Preferential Payment in Bankruptcy: A Guide

If you are considering bankruptcy, the term ‘preferential payment in bankruptcy’ might surface, causing some confusion. It is a critical concept within bankruptcy law because these payments can significantly alter the course of your bankruptcy case. Understanding what constitutes a preferential payment, why it is important, and how to handle it can prevent major setbacks and help create a smoother path to financial recovery.

This article explains preferential payments, including the look-back periods, common examples, and potential defenses available if a bankruptcy trustee tries to recover such funds. We will explore how these payments affect both debtors and creditors and what steps can be taken to address them effectively. Staying informed about this aspect of the bankruptcy process is beneficial for anyone facing financial distress, especially when a bankruptcy filing seems imminent.

What Is a Preferential Payment in Bankruptcy?

A preferential payment, also known as a preference payment or preferential transfer, occurs when a debtor pays certain creditors more than others shortly before a bankruptcy filing. The United States Bankruptcy Code defines specific criteria for a payment to be considered preferential. Essentially, it involves a transfer of the debtor’s property to or for the benefit of a creditor, on account of an antecedent debt (a debt that existed before the payment was made).

For a payment to be deemed a preferential payment, it must have been made while the debtor was an insolvent debtor, meaning their liabilities exceeded their assets (often verified by a balance sheet). The transfer must also occur within a specific preference period before the bankruptcy petition is filed. This period is generally 90 days for payments to regular creditors.

However, if the payment is made to an “insider,” such as a family member, business partners, or corporate affiliates, the look-back period extends to one year prior to the bankruptcy filing. The reasoning behind scrutinizing these payments is to prevent the debtor from unfairly favoring certain creditors, like a creditor prior to others who are also owed money, before seeking bankruptcy protection. The goal of federal bankruptcy law is to promote equal distribution among all creditors of similar class.

The bankruptcy code‘s provisions on preferential transfers aim to ensure fairness. When a transfer occurs that meets these criteria, the bankruptcy trustee has the power to avoid it. This means the trustee can demand the return of the money paid, bringing it back into the bankruptcy estate for a more equitable distribution among all unsecured creditors.

Why Do Preferential Payments Matter?

Preferential payments are a significant concern in any bankruptcy case because they can disrupt the fundamental principle of equitable treatment for all creditors. The bankruptcy system is set up to provide an orderly process for distributing a debtor’s available assets. When a debtor makes a preferred payment to one creditor over others just before filing, it undermines this fairness and can be seen as preferential treatment.

The bankruptcy trustee, appointed to oversee the bankruptcy estate, has the legal authority to identify and recover these preferential payments through a process known as a clawback action or preference action. The funds recovered from the creditor receiving the payment are then added back to the bankruptcy estate. This increases the pool of assets available for distribution to all unsecured creditors according to the priority rules set forth in the bankruptcy code.

These actions are intended to prevent creditors from racing to collect from a financially distressed debtor, potentially to the detriment of other creditors. Without such rules, debtors might be pressured to pay favored or aggressive creditors, leaving little for others. The possibility of a clawback action serves to level the playing field and ensure that any distribution of the debtor’s property is managed systematically by the bankruptcy court.

For the debtor, making preferential payments can lead to complications in their bankruptcy case. While the act of making a preference payment itself is not usually a crime, failing to disclose such payments or attempting to conceal them can lead to serious consequences, including denial of discharge. It can also create tension if the payment was made to a family member or a close business associate who is then asked to return the money.

Impact on Your Bankruptcy Case

Making preferential payments can significantly affect the progress and outcome of your bankruptcy case. The bankruptcy trustee will scrutinize your financial transactions leading up to the bankruptcy filing. If preferential transfers are discovered, it can lead to litigation, delay the administration of your case, and potentially impact your discharge.

The trustee’s effort to recover preferential payments can be time-consuming and may involve legal proceedings against the creditor who received the payment. This creditor, who might have thought they were fortunate to receive money paid on an old debt, could find themselves facing a demand letter or even a lawsuit. This is why transparency with your bankruptcy attorney about all pre-bankruptcy payments is crucial.

Furthermore, if a payment is successfully clawed back, it does not mean the creditor loses out entirely. The creditor receiving the preferential payment, after returning it, will typically have their claim reinstated as an unsecured creditor. They will then share pro-rata with other unsecured creditors from the available funds in the bankruptcy estate.

