme should be condemned by preference law.”25 So, it seems that the aim of the preference laws is not to promote equal distribution between creditors. Creditor deterrence is still the objective. It is true that the 1978 law eliminated the “reasonable cause to believe” test on the express ground that the creditor’s intentions are irrelevant to the goal of equal distribution. However, “by creating the ordinary course exception in the 1978 law, Congress indirectly resurrected the same core principle of culpability.”26
There is similar ambivalence in other common law countries about the goals of the preference laws. For example, according to the Australian Law Reform Commission, the preference laws reflect “two fundamental principles of insolvency law – that of equal sharing between creditors and that of promoting an orderly process both during and immediately preceding the formal insolvency administration.”27 However, the Australian preference provisions focus on creditor culpability and this is inconsistent with the equal sharing rationale.28 The ALRC went on to say that abandoning the preference laws “would deliberately favour and encourage creditors who quite legally extracted payments from the debtor – even at the eleventh hour.”29 This last statement implies that creditor deterrence is the real objective and that current legislation is consistent with the creditor deterrence rationale. By contrast, the English preference provisions focus on debtor culpability,30 reflecting a commitment to the debtor deterrence rationale.31 However, the English provisions have been criticized for being out of step with modern bankruptcy policy.32
D. Finality of Transactions
There is tension between the goals of preference laws and the need for finality of transactions. “From a commercial perspective, it is appropriate to encourage debtors to pay creditors. It is also important that a creditor be able to rely on the validity of a payment. Commercial transactions should not be lightly interfered with.”33 Another possible explanation for the ordinary course exception in United States preference laws is that it represents a trade-off between the goals of equal sharing and finality of transactions.34 A strict liability preference law threatens the finality of transactions because it means that creditors can never be sure that their payments will be immune from attack. This uncertainty adds to creditors’ costs and it is likely to be reflected in the cost and availability of credit. The ordinary course exception addresses this problem in part by limiting liability to cases where the creditor knows about the debtor’s insolvency.
It has been suggested that a better response to the finality of transactions concern might be to shorten the review period.35 However, while a shorter review period may limit creditors’ exposure, it does not assist them in managing the risk. This is because creditors may have no way of knowing at the time of receiving the payment whether it falls within the review period.
E. Facilitating the Provision of Credit to Financially Distressed Debtors
The finality of transactions concern is a function of the strict liability preference law model. It does not arise if the law requires proof of either debtor or creditor culpability because in both these regimes creditors have the means of knowing in advance whether a payment may be subject to attack. A possible conclusion is that an ordinary course exception is unnecessary unless strict liability is the rule.
However, this presupposes that the purpose of the ordinary course exception is to facilitate the provision of credit outside the review period. There is an alternative construction, namely that the purpose is to facilitate the provision of credit inside the review period. “Allowing creditors to obtain ordinary course payments actually encourages them to do business on a credit basis with a financially distressed debtor. As a result, the debtor may be able to stay afloat and avoid bankruptcy entirely, or at least hold a stronger financial condition when it does go into bankruptcy.”36 In other words, the function of the ordinary course exception is to maximize the value of the debtor’s estate for the benefit of all the creditors and current United States bankruptcy law trades off this objective against the equal sharing goal.
On this analysis, the ordinary course exception is not simply a function of the strict liability rule and may have a role to play in other regimes as well. For example, lawmakers who opt for a debtor culpability regime may want to incorporate an ordinary course exception in order to strike a trade-off between debtor deterrence on the one hand, and facilitating the provision of credit to financially distressed debtors on the other. Likewise, the incorporation of an ordinary course exception in a creditor culpability regime may signal a willingness to sacrifice some creditor deterrence in exchange for the stimulus to lending the exception provides.
Still, it is not certain that such trade-offs yield net benefits. Some commentators argue that the ordinary course exception may have perverse incentive effects and that, far from encouraging creditors to deal with financially distressed debtors, it may actually discourage them. The argument is that a creditor who gets paid in the ordinary course need not co-operate further with the debtor because if the debtor goes into bankruptcy, the creditor can simply keep the payment and not extend more credit.37 A related argument is that the ordinary course exception may have a chilling effect on the provision of credit to financially stable debtors, and this more than offsets the benefits of more freely available credit to debtors who are financially distressed.38
F. The Trade-Offs
There are different schools of thought in the United States on the trade-offs the ordinary course exception involves. Some favour the present law, with or without relatively minor modifications.39 Others argue that the exception should be repealed to recognize the goal of equal sharing among creditors is paramount.40 At the opposite end of the spectrum, some argue for a repeal of preference laws on the ground that they are not cost-effective.
