The Clawback Provision and Preferential Transfers

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In Chapter 7 bankruptcy, the trustee has the right to take back property or money that the debtor improperly gave away before filing. "Clawback" is the term used to describe this power, which allows the trustee to regain assets should have been part of the debtor's bankruptcy estate, but were removed or hidden from the trustee by the debtor by means of preferential or fraudulent transfers.

While not that common, the clawback provision is sometimes invoked in larger Chapter 7 bankruptcy cases.

What's in Your Bankruptcy Estate?

When a debtor files for bankruptcy, everything the debtor owns or is entitled to receive (such as an inheritance) at that moment becomes a part of the debtor's "bankruptcy estate." Under the Federal Bankruptcy Code and state exemption laws, a debtor is allowed to keep certain types of property. (Typical exemptions allow debtors to keep some equity in a home, a car, furnishings, clothing, and jewelry; here's more information on exemptions, with links to each state's list of exempt property.)

Any property that's in the bankruptcy estate and is not exempt can be taken by the trustee and sold, so the proceeds can be distributed among the debtor's creditors.

What Is a Preferential Transfer?

A preferential transfer occurs when a debtor, prior to filing for Chapter 7 bankruptcy, pays off a particular creditor or group of creditors and by doing so, causes other creditors to get less in the bankruptcy. For example, a debtor may wish to repay a debt to a friend or family member, to make sure that person gets paid in full (and shield the money used to repay the debt, which would instead be divided among all of the debtor's creditors). Or, a debtor may wish to repay a debt to a local doctor or other professional with whom the debtor has an ongoing relationship, to make sure the debtor can keep using that person's services.

Only transfers made within a certain amount of time before you file for bankruptcy count as preferences. The rules depend on your relationship to the creditor:

  • During the year before you file for bankruptcy, any payment of more than $600 to an "insider" creditor -- typically, a friend, family member, or business associate -- counts as a preference, subject to the clawback.
  • During the 90-day days before you file, any aggregate payment of more than $600 to a regular creditor (someone other than an insider). 

The problem with preferential transfers (also called preferences) is that it benefits one creditor at the expense of the rest. Rather than having their debts tossed into the bankruptcy hopper and receiving pennies on the dollar from the bankruptcy trustee (if that), creditors who receive preference payments are paid in full (which leaves that much less money to be distributed to other creditors).

Watch Out for the Clawback

When a trustee becomes aware of a pre-bankruptcy transaction that counts as a preferential transfer, the trustee can petition the court to have those assets retrieved (the clawback) and included in the bankruptcy estate. Then, those extra funds can be used to benefit all of the creditors, not just one or two whom the debtor selected.

Get Legal Advice Early

If your finances are spiraling out of control, the last thing you may feel you have money for is an attorney. However, it can be really helpful to get some advice from a good bankruptcy attorney before filing, especially if you're considering repaying a debt. An attorney can help you figure out whether the repayment would qualify as a preference -- and help you decide whether bankruptcy is the best option for handling your debts.

by: , J.D.

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