What Is Preferential Payment in Bankruptcy?

March 22nd, 2022 by Bunch & Brock

No matter which side of a bankruptcy case you fall on, it’s important to understand the answer to the commonly asked question, “What is preferential payment in bankruptcy” and why did I get sued by the trustee for the disgorgement of money that someone rightfully owed and paid to me?

Bankruptcy laws are designed to protect debtors and creditors alike. That approach often leads to difficult decisions that can leave few parties feeling fully satisfied. That’s why it’s important that you understand the rules and work with an experienced bankruptcy attorney to know your rights.

What Is Preferential Payment in Bankruptcy?

Sometimes debtors who are considering filing for bankruptcy have a hard time deciding who to pay. They may rank creditors and begin making some payments to a select number of them.

Why? Usually, it’s because they do not have enough money to pay all their creditors or they prefer to repay “friendly” creditors or insiders or business partners. Instead, they rank the creditors and choose which will get paid back some money. In most cases, there is not enough to go around.

This scenario leads to what is a preferential payment in bankruptcy. It’s a legal term that refers to payments made to creditors before a bankruptcy case is even filed, i.e., 90 days to regular creditors and one year for insiders/family members/friends/business partners/etc., that allows those creditors to be paid more than the other creditors on an old debt. That time period is referred to as the reachback period. These payments have the effect, even if unintentional, of some creditors’ receiving more than they would be able to recover in the bankruptcy case.

Preferential Payment Cases Designed to Protect All

During a bankruptcy filing, a judge will assign a bankruptcy trustee, who is responsible for managing the funds to be distributed to creditors.

The bankruptcy trustee can recover these previously made preferential payments within the reachback period and redistribute them to all unsecured creditors. That’s because preferential payments are considered assets of the bankruptcy estate, which the bankruptcy trustee manages on behalf of the court.

What Is a Preferential Transfer?

The payments must meet five criteria in order for the bankruptcy trustee to recover the payments.

First, a creditor must have received monies from the debtor or have received a benefit.

Second, the money must have been owed on account of an old debt (referred to as an antecedent debt) before the payment was actually made.

Third, the payment must have been made while the debtor was insolvent.

Fourth, the payment must have been made within the 90 days before bankruptcy filing or 1 year if the creditor was an insider.

And fifth, the payment enabled the creditor to receive more than he would have received if he had not been paid and the trustee distributed money to all creditors equally on a pro rata basis.

Time Matters with Preferential Payments

How Far Back Can the Bankruptcy Trustee Look for Preferential Transfers?

The federal bankruptcy code puts some time limits on preferential payments. For some creditors, such as credit card companies or utility companies and other unsecured creditors, the law only considers what is a preferential transfer for payments made within 90 days of filing the bankruptcy petition.

For friends and families or business partners or owners, known in bankruptcy terminology as “insiders,” the timeframe is 12 months prior to the bankruptcy filing.

The bankruptcy code also does not allow for trustees to claw back money if the debtor has paid the creditor less than $600 during the 90-day or 12-month period in a consumer-type bankruptcy case or less than $6,825 if a business-type case.

What Debtors Need to Know

What benefit is there for a debtor to consider filing a bankruptcy petition, while knowing there were sizeable preferential payments? It means the debtor should have a careful understanding and strategy in place so that a debtor could use that law to recover some money from creditors for the benefit of other creditors, like taxing entities.

It’s important to contact an experienced bankruptcy attorney to know your rights and to develop a strategy that protects your assets and results in a smooth bankruptcy process.

Are There Exceptions to Preferential Transfers?

There are several exceptions to preferential transfers. The bankruptcy trustee cannot just automatically file a lawsuit to seek a judgment against a creditor that the trustee considers to be a preferential payment. Creditors have some defenses to thwart the actions of the trustee.

A common defense refers to the “ordinary course of business.” Under this defense, money paid during the preference timeframe cannot be taken back if it was paid during the ordinary course of doing business or under regular repayment terms. In addition, the money needs to have been paid in the same manner it was normally paid for the creditor to use the ordinary course of business defense. So, a vendor who regularly supplies goods to a company might use this defense by showing consistency in how and when payments were made to them, and that the payments and circumstances surrounding these payments were no different than those made before the preference period.

A second type of defense a creditor may be able to offer is that the payment was made as a “contemporaneous exchange.” Using the vendor example, this would mean the vendor (creditor) supplied goods to the company (debtor) and was paid then and there. Both parties exchanged something of equal value at the same time or nearly the same time.

These are two basic examples. Whether these defenses are successful depends upon all the specific details involved in the case. When either of these defenses is made successfully, the bankruptcy trustee cannot take the money paid during the transactions, even if the other components of a preferential payment are in place.

Example of the GenCanna Bankruptcy

Complicated Cases Call for Smart Legal Counsel

Bankruptcy filings can affect companies of all types. In Kentucky, the case of GenCanna is one where the financial issues are complex.

GenCanna, a hemp producer, went bankrupt in 2020. However, the company’s assignee filed a lawsuit against a New York hemp company looking to recoup millions of dollars.

GenCanna claimed that Michael Falcone, the chairman of its board of directors, oversaw a $750,000 loan to Southern Tier Hemp, a company based in Johnson City, New York. The suit alleges that Southern Tier Hemp used those funds to pay growers.

The suit is complex in part because Falcone was also co-founder and CEO of Southern Tier Hemp. Several other growers are also involved in the lawsuit. GenCanna claims it has written and oral promises that the money given to Southern Tier would be repaid.

Are You Impacted by the GenCanna Bankruptcy? We Can Help

Our team is currently representing clients who are affected by the GenCanna bankruptcy. Count on our experience in this case as we serve multiple clients and know the matter in detail. Call us today for help.

Do You Believe that Preferential Payments May Affect You?

If you’re a business owner that is considering filing for bankruptcy or a creditor that believes a debtor is facing serious financial issues and may file for bankruptcy, we’re here to help you. Contact our team of seasoned bankruptcy attorneys at Bunch & Brock today at 859-254-5522.

Attorney Matthew Bunch

Matt handles complicated bankruptcies and debt restructuring in Chapters 11 and 13 for both individuals and companies. He has also negotiated with multiple creditors on behalf of his clients to avoid bankruptcy. Matt is the firm’s lead litigator and handles contract disputes, certain personal injury claims and general litigation. [ Attorney Bio ]