What Is a Preferential Transfer?

What Is a Preferential Transfer?

The bankruptcy system is designed to promote fairness to creditors while also giving debtors a chance to recover financially. Any rules for payment of creditors must be applied equitably according to the Bankruptcy Code, not favoring any one creditor over another.

This principle even extends to a period before the case is filed. When a debtor (the person who files a bankruptcy case) pays some creditors but doesn’t pay other similar creditors shortly before a bankruptcy case is filed, the debtor is said to have made preferential transfers to those creditors.

How Preferential Transfers Work

When the bankruptcy trustee is trying to determine whether and preferential transfers have occurred, they will look at several factors.

Types of Debt

For bankruptcy purposes, debt comes in different classes. Generally, debt will fall into one of four categories:

• Administrative: those debts necessary to the administration of a bankruptcy case, such as attorney’s fees or trustee fees
• General unsecured: credit cards, medical bills, trade debt, signature loans that consist of a promise to pay without collateral, casual debt such as IOUs, and loans from friends or family
• Priority unsecured: unsecured debt that for various reasons we deem to be more worthy or important, including recent taxes, domestic support obligations such as alimony and child support
• Secured: debt with collateral such as car loans or home mortgages

Under the U.S. Bankruptcy Code, creditors within the same class must be treated the same way.

What Preferential Treatment Looks Like

Why would you choose to pay one creditor more than others? In normal circumstances (outside of bankruptcy), you're generally free to make those kinds of financial choices. Your Visa card may have a higher interest rate or higher balance than your Mastercard, for instance, so you may want to pay it down faster.

It starts to get sticky when you claim you no longer have enough to pay everyone back, however. If you didn’t pay Mastercard but paid Visa instead, is that fair to Visa? Or what if you owed money to your father-in-law and wanted to make sure he got paid before you filed a bankruptcy case?

To be a preference a payment has to meet five criteria:

1. The transfer must be for the benefit of a creditor.
2. The transfer must be used to pay an antecedent debt (a debt that existed before the transfer occurred).
3. The transfer must have been made while the debtor was insolvent.
4. The transfer occurred within 90 days of the filing of the bankruptcy, or one year if the creditor was an insider.
5. The creditor received more than it would have received in a Chapter 7 case had the transfer not been made.

Avoiding the Preference

The U.S. Bankruptcy Code gives the trustee the right to capture the money that was given to creditors preferentially and redistribute it to all similar creditors on a more even basis. This is called avoiding the preference.

The trustee may not go after all preferential transfers. Just the time necessary to review every one of your pre-bankruptcy transactions will often be more than any gain to the bankruptcy estate. This is why the bankruptcy code requires that a debtor disclose in the bankruptcy schedules payments made in the 90-day period before the bankruptcy, but only if the payment(s) total $600 or more for a single creditor during that period. This amount jumps to $6,825 if most of your debt is business debt.

Consider this example: Assume that you have $10,000 in nonexempt property. You have eight creditors, each of whom has filed a proper claim with the court. All things being equal, each of those creditors would receive $1,250 in the bankruptcy case.

Suppose you paid one creditor $2,000 right before filing for bankruptcy. That creditor would receive $750 more than their share, and there would be $750 less in the pool for the other creditors to share. The trustee has the right to ask for that $750 back, but they have to weigh the benefit of going after the $750 on behalf of the other creditors. Considering the trustee’s commission is 25% or less, it would probably not be very efficient to fight hard for that $750.

Exceptions to the 90-Day Rule

If a creditor can prove that the debtor was solvent when the preference was made—in other words, they had more assets than liabilities—it will be harder for the trustee to prove that the payment was preferential. Likewise, the trustee could attempt to void payments made further back than the 90-day lookback period if they had evidence that the debtor was insolvent that far back.

In fact, the trustee can go back a year if the recipient of the payment was an insider. Insiders include family, friends, business partners, and people or other entities with a special connection to the debtor. Any payment to an insider has to be disclosed and is subject to review as a preference.

Preferences and Secured or Priority Debt

The trustee’s avoiding power is used less frequently against secured and priority debt. Secured debt has a special status because of the agreement between the creditor and the borrower that an asset of the borrower can be sold to pay the debt. Were the trustee to avoid a preference paid on a secured debt, the payment would be replaced by other property of the debtor.

Priority debt also has a special status because Congress has determined that certain debts should be paid before general unsecured debts. The most common priority debts are alimony, child support, and recent taxes. Any money a trustee collects will go first to paying any priority debts. Therefore, it is not uncommon for the trustee to avoid payments to general unsecured creditors and have that money paid over entirely to retire priority debt.

Exceptions to the Rule

Every rule has its exceptions, and the trustee’s power to avoid preferential transfers is no different. Here are three of the most common:

• Contemporaneous exchange: When you pay for a purchase you’re making at the same time, there is no preference. Preferences must be for debts that already existed before the transfer transaction.
• Ordinary course: When you’re operating in the “ordinary course of business.” For instance, if you ordinarily pay invoices 30 days after inventory is delivered, you are making your payments in the ordinary course of business, and they are not considered preferential transfers.
• New value: If you pay someone for a debt you already owe, but the creditor then gives you new value, the payment was not preferential. An example of new value would be a vendor shipping goods to you after you paid an outstanding bill.