What Are Preferential Payments In Bankruptcy: A Complete Guide

Introduction

In the complex landscape related to bankruptcy, terms like “preferential payments” might seem puzzling. But what are preferential payments, and why do they matter in bankruptcy? Simply put, preferential payments are payments made by a debtor to a creditor just before filing for bankruptcy. Though these payments may seem harmless, they can have a huge impact on bankruptcy outcomes.

In this guide, we’ll dive into preferential payments in bankruptcy, looking at its definition, effects, and legal rules. We’ll explore the regulations overseeing preferential payments, talk about common exceptions and defenses, and offer useful advice for debtors and creditors.

Understanding Preferential Payments

A preferential payment is a payment in which a debtor favors one creditor over others by paying them just before filing bankruptcy, which may disrupt the equitable allocation of assets among creditors. These payments are examined in bankruptcy courts to prevent creditors from gaining undue benefits.

The term ‘preferential’ refers to a person or entity who holds the position of preferential creditor during the insolvency of a company and is likely to get credit payment over other creditors. . Simply put, preferential payments are payments made by a debtor to a creditor prior to filing for bankruptcy.

In simple terms, preferential payments refer to the debtor choosing one creditor over others. This preference might be the result of various factors, such as personal relations with a creditor, strategic business decisions and an effort to secure future credit. Whatever the debtor’s purposes may be, preferential payments affect the creditors, the debtors, and the general integrity of the bankruptcy system in the long run.

What are Preferential Payments in Bankruptcy?

In bankruptcy, preferential payments refer to payments made to creditors within a certain period before the filing of bankruptcy. The idea behind identifying and scrutinizing these payments is to ensure fairness among creditors and prevent any particular creditor from receiving more than their share.

By assessing preferential payments, bankruptcy courts seek to ensure equality and impartiality in asset distribution, protecting the interests of all parties concerned. What distinguishes these payments in the context of bankruptcy is their timing related to the filing date as well as their possible impact on the bankruptcy estate.

What Are Preferential Transfers?

A preferential transfer is when an insolvent debtor transfers property or pays a debt to a particular creditor, thereby prioritizing them over other creditors. This transfer occurs within a specified time frame preceding the date of the bankruptcy filing, which is usually a period of 90 days.

Preferential transfers assume various forms, including payments in order to satisfy pre-existing obligations, asset transfers in order to secure outstanding obligations, or the granting of security interests to favored creditors. Preferential transfers, whatever their form may be, are judged by timing, amount, and intent for conformity with the bankruptcy laws and fairness requirements.

How Much Time Does a Preferential Payment Take?

Preferential payments may be examined for a period preceding the bankruptcy filing, which is normally 90 days for ordinary creditors and one year for insiders, family members and other business associates.

• Payments made to regular creditors, such as suppliers or lenders, are normally subject to a 90-day preference period before bankruptcy.
• Payments given to insiders, such as family members or business associates, are subject to a longer preference period of one year prior to bankruptcy filing.

The difference in preference periods indicates the risks associated with preferential payments made to ordinary creditors versus insiders. Bankruptcy regulations try to prohibit debtors from manipulating their assets to benefit specific creditors before filing for bankruptcy.

Different Elements of Preferential Payments 

Preferential payments in bankruptcy aren’t simple; they have many elements that make them complex and important. Knowing these elements is key for all stakeholders, including debtors and lenders. From the type of payment made to when and why it was made, each element is crucial in finding out if a payment counts as preferential payment and how it might affect the bankruptcy case. In this section, we’ll look into the many parts of preferential payments:

• Creditor 
  

  Thereditor, or the person who made the loan, received money from the borrower. This money could be paid freely or seized by wage garnishment or bank levy.

  
  
• Antecedent Debt 
  

  The funds must be used to repay a portion of a debt that existed before the date of payment. This is referred to as an antecedent debt.

  
  
• Transfer of Property or Payment 
  

  A preferred payment comprises either transferring property to a creditor or making a payment to them.

  
  
• Time Frame
  

  The payments are made before the bankruptcy filing within a specified time period.

  
  
• Intent 
  

  Upon payment, the debtor must have intended to favor one creditor over others.

  
  

In bankruptcy proceedings, the inspection of transactions before filing are important, especially those containing bankruptcy preference claims. These occur when a debtor makes payments or transfers assets to certain creditors before declaring bankruptcy. So, it’s important to know the impact of such claims. 

