Preventing or Defending a Preference Challenge by the Bankruptcy Trustee

Dealing with a trustee's Preference challenge can be one of the more frustrating aspects of your bankruptcy case. Most cases don'tinvolve preferences, partly because they can be easy to avoid, defend, or negotiate around. But you need to understand preferences so you and your lawyer can avoid or otherwise deal with them.

Preference law is complicated. The section of the U.S. Bankruptcy Code titled "Preferences" (Section 547) has about 1,300 words within about 55 subsections. The history of preference law goes back nearly 450 years in English law, adopted in the U.S. more than 175 years ago and revised many times since then. There's a lot to this area of bankruptcy law.

WHAT'S A PREFERENCE?

A preference, or preferential Payment, is money you pay or property you give to one creditor within a certain amount of time before filing bankruptcy that you pay or give in preference to your other creditors. Under certain conditions that one creditor could be forced to repay that money or return that property to your bankruptcy trustee. The preference payment is essentially undone, or "avoided." If that one creditor you paid was a relative or friend, or someone else you really wanted paid, you'd likely want to avoid that result.

More specifically, preference law only kicks in if a creditor takes or receives money from you within the 90 days before you file your bankruptcy case. However, this lookback period is a full year before filing if the creditor is an "insider." That includes most relatives, friends, and pretty anybody else you'd have a reason to favor.

("Insider" is partially defined in the Bankruptcy Code at Section 101(31). But this definition is only partial because it's "inclusive"—it lists types of creditors who are included as insiders but that list doesn't include some other possible ones. For example this definition says what relatives are insiders but doesn't talk about other personal relationships such as close friends. So the courts have had to flesh out this question of "non-statutory insiders." Within a few weeks I'll have a separate blog post here on what the local courts have said about this.)

SO ANY MONEY YOU PAY A CREDITOR WITHIN 90 DAYS/ONE YEAR IS A PREFERENCE?

No, it's a lot more involved than that. There are 5 elements that have to be met, and there are a number of significant exceptions. Here today I'll just list the 5 elements as they are stated in the statute, and then get into some of the main exceptions or defenses that apply to consumer bankruptcy cases.

The five elements are laid out at Section 547(b) of the Bankruptcy Code:

the trustee may avoid any transfer of an interest of the debtor in property—

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made—

(A) on or within 90 days before the date of the filing of the petition; or

(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if—

(A) the case were a case under chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the provisions of this title.

IS THERE A WAY TO AVOID A PREFERENCE ALTOGETHER?

First, as you can surmise from this list of statutory elements, your pre-petition payment may not be preferential even though at first you may think it is. You may not meet all five elements. Talk with an experienced bankruptcy lawyer to find out if you really have reason to be concerned.

Second, the 90-day/1-year element is a strict one, so it gives you a relatively easy out in many situations. If you've made a preferential payment or transfer that you care about within the pertinent time period, you could simply wait to file until enough time has passed since the payment or transfer. That would avoid the problem altogether.

Of course there are situations when the threat of creditor actions against you or your property you can't or shouldn't hold off filing.

SO HOW DO I DEFEND A PREFERENCE IF NECESSARY?

First, there are situations you may not need to defend a trustee's assertion of a preference.

• The preference challenge by the trustee is not actually against you but rather against the person you paid. Sometimes you would do nothing and just let your payee deal with it. (More about this towards the end of this blog post.)
• There's a statutory exception for payments/transfers of less than $600 in consumer bankruptcy cases (and less than $6,425 in business cases). See Subsections 547(c)(8) and (9).
• For practical reasons bankruptcy trustees often don't pursue preference payments/transfers in consumer cases that are somewhat larger than $600 if there are no other assets at issue. This depends on the case and the tendencies of your local trustees so talk with your lawyer about this.
• Some payees are uncollectible or not worth the cost and effort to try to collect against them. The person you paid may have no income or assets that the trustee can legally reach. Or finding or pursuing the person may be too risky. The trustee won't want to pay his or her lawyer to pursue a preferential payment if doing so would be fruitless.

BUT WHAT CAN I DO IF THE TRUSTEE IS REALLY GOING TO PURSUE A PREFERENCE?

