What is a Preference in Bankruptcy?

Preference related to creditor’s rights issues. If a company files for bankruptcy, the matter is turned over to a bankruptcy trustee who takes control of the debtor’s estate. In the case of the company, they have powers over the company. Preference specifically deals with voiding transactions within the last 90 days of a bankruptcy filing (sometimes longer) if it benefits one creditor to the detriment of another creditor. Such a transfer is referred to as a preference.

Let’s use a simple example commonly found in consumer bankruptcies. The debtor has maxed their credit cards with no hope of repayment, so they file for bankruptcy. Before doing so, however, they repay their grandmother the $100 they borrowed in 2015. The bankruptcy trustee can demand the $100 back from the grandmother as she has been given preferential treatment to the corporations that own the majority of the debtor’s debt.

This benefits both the creditor and the debtor. For the creditor, it prevents the debtor from moving assets out of their estate for the purpose of hiding them from the trustee. For the debtor, it prevents the creditor from using aggressive tactics that would drive them into bankruptcy since it isn’t just their debt that’s going to be repaid. In these cases, the trustee sends a demand letter to the debtor demanding the repayment of the transaction.

In this article, our California bankruptcy lawyer will discuss preference actions and how they can impact your bankruptcy or the bankruptcy of one of your debtors.

Elements of a preference action

Once a debtor has declared bankruptcy, the bankruptcy trustee will look at any payments made in the last 90 days (and sometimes go back further if the transfer was made to an “insider”). To prove that the transaction was unauthorized, the trustee must establish that the debtor was insolvent at the time of the transfer (their liabilities exceeded their assets) and that the amount paid would have been preferential (more than the creditor would have gotten in a Chapter 7 filing).

The trustee will generally send a demand letter to the creditor demanding immediate repayment of the unauthorized transaction. If the creditor wants to contest the demand then the matter proceeds to an adversary hearing. The creditor may offer several defenses to the demand for repayment.

Here, it helps to have a California bankruptcy attorney review your options to contest the demand. A preference action adversary hearing is a lawsuit filed by the bankruptcy trustee against the creditor who received a preferential payment. Some companies facing preference actions elect to resolve the matter by offering to settle part of the debt. Alternatively, a company can fight the avoidance of the payment by presenting its arguments at an adversary hearing.

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