Preference Payments in Bankruptcy: Rebutting the Presumption of Insolvency during the COVID-19 Pandemic

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As the COVID-19 pandemic continues to cause harsh economic conditions throughout the United States, many companies face the difficult prospect of bankruptcy. Smaller businesses in particular have had to endure significant pain as a result of state-mandated closures and stay-at-home orders and public fear about the virus. Certain industries, such as leisure, dining, and travel, have been hit especially hard. Recent studies suggest that 2 percent of small businesses and 3 percent of restaurant operators have already gone out of business.[1] Many of these businesses will file for bankruptcy despite having been in relatively sound financial shape a mere three months ago. These sudden collapses impact preferential transfers.

Section 547 of the Bankruptcy Code allows a trustee or debtor in bankruptcy to recover, or “avoid”, certain payments made by the debtor in the 90 days (or in the case of a payment to an insider within one year) prior to the filing of a bankruptcy petition. For example, a trustee may be able to avoid an end of year 2019 distribution to a business owner or a March 2020 payment to a restaurant supplier for goods.

Known as “preferences,” a trustee or debtor is entitled to recover these payments so that the transferred funds may be included in the bankruptcy estate for equal distributions to all similarly situated creditors. Often creditors who received payments during the applicable look-back period (and who are generally owed even more money by the debtor) are angered to learn that they may have to return the money they were paid to the debtor’s estate, however the preference statute serves an important purpose. It prevents the preferential treatment—hence the name—of some creditors over others in the weeks and months leading up to the filing of a bankruptcy petition.

To constitute an avoidable preference, five requirements must be met. One such requirement, that the transfer be made while the debtor was insolvent, is generally presumed, but this presumption can be rebutted.[2] In light of the difficult economic conditions caused by the COVID-19 pandemic, this rebuttable presumption is especially relevant as the pandemic presents the rare case where a debtor may have become insolvent only a short time before the bankruptcy filing.

The insolvency presumption usually prevents the debtor or trustee from having to present evidence of insolvency. This makes sense because, in almost all cases, a company does not transition from solvency to filing for bankruptcy during the look-back period. Usually, a company will attempt to ride out tough times before taking such an extraordinary step. However, like with so many things, the typical presumptions may not be the case for businesses hit hard by COVID-19.

Defining “Insolvency” Under the Code

Insolvency is a question of fact decided by the bankruptcy judge. In re Ames Dep’t Stores, Inc., 506 Fed. App’x 70, 72 (2d Cir. 2012). Thus, “the Bankruptcy Court has broad discretion when considering evidence to support a finding of insolvency.” Id.

To determine whether a debtor was insolvent, the court looks to the Bankruptcy Code’s statutory definition of this term. Under the Code, a debtor is insolvent if “the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.” 11 U.S.C. § 101(32). “In determining a ‘fair valuation’ of the entity’s assets, an initial decision to be made is whether to value the assets on a going concern basis or a liquidation basis.” In re American Classic Voyages Co., 367 B.R. 500, 508 (Bankr. D. Del. 2007). “If liquidation in bankruptcy was not clearly imminent on the transfer date, then the entity should be valued as a going concern.” Id. 

Rebutting the Presumption of Insolvency

The debtor/trustee bears the ultimate burden of proof and must prove insolvency by a preponderance of the evidence. See In re Roblin Industries, Inc., 78 F.3d 30, 34 (2d Cir. 1996). While Section 547(f) provides a presumption that the debtor is insolvent during the look-back period, this presumption may be rebutted by the creditor. “To rebut a presumption of insolvency, a creditor must introduce some evidence that the debtor was not in fact insolvent at the time of the transfer.” Ames, 506 Fed. App’x at 72 (citing In re Roblin, 78 F.3d at 34).

Generally, creditors attempt to present evidence from a valuation expert in order to show that the debtor’s assets exceeded its liabilities at the time of the transfer, but this expert’s methodology must be sufficiently reliable. See, e.g., In re Lids Corp., 281 B.R. 535, 546 (Bankr. D. Del. 2002). “If the creditor introduces such evidence, then the trustee must satisfy its burden of proof of insolvency by a preponderance of the evidence.” Roblin, 78 F.3d at 34.

The Insolvency Presumption and Other Concerns in the Time of COVID-19

The insolvency requirement under Section 547(b)(3), together with its presumption under Section 547(f), present important issues for both debtors and creditors as companies declare bankruptcy as a result of the economic conditions imposed by the COVID-19 pandemic. Following government orders across the country closing many brick and mortar non-life-sustaining businesses, a number of companies, both large and small, have filed for bankruptcy in the past two months.

The date of insolvency question is crucial for businesses, their owners, and their creditors as prior to COVID-19 many businesses were profitable with no knowledge that bankruptcy was imminent. Indeed, but for the outbreak of COVID-19 and the resulting shutdown orders, many of these businesses would not have been insolvent. Unlike the typical bankruptcy case, in which a company that files for bankruptcy has been in a difficult financial situation for many months or even years prior to the filing of a petition, coronavirus-related shutdowns are causing companies that may have not been insolvent to find themselves in need of initiating bankruptcy proceedings.

In such circumstances, affected creditors may seek to rebut the presumption of insolvency or use such a threat to negotiate a more favorable settlement of the dispute.

The rapid onset of bankruptcies due to COVID-19 is not entirely without precedent. Regrettably, the situation resembles the struggle faced by some businesses in the wake of the September 11, 2001 terrorist attacks. These cases provide guidance as to how the insolvency presumption may be rebutted in bankruptcy cases stemming from the pandemic.

Take, for example, the bankruptcy filed by the domestic cruise ship company American Classic Voyages on October 19, 2001, a mere month after the attacks. See American Classic, 367 B.R. at 502. In that case, American Classic sought to avoid a $29 million payment made to various banks on August 14, 2001. Id. The banks presented expert testimony analyzing American Classic’s financial statements in the months leading up to the September 11 attacks, and the court found this evidence sufficient to rebut the insolvency presumption. Id. at 509-14.

As will likely be the case in bankruptcies stemming from COVID-19, the court considered the rapid onset of cancellations and closures experienced by American Classic and concluded that, despite any financial challenges before September 11, it was the attacks themselves that struck the “fatal blow to their business.” Id. at 513. Thus, the $29 million in payments were not avoidable as preferences because American Classic was not insolvent on August 14, 2001, the date of the transfer. Id. at 516. Courts will need to perform this same analysis in bankruptcies stemming from COVID-19 to determine whether a company was already insolvent before the pandemic.

Regardless of which side of a preference payment you or your business are on, we are available to assist. Montgomery McCracken’s Bankruptcy and Financial Restructuring attorneys have experience representing both debtors and creditors in preference actions under the Bankruptcy Code. Visit the firm’s Coronavirus (COVID-19) Resource Center for more information and updates on this constantly evolving situation.

[1]  See Heather Long, “Small business used to define America’s economy. The pandemic could change that forever,” Washington Post (May 12, 2020, 5:00 PM), https://www.washingtonpost.com/business/2020/05/12/small-business-used-define-americas-economy-pandemic-could-end-that-forever/.

[2] “The debtor is presumed to have been insolvent on and during the 90 days immediately preceding the date of the filing of the petition.” Bankruptcy Code § 547(f).