Preferential Debt Payment

Preferential debt payment is defined as a payment made by debtors to existing creditors right before filing for bankruptcy. The idea is that debtors make the payment because they prefer the said creditors to others – a good example would be existing loans from friends and family members. The idea is that the debtor unfairly distributes his or her funds knowing that they will be filing for bankruptcy.

Preferential Debt Payment

Legal Definition of Preferential Debt Payment

Technically speaking, preferential debt payment is any payment that is made within 90 days before bankruptcy filing that exceeds $600. Accordingly, the said creditor managed to receive payment far beyond what they would originally receive had they been paid after the bankruptcy filing. In the event that the creditor is an insider, then the length of time is set at one year. An insider is defined as a personal acquaintance, usually a friend or a family member. So essentially, there are five requirements for a payment to be defined as a preferential debt:

  1. It is made for the benefit of the creditor.
  2. It is made in payment of a previous debt.
  3. The payment should be made while the debtor is already insolvent.
  4. The payment is made within 90 days of filing for bankruptcy – 1 year for insiders.
  5. The payment made to the creditor is more than what the creditor would have received as part of the bankruptcy settlement.

What Happens with Preferential Debt Payment?

Should the court determine that a petitioner engaged in preferential debt payment, the trustee is within his rights to obtain the money back from the creditor. It does not matter if the payment was made in good faith – the creditor is obliged to give back the funds and have them included in the bankruptcy bid. This is no way put the creditor in bad light with the law. Instead, the trustee simply adds the creditor to the bankruptcy payment schedule so that they too can be paid using the same process as all the other creditors. That being said, there is a good chance that the preferred creditor will be getting less than the actual amount owed.

Is Preferential Debt Payment Illegal?

Preferential debt payment is in no way illegal, although it does invalidate the transaction between the debtor and the creditor. The court simply undoes the transaction and included the preferential payment within the extent of the bankruptcy payment.

Of course, there are instances when the payment is considered illegal. This is when the transfer of funds is done with the sole intent of defrauding the creditors. A good example of this is if there is no actual existing debt between the debtor and the creditor prior to the transfer. In effect, the debtor is simply creating a fake creditor as a shelter to ensure that a portion of his or her funds remain untouched by the trustee.

If the transfer of funds is identified as preferential, the trustee is the one responsible for getting the said amount back and redistributing it to the creditors.