For example, McCoid contends that the objective of preference laws is creditor deterrence, but the laws fail to deter because the sanction is inadequate. If the trustee brings a successful preference action, the only consequence is that the creditor must return the payment. Except to the extent that the creditor has expended resources either obtaining the preference in the first place or defending the action, it is no worse off after returning the preference than it would have been had it never received the preference in the first place.41 A possible rejoinder is that the argument over-states the case for abolition. Creditors’ expenditure on obtaining the preference in the first place and subsequently fighting to keep it are dead-weight costs. The prospect of incurring these costs has some deterrent effect, and so the problem is one of under-deterrence rather than no deterrence at all. Under-deterrence is better than no deterrence at all, which would certainly be the result if the preference laws were repealed.42
In the course of its General Insolvency Inquiry, the Australian Law Reform Commission received a submission from Justice Pincus, a judge of the Federal Court of Australia, recommending repeal of preference provisions on the ground that the costs of litigating preference claims defeat the underlying policy objectives.43 Alan Schwartz offers a more sophisticated version of the same argument:44
(1) The creditor deterrence rationale for preference laws is misguided because creditors cannot force a financially distressed firm to pay preferences. Creditors can threaten attachment to try and force the debtor to pay, but the debtor can credibly respond by threatening to file for bankruptcy and thus stay all attachments. Therefore, if preference laws were repealed, distressed debtors would pay preferences because they wanted to, not because they had to;
(2) The debtor deterrence rationale has no purchase unless the debtor expects to be liquidated. Otherwise, the debtor will want to settle with its creditors, and non-preferred creditors will not accept in settlement an amount less than their pro rata bankruptcy payoffs. In other words, “the pro rata rule precludes a firm interested in survival from paying today what are defined as preferences. Consequently, a separate prohibition against preferences does not materially increase a financially distressed firm’s commitment to the pro rata rule”;45
(3) If a debtor firm expects to be liquidated, it will be indifferent as to how its assets are distributed among creditors because the firm will disappear with certainty. However, the firm’s principals may not be indifferent. They may cause the firm to pay particular creditors to ensure goodwill for themselves, in consequence of a personal relationship or to avoid liability exposure if a principal has guaranteed the firm’s debt;
(4) Actions to recover preferences paid in these circumstances are inefficient both ex post and ex ante. They are ex post inefficient because they cost money, thereby diminishing the value of the bankruptcy estate: “redistributing the assets of a failed firm among its general creditors amounts to redecorating the Titanic’s salon”;46
(5) Abolition of the preference laws would save the costs of redistributing the firm’s assets, thereby increasing the collective returns to creditors in future. The prospect of higher collective returns in bankruptcy should result in lower borrowing costs. Conversely, preference laws increase borrowing costs and are ex ante inefficient.
Critics might take issue with step (1) of Schwartz’s argument on the ground that it too readily assumes a debtor’s willingness to play the bankruptcy card. Unless the debtor expects to be liquidated, it will want to maintain good relations with its key suppliers and creditors. Threatening to file for bankruptcy in response to a creditor’s demand for payment is not conducive to maintaining good relations. Of course, if the debtor realizes its hopes of staying in business, the preference question will go away. On the other hand, the debtor’s hopes may not be realized. Financially distressed debtors have a tendency to over-estimate their chances of recovery and creditors may exploit the debtor’s self-deception to extract preferential payments.47 Step (4) amounts to an implicit rejection of both the debtor deterrence rationale and the equal sharing rationale for the preference laws; critics might take issue with this because it summarily discounts non-economic arguments in support of preference laws.48 It is worth noting that the Australian Law Reform Commission rejected Justice Pincus’s proposal for repeal of preference laws on the ground that it “would do much to undermine two fundamental principles of insolvency law – that of equal sharing between creditors and that of promoting an orderly process both during and immediately preceding the formal insolvency administration.”49