Understanding "Preferences"

 Posted on April 10, 2017 in Bankruptcy Law

Your trustee might be able to require a creditor to pay the trustee money you’d paid the creditor. Sometimes that’s good; sometimes not.

What’s a Preference in Bankruptcy?

Preference law allows a bankruptcy trustee to require a creditor that you paid during a certain period of time before you file bankruptcy, under certain conditions, to pay that money “back” to the trustee. The creditor you paid, voluntarily or not, would have to give up that money. The trustee would then take and divvy up the money among all the creditors. Your creditor may or may not get any of that distributed money. It would usually get either none or just a small percentage of what it had to give up.

Section 547(b) of the U.S. Bankruptcy Code lays out the 5 elements of a preference. It’s a payment paid or asset transferred:

1. to a creditor
2. for a debt owed before that payment was paid or transfer was made
3. made while the debtor was insolvent
4. during the 90 days before filing bankruptcy—or during the year before filing for special creditors
5. that gave the creditor more that it would have received in a distribution in a Chapter 7 liquidation at the time of the payment or transfer.

More about these elements in the next couple of blog posts.

The Purpose of Preference Law

What could be the point of all this? Why make a creditor who you paid before filing bankruptcy have to pay that same amount of money back, but to your trustee, after you file bankruptcy?

First, it’s supposed to discourage creditors from being overly aggressive in collecting debts. Instead of fighting to get the last dollar out of a debtor, they may work more cooperatively. Otherwise if they force a debtor into bankruptcy they could lose the money collected. Less aggressive creditors may result in less debtors being pushed into bankruptcy. Creditors have a disincentive to pushing debtors into bankruptcy if they know that any money they get on the brink of bankruptcy may have to be turned over the bankruptcy trustee.

Second, preference law is supposed to discourage debtors in financial trouble from paying only one special creditor to the detriment of their remaining creditors. You may hesitate to pay a favorite creditor before bankruptcy if that creditor would just have to “return” it to your trustee later.

Both of these are designed to promote one of the most important principles of bankruptcy law. That’s the fair and equal treatment of creditors—no favoritism for any particular creditor(s). Preference law is intended to discourage behaviors favoring a select creditor or two shortly before a bankruptcy filing. Both an aggressive creditor and a favorite-paying debtor result in a debtor’s very limited money going to a select creditor.

How Can Money Paid BEFORE Filing Bankruptcy Be Affected?

How can bankruptcy law unwind payments that were made before the bankruptcy case was filed? Bankruptcy does mostly focuses on your financial condition at the time your case is filed. (As well as after your case is filed in the case of Chapter 13.) But it also does have the power to look backwards in time to address certain perceived abuses that may occur. This preference law is one example.

Good and Bad Preferences

In our first sentence above we said that a preference is sometimes good and sometimes not. Having your bankruptcy trustee get back a payment you made to a creditor may be good. It would be good if you don’t mind that creditor’s payment being undone and perhaps be put to better use. It would be bad if the trustee was making a creditor return a payment that you’d prefer that creditor to keep.

Let’s look at these two kinds of preferences in our next two blog posts. We’ll start in a couple days with the kind you want to avoid.