What Is a Preference in Bankruptcy?

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Unsecured creditors are created equal under the U.S. Bankruptcy Code. Credit Card A has no more entitlement to your money than Credit Card B, or even your brother who loaned you his last dollar and really needs the money back. If you’re going to file for bankruptcy and you pay unsecured creditors more than a certain amount in the months leading up to your filing, this is considered a preference and your trustee can undo the transaction.

What Makes a Payment Preferential?

Paying a creditor right before you file for bankruptcy doesn’t automatically make it a preference. The code sets out certain criteria, and all of them must be met:

  • The debt must be old, not current. In bankruptcy terms, it’s antecedent.
  • The total amount of your debt must have exceeded the value of your assets at the time you made the payment; you were insolvent.
  • As a result of the payment, the creditor received more than it would have gotten if it had been paid as part of your bankruptcy case. 

Preference rules are intended to protect debtors from overzealous collection tactics by creditors when the debtors are already down and out, effectively forcing them to file for bankruptcy when they might have looked for other solutions if not for the harassment. A debtor doesn't even have to voluntarily pay the creditor; preference can also happen through garnishment. If a debtor does end up filing for bankruptcy, the rules ensure that the money that went to a preferred creditor can be divvied up among all creditors so everyone receives a rightful share.

Secured Creditors, Unsecured Creditors and Insider Transactions

Preference relates specifically to unsecured creditors. These are debts that are not tied to collateral the lender can repossess or foreclose on if you default.

The secured creditor can take back the property if you don’t pay even while you're in bankruptcy, although it requires a few extra steps and approval from the court. Secured creditors aren’t dependent on proceeds from your liquidated assets in Chapter 7 -- if you want to keep the collateral, you must keep paying for it -- so payments to these creditors can't be preferential.

As for unsecured creditors, the Bankruptcy Code breaks them down into two categories: regular creditors and insiders. Insiders are just what they sound like -- relatives, friends or business associates you may not want to see suffer because you’re filing for bankruptcy. Preference rules are different for insider transactions.

  • Payments to a regular creditor are preferential if they’re made within 90 days of your bankruptcy filing and total more than $600 toward any single debt. 
  • A payment to an insider may be preferential if you make it within a year of filing for bankruptcy. The same dollar limits apply. 

The Avoiding Powers of the Trustee

Bankruptcy trustees have the power to avoid or undo preferential payments. If you make one -- or if your wages or accounts are garnished within the allotted period -- your trustee can issue a demand letter to the creditor, instructing it to immediately repay the amount it received. The creditor can return the payment to the trustee or try to negotiate a settlement for a lesser amount, which is something a family member might try if he has already spent the money you repaid him and doesn't have it to give back. If no solution is reached, the trustee will file a lawsuit within the bankruptcy proceeding to force the creditor to return the money. In most cases, the trustee has two years from the date you filed your bankruptcy petition to begin these collection efforts.

Tip

  • Don’t lose sleep if you’ve filed for Chapter 7 bankruptcy and realized you paid someone more than $600 in the last three months -- or year, in the case of a family member or friend. You didn’t break the law by making the payment, but you do have a legal obligation to assist the trustee in getting the money back. This might involve giving him documentation of the transaction or testifying in court that you made the payment.

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