Preferential Payments: What Happens in Bankruptcy?

A preferential payment is a transfer of money or property to a creditor on account of an old debt, made within 90 days before a bankruptcy filing, that lets the creditor receive more than it would have gotten in a Chapter 7 liquidation. The debt must actually be owed, and the payment must be for a debt that predates the transfer rather than a contemporaneous exchange for new value. For example, paying last month's supplier invoice counts, but a cash-on-delivery purchase does not. The bankruptcy trustee focuses on whether the payment improved the creditor's position unfairly compared to what it would receive alongside all other unsecured creditors in a liquidation, not compared to the company's overall assets. Credit card payoffs present a special case: if the business owner signed a personal guarantee within 90 days and the company then pays down the card, the trustee may still claw back that payment from the credit card issuer as a preferential transfer, since the guarantee may itself be an antecedent debt that triggered the company's obligation. Payments to fully secured creditors up to the value of their collateral are generally safe, but any amount that exceeds the collateral's value can still be a preference.

A bankruptcy trustee claws back payments to fix an unfair imbalance. When a struggling business pays some creditors fully right before filing, it shortchanges everyone else who will only get pennies on the dollar later. The trustee's job is to recover those funds so they can be shared evenly among all creditors, as bankruptcy law intends.

Think of it this way: the law treats the 90 days before a filing as a window where a debtor can't pick favorites. A creditor who got paid in full during that period often got a better deal than they would have in a fair bankruptcy distribution. The trustee sues to pull that money back, not as a punishment, but to restore the pool of assets to split, typically on a pro-rata basis, among everyone who is owed.

The 90-day rule is the lookback period a bankruptcy trustee uses to identify most preferential payments, meaning any transfer to a creditor within 90 days before the bankruptcy filing can potentially be clawed back. This window exists so trustees can recover money paid out shortly before a collapse, treating creditors fairly rather than letting one get paid in full while others get nothing.

Here is what typically falls inside that 90-day window:

• Payments on old debts, not new purchases made during the period
• Transfers that let a creditor receive more than they would in a Chapter 7 liquidation
• Payments made while the debtor was insolvent, which the law presumes during those 90 days

The clock counts backward from the filing date. If a company files on June 1, the trustee can examine payments made from roughly March 3 onward. This rule explains why vendors suddenly receive demand letters years after they thought a transaction was finished, and it is the same timeframe that stretches to a full year for insiders, which changes the risk level dramatically.

Insider payments face a much longer lookback - a full year instead of the standard 90 days. A bankruptcy trustee can claw back payments made to "insiders" (relatives, business partners, or company officers) if the transfer happened anytime in the 12 months before the bankruptcy filing.

In a standard case against a regular creditor, the trustee must prove the payment was preferential. But in the one-year insider window, the burden flips once the 90-day mark passes. The trustee doesn't need to prove the debtor was insolvent during those earlier months; the law presumes it. You'd have to prove the opposite, which makes defending older insider payments notably harder and gives the trustee a powerful tool to recover assets insiders often saw coming before anyone else.

The people and businesses most likely to face a preferential payment claim are those who got paid right before a bankruptcy filing. A bankruptcy trustee targets payments that gave one creditor a better deal than others would get in the bankruptcy case.

The trustee usually focuses on these groups:

• Insiders of the debtor: Family members, business partners, and company directors get extra scrutiny. Because of their relationship, the lookback window stretches from 90 days to a full year, making their payments far easier to claw back.
• Ordinary trade creditors and suppliers: If you were paid for a legitimate debt within the 90 days before filing, you are a standard target. The trustee will look closely unless the payment fits the ordinary course of business defense.
• Lenders and finance companies: Any lender that received a payment on a loan, or had its secured position improved by a payment within the lookback period, is a frequent target for recovery.
• Landlords and service providers: Getting paid for back rent or catching up a past-due bill on the eve of bankruptcy makes these creditors prime candidates for a demand letter.
• Family members repaid on a personal loan: The trustee often views money paid to close relatives with high suspicion, assuming the debtor prioritized family over business debts to keep money in the family circle.

The ordinary course of business defense is the most common reason a preferential payment claim fails. If you kept paying a vendor the same way you always did, right before bankruptcy, the bankruptcy trustee often cannot claw that money back. The law recognizes that normal business shouldn't be punished just because a financial crisis was looming.

