The Bankruptcy Trustee and Preference Claims

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

Updated March 16, 2018

The Chapter 7 bankruptcy trustee—the official assigned to administer the case—has certain "strong arm" or avoiding powers which allow the trustee to reach back and undo certain transactions that took place before your Chapter 7 bankruptcy filing. Among these are "avoidable preferences"—payments that unfairly favor a creditor over others.

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

(To learn more about the bankruptcy trustee’s duties and powers, see The Bankruptcy Trustee.)

What Are Avoidable Preferences?

An avoidable preference is a transaction made before filing for bankruptcy which prefers one creditor over others that are similarly situated. The transactions can 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—see more below).

Since there are minimums set by the bankruptcy law for avoiding preferential transfers, in cases that do not involve insiders, 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 $6,425 in cases where the debt is not primarily consumer debt. (These figures are subject to change on April 1, 2019, and every three years thereafter.)

The Ultimate Preference: Insider Payments
When you complete Your Statement of Financial Affairs for Individuals Filing for Bankruptcy (sometimes referred to as SOFA), you’ll disclose whether you’ve paid on a debt owed to an insider, or paid an insider’s debt, during the year before you filed your bankruptcy case. In bankruptcy, an insider is someone close to you, such as a family member, a business partner, or a relative of a business partner.
What’s the purpose of SOFA? SOFA is one of the forms that the bankruptcy trustee—the official tasked with managing your case—will review for fraud and unfair practices. The trustee has the power to unwind transactions and recover funds for the benefit of creditors. Anyone who received money or property that should have remained in the bankruptcy estate will have to give it back. You’ll disclose debt payments made to creditors over the established limits on this form, as well.
Why must insider payments be disclosed? Family members and business associates have avoided creditors by transferring assets to each other for as long as courts have recorded case law—and it’s still a common occurrence. It’s considered unfair to give insiders payment priority over your other creditors. Creditors must receive payment according to the priority ranking system outlined in bankruptcy law. As a result, when you complete your paperwork, you’ll have to disclose such transactions.
What will happen if I made an insider payment? If it has occurred, you can expect the trustee to take steps to get the funds or property back. If you hide a transaction, however, and the trustee later discovers it, the trustee will not only unwind it, but you’ll be subject to fines and penalties of up to $250,000, 20 years in prison, or both.If you believe that you’ll have to report an insider transaction on your statement, it’s best to consult with a bankruptcy attorney before moving forward.

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 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: Can the Trustee Get the Money Back?)

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. Here’s how this works.

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 bankruptcy documents you are required to provide before the 341 meeting of creditors.

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 attended by multiple bankruptcy filers. 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 a follow-up.

At the 341 meeting, the trustee might request that you provide additional documentation to the trustee’s office within a certain time following the meeting. If the trustee has more questions, you can expect the meeting to be continued to another day and for a more extended time. (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 take more extreme measures.

When a trustee suspects a serious problem exists, the trustee (or someone else involved in the matter) can 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.

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.

(For more information, see Adversary Proceedings in Bankruptcy.)

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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