When a company faces bankruptcy, the fallout often extends well beyond the debtor. Creditors, vendors, and even business partners may find themselves pulled into disputes over money or property that changed hands before the bankruptcy filing. These lawsuits, called ‘avoidance actions,’ are among the most complex and misunderstood aspects of bankruptcy law.

What Are Avoidance Actions?

Avoidance actions are lawsuits brought by a debtor or trustee to ‘avoid’ and recover certain transfers of money or property made before a bankruptcy filing. The idea is to ensure that all creditors are treated fairly, rather than allowing some to gain an advantage by collecting early.

Christopher Horvay of Raines Feldman Littrell LLP notes the two most common types of avoidance actions are preferential transfers and fraudulent transfers. These often arise in different factual contexts that can significantly change the outcome of litigation.

• Preferential Transfers: Payments made to creditors shortly before bankruptcy that give those creditors more than they’d get in liquidation.
• Fraudulent Transfers: Transfers made either with intent to hinder creditors or for less than reasonably equivalent value while insolvent.

Preferential Transfers: The 90-Day Rule

Under Section 547 of the Bankruptcy Code, trustees can ‘claw back’ transfers made within 90 days before bankruptcy, or up to a year if the recipient was an ‘insider.’ To qualify as a preference, the transfer must meet several conditions, including that it was made while the debtor was insolvent and allowed the creditor to receive more than it would in liquidation.

James Sullivan of Seyfarth Shaw LLP highlights a critical nuance here: “The Code adds a presumption that the debtor was insolvent during the 90-day period. If the transferee rebuts the presumption then the transfer is not an avoidable preference.”

For creditors, this means that even payments received in good faith may be subject to claw back. Imagine being paid on an invoice after months of waiting, only to later receive a demand letter requiring repayment because of a bankruptcy filing. This is precisely the type of situation preference law is designed to address, and it explains why creditors often feel blindsided by these claims. But defenses exist, such as proving the transfer was made in the ‘ordinary course of business.’

Fraudulent Transfers: Actual vs. Constructive

Section 548 of the Bankruptcy Code allows trustees to challenge transfers made within two years before bankruptcy.

Fraudulent transfers fall into two categories:

1. Actual Fraud: Transfers made with intent to hinder or delay creditors.
2. Constructive Fraud: Transfers made without ‘reasonably equivalent value’ while insolvent or undercapitalized.

Bob Musur of Bodmer Price & Light, LLC advises that “To avoid a constructively fraudulent transfer, the debtor or trustee must prove that the debtor did not receive reasonably equivalent value for the transfer, and that the transfer either was made while insolvent or left the debtor with unreasonably small capital.”

The concept of ‘reasonably equivalent value’ often requires expert valuation testimony, making accountants and financial advisors critical players in these cases. Courts frequently examine whether the debtor received fair economic benefit in exchange for what was given up. For example, if a distressed company sold assets at a steep discount, the transaction may be challenged as constructively fraudulent even if both sides acted in good faith.

The Additional Complication of State Law

Bankruptcy law isn’t the only source of avoidance claims. Section 544(b) lets trustees use state fraudulent transfer statutes, such as the Uniform Fraudulent Transfer Act (UFTA). State law often provides longer ‘look-back’ periods, sometimes four years or more.

This creates additional risk for creditors and recipients of transfers, especially in cases where insolvency is hard to pinpoint. Because state law look-back periods are often longer, a creditor could face exposure for transactions that occurred several years before the bankruptcy filing. This makes record-keeping and legal diligence essential for anyone doing business with financially unstable companies.

How Do Courts Define Insolvency?

Many avoidance cases turn on whether the debtor was insolvent at the time of the transfer. Under the Bankruptcy Code, insolvency is when debts exceed assets ‘at a fair valuation.’

According to John Levitske of HKA Global, LLC the three tests used to measure insolvency include the Balance Sheet Test, the Adequate Capital Test, and the Cash Flow Test.

• The Balance Sheet Test: This looks at whether the fair value of a company’s assets exceeds its liabilities. Assets are valued at ‘fair market value.’ For example, real estate might be listed at its purchase price on the books, but if the market value has increased or decreased, that adjusted number is what matters. If liabilities outweigh assets on this fair value basis, the company is considered insolvent.
• The Adequate Capital Test: Even if the balance sheet looks okay, a business can still fail this test if it doesn’t have enough capital to survive normal ups and downs. Think of a retailer heading into holiday season with barely enough inventory and no cash cushion. If a small dip in sales or a delay in customer payments could tip the company over the edge, it may be considered undercapitalized. Courts often look at industry benchmarks here to determine if the company’s debt load was unusually heavy compared to competitors.
• The Cash Flow Test: This test looks forward. The question is whether the company can realistically generate enough free cash flow to meet its obligations as they come due. Even profitable companies can fail this test if cash is tied up in long-term assets or receivables.

Together, these tests provide a multidimensional view. A company might pass one test but fail another. For instance, a tech startup could have valuable intellectual property that balances the books (passing the balance sheet test), but if it doesn’t have the liquidity to pay employees next month, it could still be deemed insolvent under the cash flow test

Defending Against Avoidance Claims

Being on the receiving end of an avoidance action can feel unfair, especially when you’ve provided real value or extended credit in good faith. Fortunately, several defenses are available, including:

• Ordinary Course of Business: Showing that the payment was consistent with past practices.
• New Value Defense: Proving that the creditor gave new goods or services after the transfer.
• Contemporaneous Exchange: Demonstrating that the transfer was a fair swap for value at the same time.

The defeated transferee usually gets an unsecured claim for the amount avoided and recovered. That means even if money is clawed back, creditors may still have rights in the bankruptcy case. In practice, this can soften the blow, but the reality is that unsecured claims are often paid at only a fraction of their value. This underscores why defending against avoidance actions aggressively, when possible, can make a significant financial difference.

Final Thoughts

Avoidance actions have the power to reshape the financial landscape of a bankruptcy. For creditors, they mean potential repayment demands. For businesses, they require careful planning and documentation to defend transactions.  These actions are designed to ensure equitable treatment of creditors but can place significant burdens on those targeted.

For companies, the lesson is clear: plan ahead and document carefully. That means keeping thorough records of payments, contracts, and the circumstances surrounding transactions. Advisors can help ensure that if these transfers are ever challenged, there is a clear paper trail and defensible rationale. For advisors, the takeaway is that financial and legal expertise must work hand-in-hand to defend clients.

To learn more about this topic view Defending Against Bankruptcy Avoidance Actions. The quoted remarks referenced in this article were made either during this webinar or shortly thereafter during post-webinar interviews with the panelists. Readers may also be interested to read other articles about business distress.

This article was originally published here.

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This article was authored by Jane Furigay Shapiro