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What is a voidable preference in bankruptcy?

Most provisions of the United States Bankruptcy Code focus on the financial condition of the debtor, but one provision should give creditors pause before they accept a payment from a person or firm on the verge of bankruptcy. The provision, Section 547, defines the term "voidable preference" and gives the bankruptcy trustee broad powers to recover money from creditors who received a voidable preference.

The section is intended to prevent debtors from giving favorable treatment to some but not all creditors before filing a bankruptcy petition. A preference is any payment to a prior creditor within 90 days prior to filing the bankruptcy petition that meets the following tests:

  • The payment must be for the benefit of a creditor, i.e., transfer money or a thing of value to the creditor;
  • The payment must be used to pay a debt that existed prior to the transfer;
  • The transfer was made while the debtor was insolvent;
  • The creditor received more value than it would have received in a Chapter 7 case if the transfer had not been made.

The trustee bears the burden of proving that a transfer is preferential and therefore voidable. If the trustee succeeds in proving that a payment to a creditor was preferential, the creditor must return the money to the bankrupt estate, where it is combined with the rest of the debtor's assets for payment of the claims of all creditors. While the recovery of a voidable preference may seem harsh to the creditor who must return the payment, the system is fair to all creditors and ensures that all creditors will be treated in the same fashion.

Creditors who are offered a payment by a debtor who is on the verge of bankruptcy may wish to consult a knowledgeable bankruptcy attorney for advice on whether to accept the payment and incur the expense of defending a lawsuit brought by the trustee or whether to await the outcome of the bankruptcy proceeding and accept a pro rata share of the debt in question.

Source: The Balance, "What is a Preferential Transfer?," Carron Armstrong, Dec. 21, 2016, accessed on Nov. 27, 2017