A basic principle of bankruptcy law is that all like creditors should be treated alike. This principle is usually easily applied. When the trustee (or the debtor in a Chapter 11 case) has funds to pay out to unsecured creditors, each claim is paid pro rata. If, for example, there is $10,000 to distribute and there are 3 credit card accounts, with balances of $5,000, $10,000 and $15,000, the creditors would each receiver 33.33% of their claim: $1,666.67, $3,333.33, and $5,000.
But what if the $15,000 creditor garnished the $10,000 from the debtor’s bank account just before the bankruptcy case was filed? Now that creditor gets 66.67% of its claim and the other two receive 0%.
This is where the concept of a “preference” kicks in. The basic idea is that a creditor should not be paid a higher percentage than similarly situated creditors just because it was paid shortly before bankruptcy rather than during the bankruptcy case. To address this situation, Congress gave bankrutpcy trustees and Chapter 11 debtors the power to sue the $15,000 creditor to recover the $10,000 so it does not receive more than its pro rata share.
Often, the creditor received payment voluntarily, rather than by garnishment or other seizure. There are many reasons a debtor may play favorites. Sometimes the debtor needs to maintain an ongoing relationship with a critical vendor, who alone can supply the debtor with needed inventory. Other times, there is a mad rush to pay “insiders” — relatives and affiliates — before the money runs out. For the most part, each of these situations is treated as a preference, whether the payment was made eagerly, involuntarily, or for sound business reasons.
The look-back period, however, is different for insider preferences. While payments made within the 90 days before the bankruptcy filing may be preferences, payments to insiders may be recoverable as preferences if made within one year before the bankruptcy.
This is a broad overview of preferences. As with most acts of Congress, the rules are subject to numerous exceptions.
If you are considering requesting Chapter 11 bankruptcy protection, or need a review of a potential preference, you may call for a free consultation at (480) 719-1152.