There's a defense to a preference in the bankruptcy statute that states that the "trustee may not avoid . . . a transfer" "to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor." Subsection 547(c)(4). What this means is if you paid a friend or relative or other creditor back within the 90-day/1-year period before filing, but that creditor subsequently paid you back that same amount, that new payment would be "new value" that would prevent the trustee from pursuing the amount you had paid. In effect this payment to you of this "new value" would undo your preferential payment.

This assumes that you have a friendly friend/relative/creditor who is willing and able to pay you back that payment to avoid having it go to the trustee. Plus the timing of this "new value" payment to you can be very important, along with what you do with the money so received. So this is definitely something you want to plan carefully with your bankruptcy lawyer.

CAN I PAY OFF THE TRUSTEE MYSELF TO SETTLE A PREFERENCE?

What if you clearly have a preferential payment that your Chapter 7 trustee is trying to "avoid"—make your creditor repay? What if you just can't let that happen, and your friendly creditor did not have the means to pay you the money back to create a "new value" defense as just outlined? If YOU have the means yourself to pay that same amount to the trustee, doing so may be a practical solution.

The trustee will usually not care where that money comes from—from the creditor you paid or from you. So you could offer to pay that that sum of money yourself. The trustee may even accept that in monthly payments from you. You may be able to pay less than the full preference payment amount, subtracting what it would have cost in attorney fees and other costs for him or her to get it from your relative. For example, if the preference amount is $3,000, you could offer to pay $2,500, maybe being allowed to pay 10 payments of $250.

HOW CAN CHAPTER 13 HELP RESOLVE A PREFERENCE?

What if you filed a Chapter 13 "adjustment of debts" case instead of a Chapter 7 one?

You may well do so for reasons nothing to do with the preference situation. Or if you're on the edge in deciding between one or the other, having a preference problem could push you in favor of Chapter 13 if there isn't any other good solution.

That's because Chapter 13 could be a good tool for paying the trustee the preference amount (or a reduced amount as described above) through your Chapter 13 payment plan. The advantages include:

• avoiding the whims of a Chapter 7 trustee, such as whether he or she would accept payments from you and how quickly you'd have to pay the preference amount
• more time to pay the preference amount through a Chapter 13 plan
• much more flexibility in paying the preference amount while paying other important continuing debts like recent income taxes or home mortgage arrearage

WHEN SHOULD I JUST LET THE TRUSTEE CHASE THE PERSON I PAID?

All of this assumes that the person you paid before filing bankruptcy is one you want to protect. There certainly are situations you wouldn't try to protect him or her.

Your relationship with the person may not be that good. You may not care if the trustee would force that person to give back what you paid. Your relationship with the person may have deteriorated so much in the meantime that you now don't mind if your trustee now pursues repayment from that person.

Or your relationship with the person you paid pre-bankruptcy may be very good. If so, he or she may not mind so much paying back the payment to the trustee. (This assumes you did not already receive the same amount as "new value" before you file bankruptcy, as described above.) This especially makes sense if he or she can easily afford it. IF you want, you might even informally volunteer to later pay to him or her back the preference amount (a second time). Note that this would be completely voluntary on your part because very likely any debt you'd owe to the person would be legally discharged in your bankruptcy case.

BE HONEST AND THOROUGH WITH YOUR LAWYER

Maybe the most important thing to remember about this complicated area is that it's a great example why you need to be completely honest and thorough with your lawyer. He or she will ask you questions about recent payments you've made to anybody. You need to respond candidly and in detail.

Bankruptcy is stressful, so if you're not careful you might not be thinking clearly when you talk with your lawyer. You might consider a friend or relative not to be a "creditor" and so figure that payments to them don't count. You may genuinely forget about dealings with special people like that when you're asked about prior payments to creditors. Or you may try to sweep stuff like that under the rug. You might figure that if you don't tell your lawyer then nobody will find out.

All this can backfire. As you've seen here there are ways to prevent and defend a preference challenge. There may be other tactics that apply to you not covered here. Your lawyer is your advocate. It's his or her job to protect you and your interests, to find the very best path for you. Almost certainly a worse result would come from having you and your lawyer blindsided in the middle of your case by something you didn't tell him or her. Avoid that by just telling the truth and the whole truth.