Preferential Transfers in Bankruptcy: What Creditors Need to Know

When a business files for bankruptcy, creditors expect to recover only a fraction of what they are owed. Yet the surprise for many creditors is not simply the loss of future payments, but the demand to return payments already received. These lawsuits, commonly called preference actions, are among the most frequent disputes in bankruptcy cases. For creditors who rely on timely payments to keep their own operations running, preference law can feel harsh and unfair. Nevertheless, it is a central part of the Bankruptcy Code, and understanding how it works is essential for anyone doing business with financially distressed companies.

What Is a Preferential Transfer?

A preferential transfer occurs when a debtor makes a payment to one creditor shortly before filing for bankruptcy while leaving other creditors unpaid. Under Section 547 of the Bankruptcy Code, payments made within 90 days of the bankruptcy filing may be “clawed back” by the bankruptcy trustee. For insiders such as officers, directors, or family members of the debtor, the look-back period extends to one year. The rationale is straightforward. Bankruptcy is supposed to treat creditors fairly, and a debtor should not be allowed to prefer certain creditors while leaving others with nothing.

To succeed on a preference claim, the trustee must show that the debtor transferred property to a creditor, that the payment was on account of an existing debt, that it occurred during the 90-day (or one-year insider) window, that the debtor was insolvent at the time, and that the transfer gave the creditor more than it would have received in a hypothetical Chapter 7 liquidation. Insolvency during this window is presumed, which simplifies the trustee’s case. Once these elements are proven, the burden shifts to the creditor to raise defenses.

Defenses Available to Creditors

Receiving a preference demand letter does not automatically mean liability. Congress included several defenses in the Code precisely to avoid discouraging creditors from doing business with distressed companies.

One of the most important defenses is the “ordinary course of business” rule. If payments were made in a manner consistent with how the parties typically dealt with one another, or in line with industry practice, the payments may be protected. Courts examine the timing of invoices and payments, the methods used to collect, and whether the transactions appeared to be business as usual rather than special arrangements designed to favor one creditor over another.

Another frequent defense is the “contemporaneous exchange for new value.” Payments that are essentially simultaneous with the provision of goods or services, such as cash-on-delivery transactions, are not considered preferential. Similarly, the “subsequent new value” defense allows creditors to reduce liability if they provided additional goods or services to the debtor after receiving payment. In that situation, the creditor has effectively replenished the estate, and the trustee cannot ignore that contribution.

Beyond these well-known defenses, there are also less traditional arguments that may apply in certain cases. Secured creditors, for example, may assert a “no improvement in position” defense if the transfer did not actually enhance their collateral standing. In some cases, creditors can argue that they held an inchoate lien that could have been perfected, rendering the payment unnecessary in the first place. Others may rely on the “mere conduit” defense, showing that they did not actually control or benefit from the transfer, but simply passed funds through to another party. Even small transfers may escape clawback if they fall below statutory thresholds designed to avoid burdening the courts with de minimis disputes. Another important defense arises when a debtor assumes an executory contract in bankruptcy. In those cases, payments made under the assumed contract are generally not avoidable as preferences because the contract is treated as ongoing and binding.

These defenses are technical, but they often provide leverage for creditors facing substantial repayment demands.

Why Creditors Should Respond Quickly

Creditors who receive preference demand letters often hope the matter will fade away if ignored. This is rarely the case. Trustees typically begin with a demand and then proceed to file lawsuits if creditors do not respond. Bankruptcy litigation operates under strict deadlines. Trustees must bring preference actions within two years of the bankruptcy filing, but the window to prepare a defense is much shorter. The earlier a creditor begins working with counsel, the greater the opportunity to gather records, reconstruct payment histories, and negotiate from a position of strength.

Delays can be costly. A creditor that fails to preserve evidence of shipping records, invoices, or payment terms may be unable to prove defenses that could have reduced or eliminated liability. Likewise, failing to engage promptly can mean missing the chance to settle before litigation expenses escalate. In some cases, creditors who act quickly can avoid litigation altogether by demonstrating defenses during the demand stage.

Risks for Landlords

Landlords can face preference claims if a tenant made lump-sum rent payments or caught up arrears shortly before filing bankruptcy. Trustees often view these payments as favoring the landlord over other creditors. However, landlords may defend such payments by showing that they were made in the ordinary course of the lease or that new value was provided by continued occupancy. Landlords should carefully preserve lease records and payment histories to assert these defenses.

Concerns for Equipment Lessors

Equipment lessors often receive periodic lease payments that may be challenged if they occur within the 90-day preference window. Trustees may argue that such payments allowed the lessor to recover more than others would receive. Lessors can frequently rely on the ordinary course of business defense, as consistent lease payments are a standard part of the relationship. Still, lessors should maintain complete records of invoices, payments, and lease terms to protect their claims.

Issues for Vendors

Vendors are among the most common targets of preference litigation. A trustee may attempt to claw back payments for goods delivered shortly before bankruptcy. Vendors can defend these payments by invoking the subsequent-new-value defense, showing that additional goods or services were provided after the payment. Vendors should also consider the contemporaneous exchange defense when transactions were essentially cash-on-delivery. Detailed documentation of shipments and payments is essential.

Impacts on Banks and Credit Unions

Financial institutions often face preference scrutiny when borrowers make unusual loan repayments or additional collateral pledges shortly before filing. Trustees may argue that these transfers unfairly improved the bank’s or credit union’s position. Institutions can counter with no improvement in position defense or by showing that the payment was part of an assumed executory contract. Credit unions, in particular, should be vigilant when payments relate to consumer or small-business loans, which are frequently examined for preference exposure.

Why Private Lenders Must Be Cautious

Private lenders are at particular risk in preference litigation, especially when repayments appear irregular or outside ordinary business practice. Trustees may challenge lump-sum repayments or collateral transfers as preferential. Private lenders should ensure they have written loan agreements, clear repayment terms, and evidence of equivalent value to support defenses. Engaging counsel early is critical, as private lenders may lack the institutional infrastructure that larger banks rely on.

Practical Tips for Creditors

While preference law cannot be eliminated, creditors can take steps to reduce risk. Maintaining ordinary invoicing and payment practices provides a strong basis for the ordinary course of business defense. Using advance payment or cash on delivery terms can convert vulnerable receivables into protected contemporaneous exchanges. Detailed records of transactions and communications can also prove invaluable when reconstructing the flow of payments months or years later. Most importantly, creditors should treat a preference demand letter as a serious legal matter, not as routine correspondence, and should seek legal advice immediately.

Conclusion

Preferential transfer law can seem punitive to creditors who acted in good faith, but it reflects the Bankruptcy Code’s goal of fairness. The reality is that not every demand is valid and not every payment must be returned. Creditors who understand the rules, preserve their records, and assert defenses effectively often succeed in reducing or eliminating their liability. The key is to respond quickly and strategically.Contact us today to discuss your situation and protect your recovery before deadlines and litigation costs escalate.