What is a Creditor Preference in Bankruptcy?

Most consumer bankruptcy filers have been struggling with debt for at least two years before filing, and a significant percentage report ongoing financial problems for five years or more. If you’re among those who invested months or years in attempting to catch up on debts and find another solution before filing bankruptcy, creditor preferences have probably become a way of life for you.

When you don’t have enough cash on hand to cover all of your obligations, you’re forced to prioritize. Maybe that means making your rent payment but letting your credit card account slip into past-due status, or skipping a loan payment to a finance company so that you can pay back your mom for last month’s rent. Choosing which creditors to pay based on urgency, personal relationships, and other factors specific to you is a perfectly normal practice, but bankruptcy changes the rules.

Creditor Preference Defined

In bankruptcy, a preference payment is defined as a payment that puts the creditor who received it in a better position than it would have been under a bankruptcy case if the payment had not been made. Preference payments are most common in consumer Chapter 7 bankruptcy cases, where most unsecured creditors receive nothing, but they can also occur in Chapter 13 cases as well.  Preferences usually apply to any extra or unbalanced payment made by the bankruptcy debtor within the “lookback” period. 

The lookback period is different depending on the type of creditor involved. The standard lookback period is 90 days prior to filing. That means the trustee can examine payments to creditors in the 90 days leading up to filing and take action on any preferential payments. However, where the creditor is an “insider” the lookback period is extended to one year.

Who is an Insider for Purposes of Creditor Preference Analysis?

U.S. Bankruptcy Code section 101 defines an “insider” in detail. Some of the people and entities most commonly classified as insiders include:

• Family members
• Business partners
• Businesses in which the debtor is a partner or other principal

The purpose of this extended lookback period for insiders is to ensure that a bankruptcy debtor doesn’t take advantage of the time leading up to bankruptcy to direct whatever resources he has to those creditors he has a personal or professional reason to treat better than his other creditors. It’s important to note, though, that no deceptive intent is required. 

What Happens if the Trustee Identifies a Preference Payment?

When the bankruptcy trustee identifies preferential payments to one or more creditors during the appropriate lookback period, he or she can take action to “avoid” the transfer. Of course, the transfer will already be complete, so in practical terms that means reaching back and undoing the transfer. That can be bad news for the creditor, and for the relationship the debtor may have been trying to preserve by making the payment. 

Imagine, for example, that you have owed your mother $1,000 for a few years. Recognizing that you will soon be filing for bankruptcy protection and discharging your unsecured debts, you take the money you would otherwise have paid to your credit card company and the local payday loan store and instead give that money to your mother, paying off your $1,000 debt. When the bankruptcy trustee reviews your payment records and sees that you’ve made a preferential payment to your mother--an insider--within the year leading up to bankruptcy, he or she will likely take action to avoid the transfer. 

Typically, this takes the form of an adversary proceeding, which is like a mini-lawsuit that takes place within the bankruptcy case. In this proceeding, the trustee would be petitioning the court to order your mom to give back the $1,000 you’d paid her so that money could be distributed to creditors. This type of proceeding can obviously put a strain on the family relationship, but is particularly problematic if the family member you paid doesn’t have the money to return the funds to the trustee.

If the amount in question is small, the trustee may not make the investment in litigating the preference claim, or you may be able to negotiate with the trustee to resolve the preference without court proceedings. Certain creditors may also raise defenses to preferential payments, such as the “new value” defense, in which the creditor claims that new value was provided to the debtor in exchange for the preferential payment.  Insiders will generally have a hard time raising a valid defense to preference payments, though, and it is important to remember that any preferential payment creates some degree of risk.

Preparation is Your Best Defense

Many people hold off on consulting a bankruptcy attorney until the situation is urgent. That often means people who are struggling financially make innocent mistakes in the months leading up to bankruptcy that can complicate their cases and increase costs. Educating yourself early is your best defense against inadvertently making preferential payments, or even transfers that may be considered fraudulent under bankruptcy law. 

At Bond & Botes, the initial consultation is free, so you have nothing to lose by learning more about your options and how best to prepare for bankruptcy. Just call 877-581-3396 or fill out the contact form on this page to get started.