What Rights do Creditors Have to Keep Monies Received from a Debtor Right Before He Files Bankruptcy?

Commonly, a debtor will pay a creditor monies owed and then shortly thereafter, will end up filing bankruptcy. The creditor can then usually expect a telephone call from the debtor’s attorney or the bankruptcy trustee asking that the monies be returned since the debtor filed bankruptcy. Right about this time, panic sets in because the money has already been spent, or you have already scored major brownie points with your boss for collecting this money. Thus, the question becomes, whether the creditor is obligated to give the funds back, or whether the money can be kept?

The Bankruptcy Code states that nearly every transfer by an insolvent debtor made 90 days prior to filing bankruptcy is avoidable, and must be returned to the estate. These transfers are called “preferences”, and the 90 day period after the filing of bankruptcy is called the “preference period”. The key here, is that not all transfers are avoidable. In fact, there are quite a few exceptions to this rule that will allow the creditor to keep the money. These exceptions are what this article is all about.

The reason why the legislators invented this preference period, is because it was believed that this would discourage creditors from racing to the courthouse to dismember financially distressed debtors, and it would deter debtors from favoring certain creditors over others. The legislators believed that any mention of a possible bankruptcy by the debtor would send the creditors into a tail spin, scrambling to collect their debts as quickly as legally possible.

However, as I previously stated, not all transfers within the preference period are avoidable. Thankfully, the Bankruptcy Code has carved exceptions for certain transfers that will allow the creditor to keep the money.

The first exception, and the one most commonly used, is the “ordinary course of business exception”. In order to qualify for this exception, the creditor must establish that the debt and the payment are ordinary in relation to past practices between the debtor and the creditor. The key things to look for with this exception, are whether the form and or amount of payment differs from past practices, and whether the creditor engaged in unusual collection efforts to get the payment from the debtor.

For example, if the creditor usually invoices the debtor on a 30 day billing cycle, and the debtor pays on the 30th day with a company check, then a transaction where the debtor pays an invoice after 3 days with a cashier’s check will not be an “ordinary transfer made in the course of doing business.”

However, it the debtor pays on the 30th day, as usual, with a company check, then the creditor will be able to prove that the payment was just an ordinary payment made by debtor, as has been done in the past and that the creditor will not be obligated to return the monies.

A second exception carved out by the Bankruptcy Code, is when the transfer is intended by the parties to be a substantially contemporaneous exchange for new value given by the debtor. For example, if the creditor sells new goods to the debtor and the debtor pays for those new goods upon their delivery, this would be a “contemporaneous” exchange for new value, i.e. new goods for money.

The third exception which shields a creditor from a preference attack, occurs where a transfer is made that creates a security interest similar to a purchase money security interest. The security interest must secure new value that was given to enable the debtor to acquire particular property, and in fact used to acquire such property. An example of this would be when a debtor executes a promissory note for monies to buy a new car, and it is that new car that is used as the collateral to secure the note. This situation is called a purchase money security interest.

The fourth exception carved out by the Bankruptcy Code, is for State Agencies. The Bankruptcy Code declares State Agencies immune from preference.

The fifth exception deals with fraudulent transfers. It allows avoidance of transfers made without “reasonably equivalent value” within one year prior to the bankruptcy filing. This exception extends even further, in that the trustee may also avoid a transfer of the debtor’s property, or an obligation incurred by the debtor, if the debtor received less than a “reasonably equivalent value” in exchange and the debtor:

  • was or became insolvent as a result of the transfer; or
  • was engaged in business, and was left with unreasonably small capital after the transfer; or
  • intended to incur debts after the transfer, or believed he or she would incur debts after the transfer, that would be beyond his or her ability to pay as they matured.

Remember, don’t give the money back until you have explored all of these exceptions!!!