The primary purpose of bankruptcy is to give a person or business filing for bankruptcy (called the "debtor") a "fresh start." But there is another important policy behind bankruptcy: protecting creditors from one another. When creditors realize a debtor has limited funds, collection becomes something like a game of musical chairs: the first creditors to collect get paid and once the music stops and debtor is broke the remaining creditors are left empty handed. This reality is one reason creditors engage in aggressive collection practices. This is particularly true of "unsecured" creditors, which are creditors which have no property to take in payment of their debt.
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The bankruptcy code attempts to protect and reassure unsecured creditors by requiring a complete and truthful disclosure of all the debtor's assets, debts, and recent transfers. The debtor must make this disclosure under penalty of perjury, and in consumer cases the disclosures are scrutinized by a bankruptcy trustee appointed to represent unsecured creditors. With everything out in the open, these creditors can rest assured that they are being treated fairly and equally.
But sometimes a bankruptcy filing does reveal that a particular unsecured creditor was given more than others. Maybe a friend was repaid a few months before the bankruptcy. Or many small payments were made to a single credit card. In these situations, it is said the creditor was preferred over other creditors and that the payment was preferential.
Preferences apply to any type of transfers of the debtor's property. This includes payments, but also things like balance transfers on credit cards, deeding property, foreclosures, repossessions, setoffs, and garnishments. A debtor must be extra careful to consider all transfers before filing bankruptcy, or they could be exposing a friend or a relative to a preferential avoidance lawsuit by the trustee on behalf of the debtor's unsecured creditors.
Section 547(b) of the United States Bankruptcy Code, 11 U.S.C. section 547(b), permits a trustee to void a preferential transfer if the trustee can show there has been a "transfer of an interest of the debtor in property ..." exceeding $600.00 total of consumer debt or $5,000.00 of business debt, and that was:
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(4) made -
(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such creditor to receive more than such creditor would receive if -
(A) the case were under chapter 7 of this title [11 USCS (s) 701 et seq.];
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title [11 USCS (s) 101 et seq.].
The trustee must prove each of these requirements is more likely true than not. However, each one is very complex and trumpets a volume of case law interpreting the meaning. That case law interpretation can even vary between local bankruptcy courts. The only way to get a clear answer (if one even exists) on whether a particular transfer is preferential is to consult with an experienced bankruptcy attorney from your local district. The following is a general overview of each requirement.
First, the trustee must prove the transfer was for the benefit of a creditor. A gift to someone who is not owed money or a wrongfully taken payment is not preferential (it could, however, be fraudulent under 11 U.S.C. Section 548 or your state fraud laws.) Second, the trustee must show the debtor owed the creditor money before the transfer, not after. Third, the trustee must show the transfer was made when the debtor was "insolvent." Insolvency means all the debtor's assets totaled less than the debtor's debt. Further, the trustee doesn't have to prove this if the transfer was within 90 days of the petition.
Next, the trustee must prove that the transfer was made within 90 days before the bankruptcy filing, or within 1 year if to an "insider." An "insider" is someone with a close and controlling relationship with the debtor, such as a relative, friend, or even a business partner.
The last requirement for the trustee looks to whether the other creditors were harmed as a result of the bankruptcy. If the creditors would have gotten the same amount in a chapter 7 if the debtor hadn't made the transfer, then there is nothing for the creditors to complain about.
Additionally, there are a number of affirmative defenses a defendant creditor can raise to defend a transfer as non-preferential, including some payments where "new value" was given, payments in the ordinary course of business, payments of certain liens, and payments of domestic support obligations. Again, each of these defenses is very complicated, with volumes of cases dedicated to analyzing each one.
However, the good news is that you need not panic if you are served with a lawsuit alleging a preferential transfer. Instead, consult with a local bankruptcy attorney immediately! A local bankruptcy attorney can analyze your case in light of the trustee's burden of proof and the available affirmative defenses. These requirements are not always easy (and often difficult) for the trustee to prove. Even if the transfer was preferential, a bankruptcy attorney can assist you in gaining some leverage and working out a favorable settlement with the trustee.
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