Are Preferential Payments Reversible?

Yes, preferential payments can be reversed under some circumstances. When the bankruptcy trustee determines that a preferential payment has occurred, they can take a “clawback” action. Such action enables the trustee to recover the preferential payment from the creditor who received it.

The function of the clawback is to bring the payment back to the estate for distribution under the Bankruptcy Code’s requirements for fair and equal distribution among all creditors. However, not all preferential payments are clawed back immediately. . To obtain a clawback of a preferential payment, the trustee must be able to establish that certain conditions are being met. These conditions are:

• Time frame of payment
  

  The payment must have been made within a specific time frame prior to the bankruptcy filing, known as the preference period.

  
  
• Payment intent
  

  The debtor must have made the payment with the intention of favoring one creditor over others and hence is providing preferential treatment to the particular creditor

  
  
• Impact of payment on the bankruptcy estate
  

  The preferred payment should have been damaging to the pool of assets available for distribution to all creditors in the bankruptcy estate.

  
  

With the establishment of these conditions, the trustee may institute a clawback action to recover the preferential payment. However, preferential payments are only recoverable under the bankruptcy act and legal proceedings.

Are There Exceptions to Preferential Transfers?

While preferential transfers are normally evaluated in bankruptcy proceedings, there are several exceptions to the rule. These exceptions acknowledge that not all payments made prior to bankruptcy are intended to give one creditor priority over another. Some common exceptions to preferred transfers are:

• Ordinary course of business: Payments made in the ordinary course of business are generally not deemed preferential. These are payments made in accordance with the debtor’s previous practices and for goods or services received.
• Simultaneous exchange: Transfers made as part of a simultaneous exchange for new value are not preferential. For example, if a debtor pays a supplier for goods received, it may not be considered preferential.
• New value defense: Creditors that supply new value to the debtor after obtaining a preferential payment might be allowed to use the new value defense. This defense allows the creditor to offset the preferential payment against the amount of new goods or services received by the debtor.
• Floating liens: Payments made to obtain a floating lien, where the interest of the creditor in the debtor’s property fluctuates, may not be considered preferential.

These exceptions reflect that not all pre-bankruptcy contributions may indicate preferential treatment. Defining specific conditions under which preferential transfers do not apply, the bankruptcy statutes attempt to strike a balance of interest between debtors and creditors while still ensuring that assets get distributed fairly.

Bankruptcy Code on Preferential Payments

The Bankruptcy Code is the bedrock of federal bankruptcy law in the United States, providing an excellent framework to deal with preferential payments and other issues related to bankruptcy. Various sections of the Bankruptcy Code discuss preferential payments in detail, which includes the rules and regulations that govern such transactions. Among the major clauses of the Bankruptcy Code, the clauses that deal with preferential payments are as follows:

• Section 547 – Preferences
  

  This section lists the conditions that must be satisfied for a payment to be deemed as preferential. It also provides the trustee the right to avoid such preferential payments.It outlines the exceptions related to preferential payments as well as defenses that the creditors can raise.

  
  
• Section 548 – Fraudulent Transfers and Obligations
  

  Although this section does not explicitly mention preferential payments, fraudulent transfers are addressed in this section. Included in these could be preferential payments that were made with intent to defraud the creditors.

  
  
• Section 549 – Post-petition Transactions
  

  This section regulates post-petition transactions, which are transactions that transpire after the filing of the bankruptcy petition and may include preferential payments. It provides trustees the authority to avoid and nullify post-petition transactions that are deemed as preferential. 

  
  
• Section 550 – Liability of Transferee of Avoided Transfer
  

  This section makes clear who will be liable to the trustee in case of a preferential payment being avoided, so as to avoid confusion, unfair payments and discrepancies from occurring.

  
  

Regular Creditors Vs Inside Creditors

Regular creditors do not have any special relationship with the debtor, whereas inside creditors include family members and business partners. Different regulations may apply to preferential payments made to these two types of creditors.

