What exactly is a preferential transfer?
Defined in specific detail under the Bankruptcy Code, a preferential transfer must meet six key criteria:
It is a transfer of an interest of the debtor in property.
The phrase has been defined by the Supreme Court as property that normally would have been part of the debtor’s estate if it had not been transferred before bankruptcy proceedings began. It includes all of the debtor’s equitable or legal interests in property at the time that bankruptcy proceedings began. A preferential transfer does not exist if the debtor uses another entity’s property to pay a creditor.
The transfer is to or for the benefit of a creditor.
In other words, the creditor must be the final recipient of the transfer in order for it to be considered preferential.
The transfer is made on account of an antecedent (pre-existing) debt.
An antecedent debt is one that pre-dates the transfer, and which is created when a creditor, through the provision of goods or services, receives the right to payment from the debtor. In determining the existence of antecedent debt, the court looks at when the debtor became legally bound to pay, for instance by signing a purchase order for goods from the creditor, and when the transfer occurred, often indicated by the date that the debtor’s check was honored by the drawee bank.
The transfer was made within 90 days of the debtor’s bankruptcy filing.
One of the most straightforward criteria for a preferential transfer involves timing. Transfers that were not made during the 90-day period prior to a bankruptcy filing are unlikely to be considered preferential.
The transfer was made while the debtor was insolvent.
Insolvency is broadly defined by the Bankruptcy Code as existing when an entity’s debts are greater than its assets or property. For the purposes of preferential transfers, it is important to note that a debtor is presumed insolvent under the Bankruptcy Code during the 90 days before a bankruptcy case begins. In the case of a disputed preference claim, it is up to the creditor to prove that the debtor was solvent during this period.
The transfer allowed the creditor to receive more than they would have under a Chapter 7 repayment.
If the transfer had not been made, and the creditor instead received a distribution through the bankruptcy process, the transfer is considered to be preferential if it was for a sum greater than the distribution payment would have been. This is one of the clearest criteria for a plaintiff in a preference claim to satisfy, as creditors would only receive a payment equal to or greater than that under Chapter 7 if the distribution to creditors through the debtor’s bankruptcy was 100%, an extremely rare occurrence.
What is the purpose of preference litigation?
Although preference litigation might seem unfair to individual creditors, there are several reasons why it has a valuable role to play in the bankruptcy process. One is to facilitate the equality of distribution to a debtor’s creditors. In other words, it is designed to make sure all creditors are treated equally and fairly by preventing a debtor from paying some debt to “preferred” creditors while not paying others. Another reason is to discourage what is known as “dismembering of the debtor,” a situation in which creditors all race to collect claims from a debtor on the road to bankruptcy. Moreover, preference claims serve to discourage secret liens on a debtor’s collateral, a misleading situation which may prompt other creditors to extend credit to the debtor in the belief that the debtor’s collateral is free and clear.
What are some common defenses against a preference claim?
The good news for creditors is that even if a debtor’s case for a preference claim seems easily provable and the criteria above are met, a number of core defenses are still available for creditors to draw from.
The debt was incurred in the ordinary course of business.
This is the most widely used defense to a preference claim. If a creditor can show that the receipt of the transfer was a normal order of business between the debtor and the creditor – for example, if it was a recurring, customary credit transaction, and its incurrence and payment were consistent with prior payments made by the debtor to the creditor – the transfer is not considered preferential even if it meets the Bankruptcy Code’s six criteria for a preferential transfer.
The creditor gave new value to the debtor after receiving the transfer.
In order to establish this defense, the creditor must show that, after receiving what would otherwise be a preferential transfer, they provided “new value” to the debtor in the form of subsequent services or goods, and that they were not properly compensated by the debtor for the subsequent new value.
The payment was a contemporaneous exchange.
This defense holds that a transfer was not preferential if the creditor provided the debtor with services or goods at approximately the same time as the transfer was received, and if the creditor and the debtor intended for the payment to be contemporaneous.