Preference Action in Bankruptcy : What a Creditor Should Know
When a business or individual files for bankruptcy, one important aspect that comes into play is how payments made before the bankruptcy are handled. Specifically, preference actions allow a trustee to recover certain payments made by the debtor to specific creditors shortly before filing for bankruptcy.
This blog will straightforwardly explain preference actions, helping you understand why these payments might be recovered and what it means for both the debtor and the creditor.
What Are Preference Actions?
A preference action is a legal tool used by a bankruptcy trustee to recover payments that a debtor made to creditors shortly before filing for bankruptcy. These payments are known as “preferential transfers” and are considered unfair to other creditors. By recovering these payments, the trustee ensures that all creditors are treated more equally.
Why Do Preference Actions Exist?
Preference actions exist to promote fairness in the bankruptcy process. When a debtor is nearing bankruptcy, they might favor certain creditors by paying them off, leaving others with little or nothing. This is particularly problematic if the debtor has little money left to pay off other debts. By allowing a trustee to recover these preferential payments, the bankruptcy system aims to distribute the debtor’s assets more evenly among all creditors.
What Payments Can Be Recovered?
Not all payments made before bankruptcy are subject to recovery. To qualify as a preferential transfer, the payment must meet specific criteria:
- Payment to a Creditor: The payment must have been made to or for the benefit of a creditor.
- Debt Owed Before Payment: The payment must be for a debt that the debtor owed before making the payment.
- Made Within 90 Days: The payment must have been made within 90 days before the bankruptcy filing. For payments to insiders, such as family members or business partners, this period extends to one year.
- The Debtor Was Insolvent: The debtor must have been insolvent at the time of the payment. Insolvency means that the debtor’s liabilities exceeded their assets.
- Creditor Received More: The payment must have allowed the creditor to receive more than they would have in a bankruptcy liquidation.
Exceptions to Preference Actions
Not all payments that meet the criteria above are subject to recovery. There are several exceptions where a creditor can argue that the payment should not be recovered.
Ordinary Course of Business
If the payment was made in the ordinary course of business between the debtor and the creditor, it might not be recoverable. This means that if the payment was consistent with the normal business practices of both parties, it is less likely to be seen as preferential.
New Value Defense
A creditor may also avoid repayment if they provide new value to the debtor after receiving the payment. This “new value” must be something of value, such as goods or services, that helped the debtor’s estate.
Contemporaneous Exchange Defense
Another defense is that the payment was made as part of a contemporaneous exchange for new value. For example, if the debtor paid for goods or services at the time they were delivered, this might not be considered a preferential payment.
How do Preference Actions Work?
When a trustee identifies a payment as potentially preferential, they will typically send a demand letter to the creditor. This letter will request the return of the payment. If the creditor refuses to return the payment, the trustee can file a lawsuit in bankruptcy court to recover the funds.
The Demand Letter
The demand letter is the first step in the preference action process. It informs the creditor that the trustee believes the payment was preferential and asks for the money to be returned voluntarily. The letter will often outline the reasons why the payment is considered preferential.
Responding to a Preference Action
If you receive a demand letter or are sued for a preferential payment, it’s important to respond promptly. Ignoring the situation can lead to a default judgment, meaning the court could order you to repay the money without considering any defenses you might have.
The Impact on Creditors
Being involved in a preference action can be challenging for creditors, especially small businesses. Losing a payment can have a significant impact, particularly if the business is already struggling. However, it’s important to understand that the purpose of preference actions is to ensure fairness in the bankruptcy process.
Protect Yourself as a Creditor
Creditors can take steps to protect themselves from preference actions. One way is to ensure that payments received from a debtor are consistent with normal business practices. Another approach is to provide new value to the debtor after receiving a payment, which can help in defending against a preference action.
In The End!
Preference actions are a key part of the bankruptcy process, designed to ensure that all creditors are treated fairly. While they can be complex, understanding the basics can help both debtors and creditors navigate this challenging situation.
If you are involved in a bankruptcy case, whether as a debtor or a creditor, it’s important to be aware of how preference actions might affect you.
Consulting with a knowledgeable bankruptcy attorney, such as those at FLP Law Group LLP, can provide valuable guidance and help protect your rights.
FAQS
What are preference actions in bankruptcy?
Preference actions are legal tools that allow a bankruptcy trustee to recover payments made to certain creditors shortly before the debtor files for bankruptcy.
Who initiates a preference action?
A bankruptcy trustee typically initiates preference actions during the bankruptcy process.
What types of payments can be recovered under preference actions?
Payments made to creditors within 90 days before filing for bankruptcy, or up to one year for insiders, may be subject to recovery if specific criteria are met.
What is considered an insider for preference actions?
Insiders include family members, business partners, or entities closely connected to the debtor.
Are there exceptions to preference actions?
Yes, exceptions include payments made in the ordinary course of business, contemporaneous exchanges for new value, or when new value was provided after the payment.
How can creditors protect themselves from preference actions?
Ensure payments are made in the ordinary course of business and consider providing new value to the debtor.
What steps should debtors take if facing a preference action?
Debtors should consult a bankruptcy attorney to understand the implications and possible strategies for dealing with preference actions.