The Bankruptcy Trustee and Preference Claims

The bankruptcy trustee can undo certain financial transactions that occurred prior to your bankruptcy filing. Learn more.

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The Chapter 7 bankruptcy trustee has certain "strong arm" or avoiding powers which allow the trustee to reach back and undo certain transactions that took place prior to your Chapter 7 bankruptcy filing. Among these are "avoidable preferences."

Read on to learn about avoidable preferences and the process the trustee must undergo to undo those transactions.

(To learn more about the bankruptcy trustee's duties and powers in your case, see The Bankruptcy Trustee.)

What Are Avoidable Preferences?

An avoidable preference is a transaction prior to bankruptcy which prefers one creditor over others that are similarly situated. The transactions may be voluntary (you wrote a check to the creditor) or involuntary (the creditor garnishes your bank account). The look back period, or period of time that the trustee can go back to unwind these transfers, is ninety days for general creditors and one year for insiders (relatives or someone with a close or influential relationship with you). 

The rationale behind these avoiding powers is that all creditors similarly situated should be treated the same. Once the trustee collects all of your money or property that is in your bankruptcy estate and liquidates (converts to cash) the property, the trustee can redistribute the funds equally among similarly situated creditors and in accordance with the disbursement schedule set out in the bankruptcy law.

(To learn more about avoidable preferences, see Pre-Bankruptcy Payments to Creditors.)

The Procedure for Undoing Preference Transfers

While the trustee is granted these strong arm powers under the bankruptcy law, the recovery of the transfers is not automatic. The trustee must demand the return of the money or property, but the creditor  has no legal obligation to return the funds until the trustee obtains a judgment from the court. A creditor may use this time period to do its own investigation and perhaps work out a settlement of less than the full amount with the trustee.  The general procedure is as follows:

Prior to the 341 Meeting: Review of Schedules, Statements, and Preliminary Documents

In the first step of the process, the trustee will look for any avoidable transfers by reviewing your bankruptcy schedules and statements, along with any documents you are required to provide prior to the creditors meeting.

At the Creditors Meeting: Initial Inquiry and Testimony

Depending on the circumstances, the trustee may ask you questions about transactions that took place before you filed for bankruptcy, at the 341 (or creditors) meeting. Creditors meetings are usually hectic and crowded events. The trustee will have only a few minutes to conduct the initial inquiry before he or she will need to move on to the next case so, if there are suspect transfers, you can expect follow-up. At the 341 meeting, the trustee might request that you provide additional documentation to the trustee’s office within a certain time frame following the meeting. (To learn more, see The Meeting of Creditors in Chapter 7 Bankruptcy.)

After the Creditors Meeting: Follow-up and Demand Letters

Even if the trustee does not request additional documentation at the creditors meeting, if there are suspect transfers, it is likely that the trustee will request additional documentation or information after the meeting. This could come in the form of a letter, or the trustee could set a type of deposition called a 2004 examination to obtain more formal testimony and document production. This will not always involve you.

Under Bankruptcy Rule 2004, testimony and document production can be obtained from any person or entity. The trustee is looking for

  • documentation of the transfer
  • evidence that the transfer allowed the person receiving it to be paid a greater percentage of their claim than the creditor would have received if the transfer was not made and the creditor received payment through the bankruptcy proceeding, and
  • information on possible defenses.

Since there are minimums set by the bankruptcy law for avoiding preferential transfers, the trustee will only be interested in pursuing transfers equal to or greater than an aggregate of $600 in cases where the debt is primarily consumer debt and $6,8225 in cases where the debt is not primarily consumer debt.

The Adversary Proceeding (Clawback Suits)

The trustee will file an "adversary proceeding" or lawsuit once the trustee has determined that:

  • an avoidable preferential transfer took place
  • there are insufficient defenses to the recovery the transfer, and
  • the recipient has refused to voluntarily return the transferred money or property.

You might hear these avoidance actions sometimes referred to as "clawback" suits.

The recipient, now a defendant in the adversary proceeding, will have an opportunity to respond to the trustee’s action and present defenses to the recovery of the alleged preferential transfer. For example, these defenses may include:

  • new value (the creditor loaned the recipient more money after receiving the transfer and was not paid back)
  • contemporaneous exchange (the recipient received something of equal value in exchange for the transfer at the time it was made), or
  • ordinary course (the recipient made the transfer under ordinary business terms).

After considering the evidence, the court will make a determination and enter its judgment either for the trustee or the recipient. To the extent that the recipient has to return a preferential transfer, the recipient is now a creditor and can file a claim in the bankruptcy proceeding.

The Debtor's Duty in Clawback Suits and the Effect on Discharge

As the debtor, your only obligation in clawback suits is to cooperate with the trustee. This generally means providing documentation and information, and providing truthful testimony, if it becomes necessary.

The trustee’s attempts to recover preferential transfers should not delay your discharge or result in the denial or revocation of your discharge as long as you are fulfilling your duty to cooperate with the trustee and continuing to obey any court orders requiring testimony or the production of documents.

(Learn about bankruptcy trustee fees here.)

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