Legal Definitions - preferential transfer

A preferential transfer occurs in bankruptcy law when a debtor, shortly before filing for bankruptcy, makes a payment or transfers an asset to a particular creditor, giving that creditor an unfair advantage over others.

Essentially, it's a payment made by an insolvent debtor that allows one creditor to receive more than they would have if the debtor's assets were distributed fairly among all creditors during the bankruptcy process. To be considered a preferential transfer, the payment or transfer must typically occur within 90 days before the bankruptcy filing (or up to one year if the creditor is an "insider," such as a family member or business partner) and must result in the creditor receiving more than they would have through the standard bankruptcy distribution.

The purpose of identifying and recovering preferential transfers is to ensure that all creditors are treated equitably and that a debtor cannot unfairly favor certain creditors just before seeking bankruptcy protection. A bankruptcy trustee has the power to "undo" these transfers, bringing the assets back into the bankruptcy estate for a more balanced distribution to all eligible creditors.

Here are some examples illustrating a preferential transfer:

• Example 1: Favoring a Key Supplier

  Imagine "Build-It-Right Construction," a company struggling financially and on the verge of bankruptcy. Build-It-Right owes money to several material suppliers. Two weeks before filing for bankruptcy, the owner pays their most critical lumber supplier, "Timberline Wood," in full for a $20,000 outstanding invoice. Other suppliers, owed similar amounts, receive no payment.

  How this illustrates the term: Timberline Wood received 100% of its debt just before Build-It-Right filed for bankruptcy. If that payment hadn't occurred, Timberline Wood would have had to share in the bankruptcy estate with all other unsecured creditors, likely receiving only a fraction (e.g., 20-30%) of what it was owed. This full payment is a preferential transfer because it allowed Timberline Wood to receive more than its proportionate share compared to other creditors.

• Example 2: Repaying a Family Loan

  Sarah is deeply in debt and knows she will have to file for personal bankruptcy within the next few months. She owes money to several credit card companies, a bank for a car loan, and her brother, Mark, for a $10,000 personal loan he gave her a year ago. Three months before filing her bankruptcy petition, Sarah repays Mark the full $10,000, while making only minimum payments to her other creditors.

  How this illustrates the term: Mark, as Sarah's brother, is considered an "insider" under bankruptcy law. This means the look-back period for preferential transfers extends to one year before the bankruptcy filing. By repaying Mark in full, Sarah allowed him to receive 100% of his debt. In bankruptcy, Mark, as an unsecured creditor, would likely have received only a small percentage of his loan back, similar to the credit card companies. This full repayment to Mark is a preferential transfer because it unfairly favored him over Sarah's other creditors.

• Example 3: Selective Bank Payment by a Corporation

  "Tech Solutions Inc." is facing severe financial difficulties and is preparing to file for Chapter 11 bankruptcy. The company has unsecured loans from two different banks, "First National Bank" and "Community Savings Bank." Sixty days before filing its bankruptcy petition, Tech Solutions Inc. makes a substantial payment of $50,000 to First National Bank on its unsecured loan, hoping to maintain a good relationship for potential future business. No similar payment is made to Community Savings Bank or other unsecured creditors.

  How this illustrates the term: The $50,000 payment to First National Bank occurred within the 90-day preference period. If this payment had not been made, First National Bank, like Community Savings Bank, would have been an unsecured creditor sharing in the remaining assets of Tech Solutions Inc. The payment allowed First National Bank to recover a significant portion of its loan, receiving more than it would have through the bankruptcy distribution, thereby creating a preference over Community Savings Bank and other unsecured creditors.