Regular Creditors	Inside Creditors
They do not have a special relationship with the debtor	Insider relationship with the debtor (e.g., family members, business partners)
Subject to a 90-day lookback period for preferential transfers	Subject to a one-year lookback period for preferential transfers
Typically they do not have a higher likelihood of receiving preferential payments	May have a higher likelihood of receiving preferential payments due to their closer relationship with the debtor
Examples include suppliers, lenders, and trade creditors	Examples include family members, business partners, and insiders with control over the debtor’s finances

The difference between normal and inside creditors is very essential to understand the laws and procedures around preferential payments in the framework of bankruptcy proceedings. A clear understanding of the differences that exist between these two types of creditors helps debtors and creditors perceive their rights and responsibilities more accurately within bankruptcy proceedings.

What should you do when the money can’t be paid back to you?

If you are the unlucky recipient of a preferential payment clawback, it is critical that you consult with legal counsel to understand your alternatives and traverse the complex landscape of bankruptcy law. Depending on the circumstances, you may be able to reach an agreement with the trustee or dispute the clawback in court. By seeking competent guidance, you can safeguard your interests and increase your prospects of recovering cash owed to you.

What Debtors Need to Know

Debtors should understand that preferred payments might have major consequences in bankruptcy proceedings. It is critical to understand the rules governing these payments and to seek expert assistance if necessary. Debtors can avoid costly court fights and ensure a smoother bankruptcy process by dealing with potential preferential payments ahead of time and taking efforts to limit the risk. 

Working with an experienced bankruptcy attorney can help debtors manage the complexities of preferential payments and minimize the impact on their financial situation.

A Real Life Example of Bankruptcy

Sears Holdings Corporation is a real-life example of a business that was declared bankrupt. Once loved as a traditional department store and catalog sales company, Sears failed to adjust to changing consumer tastes and address the increasing competition in online shopping. This is an overview of Sears’ bankruptcy.

• Background
  

  Started in 1886, Sears has since changed to become one of the largest merchants of all goods in the United States, selling appliances, clothing, tools, and home furnishings. However, in the first decade of the new millennium, Sears came under fierce competition from low-cost retailers like Walmart and Target, as well as the new powerhouse of e-commerce, Amazon. It was unable to update its stores and address the changing consumer tastes.

  
  
• Financial Challenges
  

  Owing to its ability to adjust to dynamic market changes, Sears faced financial challenges, including high debt and declining sales and profits. Despite efforts to streamline operations and reduce costs, the company’s losses grew and its cash reserves shrank. In 2017, Sears Holdings Corporation, the parent company of Sears and Kmart, declared a net loss of more than $2 billion and issued a warning to investors about its capacity to continue operations.

  
  
• Bankruptcy Filing
  

  In October 2018, Sears Holdings filed for Chapter 11 Bankruptcy, in the Southern District of New York. The corporation blamed its financial difficulties on years of dwindling revenues, growing debt, and increased competition. Sears’ bankruptcy case enabled it to restructure its business, shut down unproductive locations, and renegotiate its debts while maintaining its remaining stores and online platform.

  
  

Sears’ bankruptcy serves as a cautionary tale about the issues that traditional retailers face in the digital age, as well as the significance of adjusting to changing market conditions. It also emphasizes the challenges of company restructuring and the consequences of bankruptcy for numerous stakeholders.

How HighRadius Can Help?

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FAQs

1) What constitutes an unfair preference payment?

Unfair preference is defined as making a transaction that benefits a creditor in the case of the company’s liquidation. An unjust preference payment occurs when a debtor favors one creditor over another shortly before bankruptcy, thereby jeopardizing the equal allocation of assets.

2) How can I avoid preferential payments?

To avoid preferential payments, keep financial transactions transparent and avoid favoring certain creditors prior to bankruptcy. Consult with a lawyer to verify compliance with bankruptcy laws to reduce the risk of clawback actions. Consider restructuring debts or pursuing alternative payment methods.

3) What is the priority of payments in bankruptcy?

The sequence or priority order in which creditors are paid in bankruptcy is determined by their priority of initial payment, and the trustee, more often than not, begins with secured creditors, followed by administrative charges, priority debts, and finally unsecured creditors. 

4) Who gets paid first in cases of bankruptcy?

Secured creditors have a security interest in part or whole of the company’s assets and are usually the first to be paid. Fixed charge holders include banks and other asset-based lenders who own a company’s assets. Such charges may include assets such as plants, machinery, vehicles, and property.

5) Give an example of unfair preference. 

Paying off a personal loan to a family member right before bankruptcy, giving them preferential treatment over other creditors, is an example of unfair preference, as it disadvantages other creditors and disrupts the equitable distribution of assets.