Common Examples of Preferential Payments

Understanding what constitutes a preferential payment can be clearer with some common examples. These are types of debtor transfers that often attract the attention of a bankruptcy trustee:

• Large, unscheduled payments to a family member to repay a personal loan shortly before filing for bankruptcy. Payments to family members are scrutinized over a one-year period preceding the filing.
• Significant payments made to business partners or key suppliers outside the normal course of business to settle outstanding invoices. This is particularly relevant if these payments favor one supplier over others.
• Accelerated repayment of an unsecured loan to a friend or relative.
• Making a substantial lump-sum payment to clear a specific credit card balance, especially if other credit cards receive only minimum payments or no payments.
• Returning recently purchased goods to a supplier for credit on an old debt, if this gives the supplier more than they would get in bankruptcy. This can be a form of asset transfers.
• A bank levy or wage garnishment executed by a creditor within the preference period could also be considered preferential, as it allows that creditor to receive money that might otherwise have gone to the bankruptcy estate for distribution.

These transactions, where a debtor pays specific creditors disproportionately, are considered preferential because they deplete the assets available for all creditors. Even if made with good intentions, such as trying to honor a personal obligation, these payments affect the equal distribution principle in bankruptcy law. The money paid might have to be returned by the recipient.

How to Avoid Preferential Payment Issues

If you are contemplating a bankruptcy filing, proactive steps can help you avoid complications related to preferential payments. Awareness and careful financial management in the period preceding your filing are important. Consulting with an experienced bankruptcy attorney early in the process is highly recommended.

Here are some general guidelines:

1. Continue making regular, scheduled payments on secured debts like mortgages or car loans, as these are often treated differently if they do not improve the secured creditor’s position. However, avoid making extra payments or catching up on large arrearages without legal counsel.
2. Avoid making large or unusual payments to any single unsecured creditor, especially if it is for an antecedent debt. This includes significant credit card payments beyond the minimum due.
3. Refrain from repaying personal loans to friends, family members, or business partners within the relevant look-back period (one year for insiders, 90 days for others). These are classic examples of preferential treatment.
4. Maintain consistency in your payment patterns. Any abrupt changes, like suddenly paying off one creditor in full while ignoring others, can be a red flag for the bankruptcy trustee.
5. Discuss any essential payments, such as those to utility companies to maintain service, with your bankruptcy attorney. Sometimes these payments can be justified, but it is best to seek advice.
6. Do not engage in unusual asset transfers, such as transferring property to relatives or selling assets for less than fair market value to raise cash for specific creditor payments.

The overarching advice is to seek guidance from a qualified bankruptcy attorney before making any significant financial decisions if bankruptcy is a possibility. They can explain how bankruptcy payments made before filing could be viewed by the bankruptcy court and help you plan accordingly. Proper legal counsel can make a substantial difference in avoiding preference claims.

What Happens If You’ve Made a Preferential Payment?

If you realize you have already made what could be considered a preferential payment before consulting with a bankruptcy attorney, it is important not to panic. The first and most crucial step is to be completely transparent with your attorney about these transactions. Full disclosure allows your legal counsel to assess the situation accurately and advise on the best course of action.

Your bankruptcy attorney will analyze the payment to determine if it truly meets all the criteria of a preferential transfer under the bankruptcy code. They will also explore whether any common exceptions or defenses might apply to the situation. For instance, if the payment was a contemporaneous exchange for new value, or part of ordinary business terms, it might not be recoverable by the trustee.

If the payment is indeed preferential and no clear defense exists, the bankruptcy trustee will likely seek to recover preferential funds from the creditor who received them. This process usually begins with a demand letter. If the creditor refuses to return the payment, the trustee may file a preference action (a lawsuit) in bankruptcy court to compel its return.

In some instances, it might be possible for your attorney to negotiate a settlement with the trustee regarding the preferential payment, perhaps involving a structured repayment into the bankruptcy estate. While repaying these funds might seem counterintuitive, it is often preferable to facing allegations of attempting to hide assets or hinder the bankruptcy process. Your attorney can guide you through this.

Exceptions to the Rule

Not every payment made by an insolvent debtor within the preference period preceding a bankruptcy filing is considered a recoverable preferential payment. The Bankruptcy Code recognizes several common exceptions, acknowledging that some transactions are legitimate and necessary. Understanding these exceptions is important for both debtors and creditors.

