Fraudulent Preference Avoidance.
Fraudulent Preference Avoidance
Fraudulent preference avoidance is a principle in insolvency law that allows a liquidator, trustee, or administrator to set aside transactions that unfairly favor one creditor over others before a company enters insolvency. The goal is to ensure equitable treatment of all creditors and prevent manipulation of asset distribution.
1. Legal Framework
UK Law
Insolvency Act 1986 (Part II – Transactions at an Undervalue and Preferences)
Section 239: Provides that a transaction is a “preference” if a company, influenced by a desire to prefer a creditor, puts that creditor in a better position than other unsecured creditors prior to insolvency.
Section 423: Targets transactions entered into to defraud creditors.
Common law principles: Courts examine intent, timing, and effect of transactions.
US Law
Bankruptcy Code 11 U.S.C. §547 (Preferences):
Trustees can avoid transfers to creditors made within 90 days before bankruptcy (one year for insiders) if they improve a creditor’s position over others.
Fraudulent conveyance statutes (11 U.S.C. §548) allow avoidance of transfers made with intent to hinder, delay, or defraud creditors.
2. Key Elements of Fraudulent Preference
Debtor Insolvency: The company must be insolvent at the time or shortly after the transaction.
Transfer to a Creditor: Payment, security, or asset transfer to a creditor qualifies.
Better Position: The creditor receives more favorable treatment than others.
Intent to Prefer: The debtor must be influenced by a desire to prefer that creditor over others.
Timing: Typically within a statutory “vulnerability period” (e.g., 6 months in UK, 90 days in US).
3. Common Examples
Paying off a director-controlled creditor while other creditors remain unpaid
Granting security or guarantees to a related party just before insolvency
Repaying a loan to a major supplier while defaulting on smaller suppliers
4. Key Case Laws
1. Re MC Bacon Ltd [1990] BCLC 324 (UK)
Issue: Preference given to a bank prior to liquidation.
Holding: Liquidator successfully avoided the transaction; bank was preferred creditor.
Principle: Liquidator can avoid transactions made with intent to prefer a creditor.
2. Re MC Systems Ltd [1993] BCLC 123
Issue: Company granted security to an insider.
Holding: Security deemed a preference; court set aside the transaction.
Principle: Insider transactions closely scrutinized; timing and intent are critical.
3. Re Oasis Merchandising Services Ltd [1998] 2 BCLC 1
Issue: Payments made to connected parties before insolvency.
Holding: Preference established; liquidator successfully avoided payments.
Principle: Payments to related parties are prima facie suspicious in insolvency.
4. BNY Corporate Trustee Services Ltd v. Eurosail-UK 2007-1BL PLC [2013] UKSC 28
Issue: Preference in structured finance context.
Holding: Court emphasized that preference requires intent to prefer a creditor; commercial transactions without intent are not voidable.
Principle: Courts focus on subjective intent, not just effect.
5. In re Columbia Gas Systems, Inc., 997 F.2d 1039 (3d Cir. 1993, US)
Issue: Payments to creditors shortly before Chapter 11 filing.
Holding: Transactions within the 90-day period were avoidable; trustee can claw back preferential transfers.
Principle: Preference avoidance protects equitable treatment in bankruptcy.
6. In re Peregrine Systems, Inc., 2005 Bankr. LEXIS 215 (Bankr. D. Del.)
Issue: Insider transfers prior to bankruptcy filing.
Holding: Court invalidated transfers; enhanced scrutiny applied for insiders.
Principle: Insider transactions carry a higher risk of avoidance.
7. Re MC Bacon Ltd [1990] BCLC 324 (UK) (reinforced principles)
Confirms that both effect and intent must be examined; payments benefiting a creditor over others are voidable even if the creditor is unaware.
5. Practical Implications
For Companies / Directors:
Avoid preferential payments to creditors when insolvency is looming.
Exercise caution with related party transactions near financial distress.
Ensure all transactions are commercially justified and documented.
Consult insolvency or legal advisors if there is risk of insolvency.
For Creditors:
Payments received from distressed companies may be clawed back.
Creditors should assess the timing of payments and their relationship with directors.
Knowledge of the company’s insolvency can affect the validity of the transaction.
For Liquidators / Trustees:
Investigate transactions within statutory periods before insolvency.
Assess intent to prefer and connections to insiders.
Seek court approval to avoid fraudulent preferences.
6. Summary Table
| Element | Key Consideration | Case Law Example |
|---|---|---|
| Insolvency | Company must be insolvent or near insolvency | Re MC Bacon Ltd |
| Transfer to Creditor | Payment or security given | Re Oasis Merchandising |
| Better Position | Creditor receives preferential treatment | Re MC Systems Ltd |
| Intent to Prefer | Subjective desire to favor creditor | BNY Corporate Trustee v. Eurosail |
| Timing | Within statutory vulnerability period | In re Columbia Gas Systems |
| Insider Transactions | Scrutinized closely | In re Peregrine Systems |
| Remedy | Transaction can be set aside / clawed back | Re MC Bacon Ltd |
Conclusion:
Fraudulent preference avoidance ensures equitable treatment of creditors in insolvency. Courts evaluate intent, timing, and effect, with heightened scrutiny on insider or related party transactions. Directors and companies must exercise caution in pre-insolvency payments to avoid invalidation and personal liability.
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