By: Donald L Swanson
Preference avoidance provisions are a crucial part of the Bankruptcy Code—contained, primarily, in § 547 & § 550.
States also have a preference avoidance statute—for insiders. It’s in the Uniform Voidable Transactions Act (“UVTA)” or in its predecessor, the Uniform Fraudulent Transfer Act (“UFTA)).
The insider preference statute appears to be rarely-used and, apparently, little-known. It reads like this:
- “A transfer made by a debtor is voidable as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at that time, and the insider had reasonable cause to believe that the debtor was insolvent.”
- From Uniform Voidable Transactions Act, § 5(b); and Uniform Fraudulent Transfer Act, § 5(b) (except the word “voidable” in the UVTA is “fraudulent” in the UFTA).
Paragraph 2 of the UVTA’s “Official Comment” to § 5 says that such provision “adopts for general application” the rule of such cases as In re Lamie Chemical Co., 296 F. 24 (4th Cir. 1924).
What follows is an attempt to summarize the In re Lamie Chemical Co. opinion—from 1924—to shed light on today’s application of insider preference provisions under the UVTA and the UFTA.
The Lamie Chemical Company began in 1917, with its common stock held by 12 persons and 4,180 out of 5,000 shares owned and controlled by four officers having a close family relationship (the “Four Officers”).
The Company prospers, at the beginning—especially during the war years of 1918 and 1919, and until spring of 1920, when most of its foreign orders are cancelled, including contracts with customers in Japan valued at a half million dollars.
During 1920, the Company’s liabilities increase significantly, with many of those liabilities guaranteed by the Four Officers. By December 1920, the Company is running on borrowed money.
On December 14, 1920, the Company holds its annual meeting in Chicago, at which the Company resolves to pledge all its assets to the Four Officers to secure repayment of any guaranteed obligation they may be required to pay. The pledges are executed on January 3, 1921 but are not recorded until late 1921.
Two days before recording the pledges, two of the Four Officers sue the Company, (i) alleging that the Company is insolvent, and (ii) seeking appointment of a receiver to wind up the Company’s affairs.
Later, an involuntary bankruptcy petition is filed against the Company, and it is adjudged bankrupt. An action in bankruptcy to avoid the pledges produces this evidence:
- the Four Officers intended to raise $20,000 among themselves—none of which materialized;
- the pledges are given to secure past due obligations of the Company that the Four Officers had guaranteed; and
- no present consideration passes for the execution of the pledges in question.
A solvent corporation may secure its officers and directors from losses arising from their loans to and guarantees of the corporation’s obligations. But such transactions require the utmost good faith and must be free from every reasonable ground of suspicion.
Even if the Company were solvent at all material times, the following facts in this case raise questions about intentions of the Four Officers:
- withholding the pledges from the public record inflates the Company’s credit and can mislead or deceive creditors (this fact, alone, is sufficient to avoid the pledges);
- the pledges embrace all of the Company’s assets;
- the Company continues in possession and control of the pledged assets; and
- the pledge is to insiders—i.e., officers and majority owners of the company;
The Four Officers claim the Company is solvent at the time the pledges are signed (on January 3, 1921) but also admit that the Company is insolvent by October of 1921, when the pledges are recorded and a state receiver appointed.
But whether solvent or not, in January of 1921, the Company is in a precarious condition:
- it does well during the flush years of the World War and into early 1920; but
- beginning in the summer of 1920, a premonition that such conditions cannot last is painfully apparent.
In the latter part of 1920:
- some of the Company’s larger foreign contracts are canceled;
- the Company owes large sums of borrowed money;
- debt obligations from as early as 1919 are being renewed, again and again; and
- the Company cannot find a market for its inventory.
The date for determining solvency, for avoidance purposes, is the date of recording the pledges—not the date of their execution.
After execution of the pledges, and before their being placed on the public record, the Four Officers take deceptive action. For example:
- The audit and statements of the Company’s affairs give no intimation of the proposed pledges, or that the same are contemplated;
- On January 17, 1921, the Company’s vice president gives to the well-known commercial agency of R.G. Dun & Co. a statement of the Company’s financial standing, indicating that:
- it has no bonded indebtedness;
- none of its accounts are pledged in any manner; and
- there are no liens against its property, except for $16,250 on the New York branch.
- On September 23, 1921, the Company’s president tries to sell stock in the Company, by issuing flattering statements and by focusing on unusual dividends paid in the past and large sales made during the prior three years—but saying nothing about the unrecorded pledges or any other encumbrance.
–Settled State Law
The great weight of state law authority is settled that, when a corporation becomes insolvent or in a failing condition, the officers and directors:
- represent not only the stockholders, but by the fact of insolvency become trustees for the creditors; and
- cannot by a transfer of property or payment of cash prefer themselves or other creditors.
Such settled state law is “independent of any provision of the National Bankruptcy Act”; moreover, any transfer avoidable under such state law is also avoidable under the Bankruptcy Act.
States have an insider preference law—under the Uniform Voidable Transactions Act (or its predecessor, the Uniform Fraudulent Transfer Act).
Such law is, apparently, little-known and rarely used.
But it’s there . . . and it works.
** If you find this article of value, please feel free to share. If you’d like to discuss, let me know.