The Clawback Provision and Preferential Transfers

By , Attorney · University of the Pacific McGeorge School of Law

A "clawback" happens when the bankruptcy court takes back a large sum of money paid to a creditor before bankruptcy. These large payments, called "preferential transfers" or "preference payments," occur when a bankruptcy filer unfairly pays money or transfers property to a favorite creditor shortly before bankruptcy, leaving less for other creditors.

In many instances, the intent is innocent enough. The filer wants to pay off a creditor they'd like to work with in the future or a family member or business associate the filer doesn't want to leave high and dry. But bankruptcy law must be followed. And although bankruptcy trustees don't use the clawback provision frequently, they check for preference payments in large and small cases alike.

To avoid this potential bankruptcy problem, you'll want to understand:

  • what constitutes a preferential transfer
  • the types of transfers you'll report in bankruptcy, and
  • what you can do to avoid a clawback action.

If you're concerned about subjecting your creditors to a clawback action, consider consulting a bankruptcy lawyer about your options.

What Is a Preferential Transfer in Bankruptcy?

A preferential transfer is a substantial payment made to a creditor before bankruptcy. Typically, the payment far exceeds the amount the creditor would receive in the bankruptcy case itself.

A preferential transfer often involves money, but the payment could involve property or anything else of value. You'll find more details about what constitutes a preference payment below.

Examples of Preferential Transfers

Suppose the bankruptcy filer knows that a favorite creditor will receive only a fraction of what's owed in the filer's bankruptcy case. Or the filer doesn't want a local doctor or another professional to know about the bankruptcy so the filer can keep using that person's services.

If the filer takes steps to ensure that the favored creditor is paid fully before filing for bankruptcy, a preferential payment will likely have occurred and could be subject to a clawback action.

What Is a Clawback in Bankruptcy?

Sometimes the trustee appointed to administer the bankruptcy case becomes aware of a prebankruptcy transaction that meets preferential transfer criteria. When that occurs, the trustee can ask the court for permission to use the clawback provision to retrieve the assets.

If the trustee is successful, the trustee will use the recovered funds to benefit all creditors, not just the one or two the filer selected to pay.

When Will the Trustee Use the Clawback to Recover a Preferential Payment?

First, the trustee needs to find the preferential payment. And in many cases, you'll be the one to tell the trustee about it.

When you fill out your bankruptcy paperwork, you'll report many types of transfers on the Statement of Financial Affairs for Individuals Filing for Bankruptcy ("SOFA") form. Any reported or unreported transfers the filer made to defraud a creditor can be undone. For instance, plan on listing sales and gifts of cash, cars, businesses, and more.

However, the term "preferential transfer" refers to payments made to creditors—people you owe money to—within a particular time before a bankruptcy filing. You'll report two types of potential preference payments:

  • All creditors. Any payments made to a creditor totaling more than $600 during the 90 days before you file.
  • "Insider" creditors. The reporting period extends to a year if the creditor is an insider, such as a friend, family member, or business associate.

Because a preferential transfer or preference payment benefits one creditor at the expense of the rest, the payments are subject to a clawback. If a clawback action is successful, the creditor must return the payment for distribution between all creditors who file proof of claim forms.

How to Avoid a Clawback in Bankruptcy

If you've made your regular monthly payments and haven't paid anything extra toward your debts, it's unlikely that you'll have a preference problem—especially if none of your creditors are insiders.

If that's not the case and you need to file for bankruptcy quickly, you might not be able to avoid a clawback. Your bankruptcy attorney will evaluate whether you have some situation the lawyer can explain to the trustee.

However, if you don't have a defense or valid reason, remember that you won't repay the preference payment or fight the matter. The creditor will. So even if you paid extra on a credit card, you likely wouldn't care if the trustee demanded that the credit card company return the money, and you'd still get the credit card debt wiped out.

However, sometimes filers don't want the creditor to be subjected to bankruptcy proceedings, especially when a family member is involved. If you fall into this category, you might want to work with the trustee to repay the funds.

It's an approach your bankruptcy attorney can explore with you when determining whether filing for bankruptcy would be in your best interests.

Speak With a Bankruptcy Lawyer

Even people tight on funds usually find it helpful to get advice from a bankruptcy attorney before filing, especially when concerned about potential preference payments.

Also, while our simplified explanation might be enough for many cases, the actual law is complicated. (You'll find it at 11 U.S. Code § 547 if you'd like to review it yourself.) A bankruptcy lawyer will be in the best position to help you determine whether bankruptcy is the best option for handling your debts.

Navigating Your Bankruptcy Case

Bankruptcy is essentially a qualification process. The laws provide instructions for completing a 50- to 60-page bankruptcy petition, and because the rules apply to every case, you can't skip a step. We want to help.

Below is the bankruptcy form for this topic and other resources we think you'll enjoy. For more easy-to-understand articles, go to TheBankruptcySite.

More Bankruptcy Information

Bankruptcy Forms and Document Checklist

Chapter 7 and 13 Bankruptcy Form List

Bankruptcy Document Checklist

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We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.

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