Here are some of the primary defenses to a preference claim:

Exception Name	Brief Description	Example
Contemporaneous Exchange for New Value	The transfer was intended by the debtor and creditor to be, and in fact was, a substantially contemporaneous exchange for new value given to the debtor. This is often referred to as an ‘contemporaneous exchange’.	Paying cash on delivery (COD) for goods or services; the payment and receipt of value occur at nearly the same time.
Ordinary Course of Business	The payment was made in the ordinary course of business or financial affairs of the debtor and the creditor, or made according to ordinary business terms. This is a common business defense.	Regular monthly payments for rent, utilities, or routine supplies, consistent with past practices between the parties or industry standards. This is a key business’ defense.
Subsequent New Value	After receiving the preferential payment, the creditor provided new value to the debtor on an unsecured basis. The preference amount may be offset by this new value.	A supplier receives a payment on an old invoice and then ships additional goods to the debtor on credit before the bankruptcy filing.
Perfected Security Interests	Payments to a fully secured creditor generally are not preferential because the creditor would have received the collateral’s value anyway. However, payments that improve a partially secured creditor’s position can be preferential.	Regular mortgage or car loan payments where the loan is fully secured by the collateral.
Domestic Support Obligations	Payments made for alimony, maintenance, or child support are generally not considered preferential payments that can be recovered by the trustee.	Making a scheduled monthly child support or alimony payment.
De Minimis Transfers	For debtors whose debts are not primarily consumer debts, transfers totaling less than a specific statutory amount (adjusted periodically) to a single creditor are not recoverable. For consumer debtors, there’s also a small aggregate threshold.	Small, isolated payments below the current statutory limit. This prevents the trustee from pursuing minor payments where the recovery cost might exceed the payment amount.

These exceptions aim to balance the goal of equal distribution among creditors with the practical realities of ongoing financial and business activities. If a creditor receives a demand for repayment of a preference payment, they should consult with legal counsel to determine if any of these defenses apply. Proving an exception often requires careful documentation and legal argument.

The Role of the Bankruptcy Trustee

The bankruptcy trustee plays a central role in the administration of a bankruptcy case, particularly concerning preferential payments. One of the trustee’s primary duties is to maximize the assets available in the bankruptcy estate for distribution to creditors. This includes investigating the debtor’s financial affairs for any avoidable transfers, such as preferential payments or fraudulent conveyances.

Upon appointment, the trustee will review the debtor’s bankruptcy petition, schedules of assets and liabilities, statement of financial affairs, and other relevant financial documents like bank statements and tax returns. They are looking for any debtor transfers of property that occurred within the preference period – 90 days for regular creditors or one year for insiders like a family member or business partners – while the debtor was an insolvent debtor. The bankruptcy code’s provisions grant the trustee strong powers to do this.

If the trustee identifies a potential preferential payment, they will typically first send a demand letter to the creditor who received the money paid, requesting its return. If the creditor refuses or a dispute arises, the trustee can initiate a preference action, which is a lawsuit filed in the bankruptcy court, to recover preferential funds. The trustee must prove all the elements of a preferential transfer for the court to order the return of the payment.

This investigative and litigation role is crucial to uphold the principle of equal distribution. By recovering preferential bankruptcy payments, the trustee ensures that one creditor does not receive an unfair advantage over other, similarly situated creditors. The trustee’s actions aim to prevent creditors from dismembering the debtor’s assets piecemeal before the bankruptcy case can ensure an orderly distribution.

What Creditors Need to Know

If you are a creditor and have received a payment from a debtor who subsequently files for bankruptcy, you might face a demand from the bankruptcy trustee to return that money if it is deemed a preferential payment. Receiving such a demand can be unsettling, especially if you believed the payment was rightfully yours for an antecedent debt. It is important to understand your rights and potential defenses.

Upon receiving a demand letter for a creditor payment considered preferential, do not ignore it. Consult with legal counsel, preferably an attorney experienced in bankruptcy law and creditor rights. Your attorney can help analyze whether the payment truly meets the definition of a preference and if any defenses, such as the ordinary course of business defense or the contemporaneous exchange for new value defense, apply to your situation. This is where a solid business defense strategy becomes important.

Common defenses for a creditor receiving such a claim include demonstrating that the payment was made in the ordinary business dealings between you and the debtor, or that you provided new value to the debtor after receiving the payment. If a valid defense exists, you may not have to return the funds, or you might be able to negotiate a resolution with the trustee. The existence of these defenses acknowledges that not all payments made during the preference period are unfair or should be clawed back.

