Caution: Preference Liability

Kegler Brown Litigation Newsletter

Preference liability is another potential pitfall to bystanders in the bankruptcy process. Section 547 allows the bankruptcy trustee to recover payments and transfers made by the debtor on account of a pre-existing debt. The trustee can recover a transfer:

  • To or for the benefit of a creditor;
  • On account of a pre-existing debt;
  • Made while the debtor is insolvent;
  • Made within ninety days prior to the bankruptcy filing, or within one year of the filing if the transferee is an “insider;” and
  • Which enables the creditor to receive more than it would have received by filing a proof of claim.

Preference liability is a concern that creditors should take note of when settling claims. If the debtor transfers money or property to you pursuant to a settlement agreement, then declares bankruptcy within the following ninety days, the bankruptcy trustee may be able to avoid the transfer and force you to repay the settlement funds. You could then file a claim in the bankruptcy for the amount of the avoided transfer, but you would most likely not receive the full amount. The good news is that typically, creditors will not be forced to repay 100% of the transfer to the trustee. The best course of action is to accept the settlement and repay the preference as opposed to rejecting a settlement if the creditor suspects that the debtor is near bankruptcy.

Fortunately, not all transfers are avoidable preferences. Section 547(c) lists the exceptions. For example, a transfer is not a preference, and therefore cannot be avoided, if the payment was made in the ordinary course of business. Because preference liability applies only to payments made on account of pre-existing debt, there is no liability if the transfer was a contemporaneous exchange for new value (i.e., a sale of goods or services).