Optimal Deterrence and the Preference Gap: Preference law doesn’t do what you think it does

One of the most controversial legal issues arising in US corporate bankruptcy proceedings is the avoidance of preferential transfers. Defined simply, preference avoidance allows a debtor in bankruptcy to claw back payments made to a creditor in the few months before the bankruptcy filing, even when those payments were made on account of a valid outstanding debt. These recovered funds can then be redistributed to all creditors on a pro rata basis. Despite being a historical mainstay of bankruptcy proceedings, there remains disagreement over what preference law is intended to accomplish, and whether it is successful in accomplishing that goal. 

A number of bankruptcy scholars have argued that preference law is about preserving the equality of distribution inherent in bankruptcy: all similarly situated creditors should be treated similarly.  Accordingly, those creditors who were fortunate enough to be paid just before the bankruptcy should return the funds for equal distribution with others who were not so fortunate. Proponents of this view would find most legal exceptions to preference law, or efforts to distinguish between ‘good’ and ‘bad’ preferences, abhorrent. 

Nonetheless, such distinctions do exist, and are justified by virtue of an alternative explanation for preference law: that it exists to deter creditors from engaging in ‘unusual collection efforts’ when the debtor is insolvent, as such efforts may push a struggling debtor into bankruptcy. Although scholars have previously raised serious objections to preference deterrence theory, this article is the first to test it against the theories established by Gary Becker (Crime and Punishment: An Economic Approach, 76 Pol. Econ. 169 (1968)) and Richard Posner (A Theory of Negligence, The Journal of Legal Studies 29, 32 (1972)) in the criminal and torts contexts, respectively.  

The theory of deterrence established by Becker, and followed by Posner, is that a law can discourage actors from engaging in behaviour by creating an associated cost, so that rational actors will avoid the behaviour (and forego its benefits) in order to avoid the costs. The deterrent power of the law will depend primarily on the perceived likelihood of the cost being imposed and the perceived severity of the cost vis-à-vis the perceived benefit. The less the likelihood of punishment, the greater the need for severity (in order for the law to remain effective), and vice versa. 

Under this theory, preference law is a profoundly weak example of deterrence, since preference avoidance only arises in situations where the debtor files for bankruptcy within 90 days of the targeted transfer, and even then, only when the debtor is inclined to pursue the transfer, as doing so is optional under the statute.  Further, the penalty associated with obtaining a preference is, at worse, to return the amount of the preference, and in the vast majority of cases, debtors will agree to accept only a partial return – something like 50% – in order to avoid the costs of litigating the preference action. 

Empirical evidence gleaned from interviews with debtors, creditors, and attorneys involved in recent Chapter 11 bankruptcy cases further demonstrates that preference law is uniformly ineffective as a deterrent. Creditors are advised by their attorneys to always accept (or even push for) payment from a debtor, since liability is unlikely to arise and, if it does, settlement is practically assured.  Unrepresented creditors are largely unaware of preference law, or are confident in their ability to avoid liability by collecting early or arguing for an exception, such that preference law has relatively little impact on their ways of doing business. 

Debtors typically will not bring a preference action against creditors they need to work with, and more sophisticated creditors are typically more able to predict bankruptcies and avoid preference liability by recovering early or fitting a transfer into one of the state exceptions. Accordingly, those creditors who are most impacted by preference law tend to be those who lack sufficient influence over the debtor to force or prevent a bankruptcy filing. To successfully deter actions that force a debtor into bankruptcy, preference law should be more focused on actors with the ability to influence a debtor’s decision to file for bankruptcy and should impose a greater penalty for such actions, so as to account for a low likelihood of punishment. 

Brook E. Gotberg is Associate Professor of Law at University of Missouri.