B. Preferences

Author:Roderick J. Wood
Profession:Faculty of Law. University of Alberta

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Anti-preference provisions are legislated by federal and provincial statute. The provincial provisions refer to the impeachable transactions as fraudulent preferences, while the BIA provisions merely refer to them as preferences. The latter usage is superior in that it more accurately describes the policy that is being pursued. A preference does not involve an intention to defraud in the same sense that the term usually carries in the law. Rather, a preference is unjust because it prefers one creditor over the others and thereby undermines the statutory scheme of distribution mandated by bankruptcy law.

1) Distinction between Fraudulent Conveyances and Preferences

A distinction is often drawn between a fraudulent conveyance and a preference. A fraudulent conveyance involves a transfer or other disposition of property that defeats, hinders, or delays the efforts of per-

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sons having claims against the debtor. A debtor may transfer property on the understanding that the property will be returned to the debtor once the financial difficulties come to an end, or once the creditors tire from their pursuit of the debtor. This transfer is designed to hinder the collection efforts of the creditors. The debtor might also transfer property to a friend or relative without any expectation of sharing in the use of the property transferred. This transfer prejudices the claimants since there are fewer assets available to them to satisfy their claims.

A preference does not involve an attempt to defeat creditors. Rather it is a selective transfer of property made to a creditor. Ordinarily, the payment of creditors by debtors is considered to be a good thing. However, if the debtor does not have sufficient assets to satisfy all claims against the debtor, a transfer of property will have the effect of giving that creditor a preference over the other creditors. This is considered unfair because it undermines the scheme of distribution that would otherwise prevail under bankruptcy law or under provincial judgment enforcement law.

A preference requires a transfer of property to a creditor. A fraudulent conveyance does not. A transfer that involves a transfer of property to a creditor will not generally be impeachable as a fraudulent conveyance.53The problem associated with a preference is not that it defeats, hinders, or delays creditors; rather, the problem is that a preferred creditor obtains a greater share of the assets, leaving less for the other creditors.54There are some instances where a transfer to a creditor may nevertheless be impeached as a fraudulent conveyance.55This can occur where the transaction is a sham. For example, a mortgage document might be prepared under which a debtor grants a mortgage to a lender to secure of debt of $100,000. In fact, the debtor owes only $20,000 to the lender. The document is prepared in the hopes that it will dissuade other claimants from attempting to enforce against the property. Alternatively, property valued at $100,000 may be transferred to a creditor in satisfaction of a debt of $20,000. In both instances, the transaction may be impugned as a fraudulent conveyance despite the fact that both involve a transfer to a creditor.

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2) Preferences under the BIA

A trustee may attempt to avoid a transaction as a preference under the BIA. The Act provides a general rule for the avoidance of a preference. The general rule is modified if the person receiving the preference is not acting at arm’s length with the debtor. The general rule will be examined first.

Under the general rule, a transaction can be avoided as a preference under the BIA if the following conditions are satisfied:56

· the debtor has transferred property, provided services, given a charge on property, made a payment, incurred an obligation, or suffered judicial proceedings;

· the transaction is in favour of a creditor;

· the transaction has the effect of giving the creditor a preference;

· the debtor intended to prefer the creditor over other creditors;

· the debtor was insolvent at the time of the preference and

· the transaction occurred within a period beginning three months before the date of the initial bankruptcy event and ending on the date of the bankruptcy.

Each of these elements will be separately discussed below.

a) Transactions That Constitute a Preference

A preference will usually take one of three forms. First, it may involve a full or partial payment to a creditor. Second, it may involve the granting of a security interest by the debtor to a creditor to secure a previously unsecured debt. Third, it may involve the transfer of property to the creditor in satisfaction of a debt or other liability. An example of this third category of preference is where a debtor returns inventory that had been sold to it by a seller in cancellation of the purchase price.

The preference provision of the BIA is not limited to these usual situations but also covers a number of less common cases. A creditor who recovers money pursuant to legal proceedings may discover that its recovery is subject to impeachment by a trustee. The BIA provision is not limited to consensual transfers by the debtor but extends to judicial proceedings suffered by the debtor. This will cover a landlord who exercises a right of distress against the debtor’s property.57It will also cover a debtor who consents to a judgment in order to permit a creditor to recover the claim through judgment enforcement proceedings before any of the other creditors can enforce their claims.

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An interesting issue arises in connection with the operation of an after-acquired property clause in a security agreement where the secured creditor is not fully secured. This is illustrated in the following scenario:

A secured creditor S is given a security interest in all of D’s present and after-acquired personal property to secure a loan. The security is properly registered and was given while D was solvent. D later becomes insolvent. The value of D’s assets is less than the amount owed to S. D makes unusually large purchases of goods from suppliers on credit. D’s intention in doing so is to reduce the amount of S’s indebtedness.

Although there are no cases on point, the transaction in principle should be capable of being impeached as a preference. The transfer to S occurred when D acquired the property rather than when the security interest is executed, since this is the time when the security interest attaches to the new goods. The impeachment of this transaction by a trustee would not result in the complete avoidance of the security interest. The security interest could be avoided only in respect of the new assets acquired by the debtor during the relevant time period. Although the trustee has the benefit of a statutory presumption that the debtor intended to give a preference, a secured creditor could rebut this by showing that the acquisition of inventory occurred in the ordinary course of business of the debtor.

b) In Favour of a Creditor

The preference must be in favour of a creditor. The definition of creditor is not restricted to persons who are owed a debt or liquidated demand but includes any person who has a provable claim.58This is sufficient to cover claimants who have unliquidated or contingent claims against the debtor. The definition of creditor is further expanded for the purposes of the preference provision to include a surety or guarantor for the debt due to the creditor.59This covers the situation where a debtor makes a payment to a creditor with the intention of giving a preference to a guarantor.60For example, a bank may have made a loan to a debtor and obtained a personal guarantee from the debtor’s mother. The debtor may decide to repay the loan in order to release his or her mother from liability under the personal guarantee. The expanded definition of creditor ensures that the trustee can recover from the bank

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even though the debtor’s intention was to prefer the guarantor rather than the bank.61c) Preferential Effect

The transaction must have the effect of giving a creditor a preference.62

Some courts refer to this as a requirement that there be a "preference in fact."63The test for preferential effect is whether it has improved a creditor’s position from that which would have prevailed under the statutory scheme of distribution in bankruptcy. Payment of a creditor does not have preferential effect if the creditor ranks as a preferred creditor under the statutory scheme of distribution in the bankruptcy and if there would have been sufficient assets to pay the preferred claim in full.64A payment to a fully secured creditor does not have preferential effect since it reduces the obligation secured by the security interest. The value of the payment lost by the bankrupt estate is matched by the gain in the unencumbered value of the collateral. However, a payment to a secured party can be impeached if the payment exceeds the value of the collateral, or if the security interest is subordinate to the trustee.65

Although a payment to a fully secured creditor does not have the effect of preferring the secured creditor, it may in some circumstances prefer a subordinate secured creditor. This is illustrated in the following scenario:

A senior secured creditor (S1) has first priority to an asset valued at $10,000 that secures an obligation of $5,000. A junior secured creditor (S2) has second priority to the asset that secures an obligation of $10,000. The debtor pays...

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