If the payment is ultimately recovered by the trustee, you are not left completely empty-handed. The amount you return generally becomes an unsecured claim against the bankruptcy estate. While you will likely not recover the full amount, you will have the opportunity to share in any distributions made to unsecured creditors. Being labeled a preferential creditor can be frustrating, but understanding the bankruptcy process helps manage expectations.

Preferential Payments in Different Types of Bankruptcy

The handling and impact of preferential payments can differ somewhat depending on the type of federal bankruptcy chapter under which the debtor files their bankruptcy petition. While the definition of a preferential transfer remains consistent under the Bankruptcy Code, the mechanisms for addressing them and their practical effects vary.

In a Chapter 7 bankruptcy, often called a liquidation bankruptcy, a trustee is appointed to gather the debtor’s non-exempt assets, liquidate them, and distribute the proceeds to creditors. In this context, the trustee is highly motivated to pursue and recover preferential payments because these recovered funds directly increase the amount available for distribution to unsecured creditors. Any money recovered from a preference action goes into the general pot for all creditors.

In a Chapter 13 bankruptcy, which involves a repayment plan for individuals with regular income, the treatment of preferential payments is also important. While a Chapter 13 trustee can also pursue preference claims, it is often addressed through the debtor’s repayment plan. The plan must satisfy the “best interest of creditors” test, meaning unsecured creditors must receive at least as much under the plan as they would in a Chapter 7 liquidation. If significant preferential payments were made, the debtor might need to contribute more to their plan to ensure creditors are not worse off than if those payments had been recovered in a Chapter 7.

In a Chapter 11 bankruptcy, typically used for business reorganization (though also available to individuals), the debtor often remains in control of their assets as a “debtor-in-possession” (DIP). The DIP has many of the same powers as a bankruptcy trustee, including the ability to pursue preference claims to recover preferential transfers. Recovering these funds can be crucial for the success of the reorganization plan, as it can provide necessary capital or improve the balance sheet for negotiations with creditors. Sometimes, a Chapter 11 trustee or an official committee of unsecured creditors may pursue these claims if the DIP does not.

The Bigger Picture: Bankruptcy and Financial Health

Understanding the rules surrounding preferential payments is an integral part of managing the overall bankruptcy process effectively. These rules are not designed to be punitive but to support the core objectives of bankruptcy law: providing a fresh start for honest debtors while ensuring a fair and orderly distribution of assets to creditors. Avoiding or properly addressing preferential payments contributes to a smoother journey through bankruptcy and can positively impact your long-term financial health.

Transparency with your bankruptcy attorney about all pre-filing financial activities, including any payments that could be considered preferential, is fundamental. An experienced bankruptcy attorney can provide critical guidance, help you understand how these payments affect your specific situation, and work to mitigate potential problems. This proactive approach can prevent delays, disputes, and more serious complications in your bankruptcy case.

Ultimately, the bankruptcy process is a tool to help individuals and businesses resolve overwhelming debt and rebuild their financial foundations. By understanding and respecting the principles that govern it, including those related to creditor preference and equal distribution, debtors can navigate the system more successfully. This sets the stage for emerging from bankruptcy with a genuinely improved financial outlook and the ability to make sound financial decisions moving forward, free from the weight of past creditor payment issues.

Conclusion

Preferential payments in bankruptcy represent a critical area of bankruptcy law that both debtors and creditors must understand. A payment made to a creditor shortly before a bankruptcy filing, which allows that creditor to receive more than they would in the bankruptcy distribution, can be clawed back by the bankruptcy trustee. This rule aims to prevent preferential treatment and uphold the principle of equal distribution among creditors.

The look-back period for these payments is typically 90 days for regular creditors but extends to one year for insiders like family members or business partners. While making such a payment can complicate a bankruptcy case, there are legitimate defenses and exceptions, such as payments made in the ordinary course of business or as a contemporaneous exchange for new value. Full disclosure to your legal counsel is paramount if you believe you have made or received such a payment.

Working with an experienced bankruptcy attorney is essential to properly address any issues related to preferential payments. They can help analyze the situation, advise on potential consequences, and represent your interests. By understanding how these payments affect the bankruptcy process, you can take steps toward a more predictable outcome and a genuine fresh financial start. Schedule a free consultation with The Law Office of William Waldner today at 212-244-2882.