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Imagine a debtor who owes $500, $100 to each of Creditor A, B, C, D, and E. The debtor has $100 in his pocket. The debtor takes that money and gives it to Creditor A, thereby satisfying his $100 debt to Creditor A. In theory, the debtor could have given the same money to any of the other creditors in satisfaction of his debt to those creditors. In effect, the debtor preferred Creditor A over Creditor B and the other creditors. Under the United States Bankruptcy Code, or the Code, this is known as a preference.
The Code sets forth a preference period wherein it allows a bankruptcy trustee to “avoid,” or set aside certain payments to creditors because those payments are preference payments. When those payments are set aside, the creditor will be required to put the preference payment back into the bankruptcy estate. The Code provides for “clawback” provisions, which are provisions, pursuant to a bankruptcy, that a bankruptcy estate can “reclaim” certain monies. The Code provides that certain preferences and fraud are clawback provisions, allowing the bankruptcy trustee to compel a creditor to return funds to the estate.
Chapter 5 of the Code provides that a trustee may avoid a preference if the following elements are met:
- There was a transfer of interest of the debtor in property;
- Made to or for the benefit of a creditor;
- For or on account of an antecedent debt;
- Made while the debtor was insolvent;
- Made within ninety days before the date of filing of the bankruptcy petition;
- That resulted in the creditor receiving a greater distribution than it would otherwise have received in a Chapter 7 liquidation.
Regarding the term ”transfer” in element one, the Code provides a broad definition. In essence, a transfer is any benefit that a debtor provides to a creditor, whether it is tangible or intangible, if such benefit has value. This includes a monetary payment, a guarantee of obligations, the right to collect from a third party, a security interest in the debtor’s property, and more. The 2005 amendments to the Code, the Bankruptcy Abuse Prevention Creditor Protection Act, or BAPCPA, further expanded the definition of transfer. Under BAPCPA, a transfer of property includes the creation of a lien, retention of title as a security interest, disposing of property, and a foreclosure of a debtor’s equity of redemption amount to a transfer.
To or for the Benefit of a Creditor
The Code defines a creditor as anyone with a “claim” against the debtor. A “claim” is a right to payment. This right to payment can be any right, whether such right is reduced to judgment, has been liquidated, is fixed, is contingent, is matured, is unmatured, and so on.
For or on Account of an Antecedent Debt
Regarding the term “antecedent debt,” this requires that the creditor’s claim arose before the debtor’s payment of such claim. If a debtor paid an amount before it came due because the debtor believed such payment would eventually be required, then it does not satisfy this element and therefore not a preference action.
A Greater Distribution than Chapter 7 Liquidation
Regarding this element, a creditor who receives more that it would otherwise get in a liquidation is at risk of a preference. In the above example, if a debtor only has $100 and all creditors are unsecured, in a liquidation, each creditor would receive $20, so the $100 preference payment is avoidable. Assuming that the creditor who received the payment was secured while the others were unsecured, then that creditor, in a liquidation, would receive the entire amount so such creditor would not be a target of an avoidance action.
Even if all elements have been satisfied, a trustee can only avoid a preference if the payment from the debtor to the creditor occurred during the preference period. The preference period is generally 90 days before the debtor filed for bankruptcy. This rule can be harsh for creditors. Suppose Michael lent money to Brian and later collected the amount owed. Michael acted in an appropriate and correct manner. Shortly after, Brian filed for Chapter 7 bankruptcy protection. If the preference elements would have been satisfied, Michael would be legally required to contribute the repayment to Brian’s bankruptcy estate.
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