Preferential Payments: The Basics

by Johnny Tisdale on January 24, 2013

preferential-payments-the-basics

A preferential payment is a payment that a debtor makes to a creditor shortly before filing for bankruptcy. The Bankruptcy Code allows the trustee (or debtor-in-possession) to recover such payments from the creditor. The logic is that, unless the preferential payments are recovered, the creditor will receive more than other unsecured creditors. This would violate a major tenet of the bankruptcy system – namely, that all creditors must be treated fairly.

When a preference occurs

According to Section 547 of the Bankruptcy Code, there are several conditions under which a payment may be considered preferential. These include:

  • The debtor is insolvent (unable to pay debts).
  • The payment exceeds $600.
  • The payment is for a debt.
  • The payment allows the creditor to receive more than it would under Chapter 7.
  • The payment was made within the 90 days preceding the bankruptcy filing (or within one year if the creditor is an “insider,” such as a family member).

There is nothing wrong or illegal about a preferential payment. In the worst case scenario, the trustee will simply invalidate the transfer and recover the payment for the benefit of the bankruptcy estate.

Defenses against preference actions

Defenses against the recovery of a preferential payment are found in 547(c). Under certain circumstances, the trustee may not invalidate a payment. These include:

  • The payment is a “contemporaneous exchange for new value.” In other words, it is not a payment for a past debt. It is a payment for a new product or service.
  • The payment is made “in the ordinary course of the business” or “pursuant to ordinary business terms.” If one of your creditors is your Internet service provider, your payment of the monthly Internet bill will not be considered preferential – as long as it does not significantly differ from previous payments.
  • The payment consists of a security interest that secures a new loan. If you get a car loan, you transfer the title of the car to the lender as collateral. The trustee cannot seize that car.

When the trustee files a preference action against a creditor, a defense such as those above will need to be set forth. The burden of proof lies with the creditor. The creditor must establish that although the payment meets the requirements of a preferential payment, it is protected by one or more of these defenses.

If you are a creditor who has received a payment from a debtor within 90 days of the bankruptcy filing, you should seek legal counsel to assist you with defending against a preference action.

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Johnny Tisdale

Paralegal at Dowe Law Firm
Johnny Tisdale is a paralegal, web designer, and writer at the Dowe Law Firm. He earned his BS in psychology and ABA-approved paralegal certificate from Auburn University Montgomery in 2011.

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