What is Preferential Debt Payment and How is it Handled in Bankruptcy?

Preferential debt payment is what it sounds like: one creditor is paid in preference to other ones, when a debtor is filing bankruptcy. It is a violation of bankruptcy rules; it also poses the risk of various kinds of corruption or improper influence during the bankruptcy process. For these reasons, it is possible that the bankruptcy trustee can avoid a preferential transaction--or set aside the transaction and recover the money.

What Are Preferential Debt Payments?

A payment to a creditor may be a preferential payment if--

1. It's made shortly before or while filing bankruptcy (e.g. within 90 days of filing)
2. The payment is made while the debtor is insolvent, which means not having enough income or cash flow to meet obligations
3. The payment is for a pre-existing debt (one where the debtor has already received the benefit, service, or product)
4. The creditor who receives the payment receives more than he, she, or it would have received in bankruptcy

Why Preferential Payments are Suspect

Number 4, above, is really the heart of preferential payments--preferential treatment: a creditor receives more than that creditor's share in bankruptcy. If preferential payments were allowed, there would be an extraordinary temptation for--

• Creditors to abuse debtors--such as by threatening or harassing them to receive preferential treatment
• Debtors to abuse creditors--such as by offering preferential treatment only in exchange for having part of the payment kicked back "under the table" or for some other consideration
• Collusion between debtors and "friendly" creditors (including, for example, family members or friends) to defraud others

The Trustee's Power

If a payment is shown to be preferential, the bankruptcy trustee can look to undo it. The trustee can force the money to be repaid to the bankruptcy estate, to go back into the "pool" from which all creditors are paid. The trustee can even do this to innocent creditors, who had no bad intentions and no knowledge they were receiving preferential treatment.

When It's Not a Preferential Payment

If the criteria for a preferential payment are not met, the payment is not preferential. That means that if the payment was more than 90 days prior to bankruptcy, or if the debtor was not then insolvent, or if the creditor did not receive more than that creditor's fair share, it probably is not a preferential payment.

In addition, a debtor may make "preferential" payments for new debts--i.e., the debtor can pay for new goods or services it is receiving, even if there are older, unpaid debts. This is to allow debtor to still run his or her household or business. As long as there is something of value being exchanged for the payment at the time it's made, it's not preferential.

How an Attorney Can Help

If you are a debtor filing or contemplating filing bankruptcy, an attorney can advise you as to how to structure any payments to creditors so as to avoid having them overturned as preferential. If you're a creditor and you're concerned that other creditors are being paid preferentially, leaving less for you, a lawyer can help you challenged those preferential payments.