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Preferential transfers in bankruptcy

On Behalf of | Jan 5, 2021 | Bankruptcy

Absent a unique catastrophe, people rarely become insolvent overnight. Most of the time, the slide into bankruptcy starts out slow and picks up speed only once the situation becomes truly unmanageable.

Sometimes a debtor will route a big payment to one or more of their creditors shortly before they file for bankruptcy protection. That kind of preferential treatment, however, isn’t legal.

Why can’t debtors pick and choose who they pay?

Essentially, the U.S. Bankruptcy Code exists to protect both debtors and creditors alike. Once a bankruptcy petition is filed, debtors are protected from collection efforts by their creditors. The creditors, too, can rest assured that they will be treated equally (according to the type of debt they hold) with all other creditors — and no one creditor will be permitted to swoop in and grab any of the debtor’s assets in a hurry before anybody else gets anything.

When does “preferential treatment” come into play?

It’s generally assumed that anybody who is filing for bankruptcy was probably insolvent 90 days prior to filing, so all payments to any creditors that are an “arms-length” away from the debtor in that time will be scrutinized.

The bankruptcy trustee can, if they’re so inclined, look at any payments made to “insiders” in the debtor’s life over the entire last year before the bankruptcy petition was filed. Insiders include people like the debtor’s parents, siblings, close friends, business partners and others with whom they share a personal connection.

What happens if the trustee decides that a preferential transfer took place?

The trustee has the power to “claw back” any assets that were given to a creditor during the applicable look-back period. That can, naturally, end up being a major legal headache for the creditor involved — especially if they no longer have the funds themselves.

Avoiding problems with a bankruptcy is important whether you’re a debtor seeking protection or a creditor looking to preserve your rights. Make sure that you fully understand your obligations under the law at each step of the process.