Section 547: What Is a Preferential Transfer?

In U.S. bankruptcy law, the principle of equitable distribution among creditors is fundamental. To uphold this, Section 547 of the Bankruptcy Code establishes the concept of a preferential transfer. This provision prevents a debtor, before a bankruptcy filing, from favoring certain creditors over others. By allowing a bankruptcy trustee to “avoid” or undo these payments, the law gathers the preferential payments and redistributes them proportionally among all creditors.

Elements of a Preferential Transfer

For a payment to be classified as a preferential transfer, it must satisfy several distinct conditions. First, there must have been a transfer of the debtor’s property, which is broadly defined to include direct payments of money, the granting of a security interest, or the return of goods. The transfer must also be made to or for the benefit of a creditor, meaning it settles or secures a claim held against the debtor.

The payment must be for an “antecedent debt,” which is a debt that existed before the debtor made the transfer. This element distinguishes these payments from transactions where payment is made when goods or services are provided. For example, paying an outstanding invoice from 60 days prior would be for an antecedent debt. A cash-on-delivery (COD) purchase would not.

Another element is the debtor’s insolvency at the time of the transfer. The Bankruptcy Code simplifies this by creating a legal presumption that the debtor was insolvent during the 90 days immediately before the bankruptcy petition was filed. While a creditor can present evidence to rebut this presumption, the initial burden falls on them.

The timing of the transfer is governed by a specific “look-back” period. For most creditors, this period is 90 days before the bankruptcy filing. However, this window extends to one year if the payment was made to an “insider,” who are individuals or entities with a close relationship to the debtor, such as relatives, general partners, or corporate directors.

Finally, the transfer must have enabled the creditor to receive more than they would have in a Chapter 7 liquidation proceeding had the transfer not occurred. In a Chapter 7 case, a debtor’s assets are sold, and the proceeds are distributed to creditors based on a priority system. An unsecured creditor would typically receive only a fraction of their claim. A pre-bankruptcy payment in full is a clear advantage.

Excluded Payments and Transactions

The Bankruptcy Code outlines several types of payments that are not considered preferential, even if they meet the standard elements. These exceptions protect routine and fair transactions that do not diminish the bankruptcy estate or unfairly favor one creditor.

An exception exists for a “contemporaneous exchange for new value.” This applies when a creditor and debtor intend for a transfer to be an immediate exchange for new goods or services, and the exchange is substantially contemporaneous. A classic example is a COD transaction, where the debtor’s estate receives equivalent value in goods for the cash paid, so its net worth is not depleted.

Payments made in the “ordinary course of business” are also excluded. This protects routine payments on debts incurred in the normal financial affairs of both the debtor and the creditor. To qualify, the payment must align with the past payment history between the parties or conform to standard business terms within their industry. For example, paying a monthly utility bill within the typical 30-to-45-day window would likely be protected.

A “purchase money security interest” (PMSI) is another exception. This situation arises when a creditor lends money to the debtor to purchase a particular asset, and the creditor takes a security interest in that same asset. The law protects this arrangement from being clawed back, provided the security interest is legally recorded within 30 days of the debtor receiving the property. This encourages financing for new assets.

An exception for “subsequent new value” allows a creditor to reduce its preference liability if it provided additional goods or services to the debtor after receiving the preferential payment. For example, if a supplier receives a $10,000 payment and later ships another $5,000 worth of goods on credit, the creditor can offset its preference exposure by that $5,000. This is because the new value replenished the bankruptcy estate.

The Avoidance and Recovery Process

Once a bankruptcy case is filed, a court-appointed bankruptcy trustee begins the process of identifying and recovering preferential transfers. The trustee’s duty is to maximize the assets available for distribution. This involves a careful review of the debtor’s financial records, including bank statements and payment histories, during the look-back period to spot payments that may qualify as preferences.

The first formal step is the issuance of a demand letter. The trustee sends this letter to the creditor who received the potential preference, explaining the legal basis for the claim and demanding the return of the funds. This communication opens the door for negotiation and allows the creditor to present any defenses.

If the creditor refuses to return the payment or a settlement cannot be reached, the trustee will commence a lawsuit known as an “adversary proceeding.” The trustee files a complaint with the bankruptcy court, alleging that the creditor received an avoidable preferential transfer. The adversary proceeding functions like a civil lawsuit and involves discovery, motions, and potentially a trial before the bankruptcy judge.

The goal of this process is to bring the recovered funds back into the bankruptcy estate. Any money clawed back from a creditor, whether through a settlement or a court judgment, is pooled with the debtor’s other assets. These funds are then distributed pro-rata among all unsecured creditors according to the priority scheme in the Bankruptcy Code, fulfilling the statute’s purpose of ensuring equitable treatment.