To use this defense, the payment must match your historical routine. Courts look at whether the timing was consistent (you paid within 30 days before and during the crisis period) and whether the method was typical (same check, same wire, same ACH). The key is proving the deal didn't change because bankruptcy was near. A sudden switch to cash-on-delivery or paying a stale invoice after months of silence typically won't qualify as ordinary.

If a bankruptcy trustee demands return of a payment you received, you often have strong legal defenses. The most powerful one is proving the payment was in the 'ordinary course of business' between you and the debtor. This means you don't automatically have to give the money back.

Key defenses that may protect you include:

• Ordinary course defense: You show the payment was made in the usual way and timeframe based on your history with this customer, or based on standard industry practices. If the debtor always paid 20 days late and that pattern stayed consistent, the transfer often survives scrutiny.
• New value defense: You kept extending credit or delivering goods after receiving the payment. If the debtor paid you $5,000 but you then shipped them $4,000 in new materials they never paid for, your liability may drop to just the $1,000 net benefit.
• Contemporaneous exchange: The payment wasn't really for an old debt. It was a substantially simultaneous swap of money for new goods or services, which means no net loss to the bankruptcy estate occurred.
• Running account or earmarking defense: You can show the funds came from a new lender specifically to pay you, rather than from the debtor's general cash pool. This doesn't reduce the debtor's overall estate value in the same way.

Trustees often settle when a solid ordinary course or new value defense is well documented. Gather your payment history, invoices, and correspondence immediately because your instinct to prove a normal business relationship is often the correct one.

Ignoring a demand letter is the fastest way to turn a bad situation into a court judgment. The bankruptcy trustee is asking you to return money they believe was a preferential payment, and your response sets the tone for everything that follows.

Don't ignore it, and don't call casually. The letter's deadline is real. Mark your calendar, but understand that anything you say in a phone call can be used to undermine your defenses later.

Pull your records immediately. You need the exact dates and amounts of every payment you received in the 90 days before the bankruptcy filing (or one year if you're an insider). Compare the payment pattern to earlier months. If the amounts and timing were consistent with your normal billing cycle, you likely have a strong ordinary course defense.

Have a lawyer send the written response. A bankruptcy attorney who understands preferential payments can draft a letter that raises your specific defenses without admitting damaging facts. The goal is to show the trustee that proving their case against you will be expensive and uncertain.

Evaluate an early settlement. Litigation is pricey for both sides. If your defenses are weak, a quick offer to return a percentage of the payment often ends the matter for less than the full claim. Most trustees will negotiate a reduced lump sum.

This is not a do-it-yourself dispute. A single wrong statement can waive a defense that would have gotten the case dropped.

Preferential payment claims often involve transactions that looked completely normal at the time but become vulnerable in hindsight. A bankruptcy trustee can demand repayment from a creditor who received money or property during the 90 days before the bankruptcy filing, or within one year for payments to insiders like family members, officers, or directors of the debtor.

Common real-world claims include a business paying off an old invoice to a key supplier while ignoring newer bills from others, allowing that supplier to recover more than they would have in the bankruptcy. Another frequent scenario is a company repaying a loan from a founder or executive shortly before filing, while trade creditors remain unpaid. Payments on personal debts to relatives, such as repaying money borrowed from a parent within the year before bankruptcy, regularly trigger insider claims. Even one-time lump sum payments on credit card debt, made during financial distress, can be clawed back if the creditor received a larger percentage of their claim than similar creditors.

Even a handful of small payments can be clawed back if a bankruptcy trustee decides the total recovery justifies the legal cost. There is no minimum dollar threshold that automatically protects a transfer from being challenged as a preferential payment.

Trustees often bundle multiple small payments into a single claim to make the pursuit financially worthwhile. A series of $500 checks to the same creditor over the 90-day lookback period can add up quickly, creating a recovery target that is suddenly worth the trustee's time and legal fees.

The practical risk depends less on any individual transfer amount and more on the trustee's cost-benefit analysis. If you made regular small payments to a family member or business partner during the year before their bankruptcy, you should still treat a demand letter seriously. The defenses that apply to larger payments, such as the ordinary course defense, work the same way here and may resolve the issue without litigation.