For New Yorkers involved with the bankruptcy process, whether debtors or creditors, the concepts of “preferences” and “fraudulent conveyances” often cause confusion. (Actually, it’s not just laypeople. They cause confusion for many law students and even some lawyers as well.)
They cause confusion because they both often relate to attempts by debtors to keep certain assets from being dealt with in the bankruptcy process. So here’s the nutshell version of the differences between the two:
A preference relates to a specific creditor. A debtor (often a business debtor) wants to make sure that a certain creditor gets paid in full before the debtor files their bankruptcy case. Perhaps it’s an important business relationship, or a supplier with whom the debtor is friendly. The result would be that that creditor gets 100% of their money back rather than a pro rata share.
However, the bankruptcy process is about having an orderly procedure for protecting creditors as much as it is about protecting debtors. And paying a preferred creditor back ahead of the filing means that the other creditors get paid back less as a result. So the bankruptcy law says you can’t prefer one creditor over another.
Specifically, if a debtor makes any payment to a creditor during the 90-day period prior to the bankruptcy filing, and that payment is not within the “ordinary course of business” (e.g., a payment you make regularly for supplies you need to conduct your business), then the trustee can initiate a “preference action” to undo that transaction, take the money back from that creditor and put it into the bankruptcy estate to be divided equally among creditors. Additionally, if the creditor is an “insider” (e.g., a family member), then the pre-filing period increases from 90 days to one year.
Preference actions may be familiar to many businesses who have dealt with a company that filed for bankruptcy. Trustees often cast a wide net, initiating preference actions against many creditors and suppliers in an effort to increase the assets in the bankruptcy estate and to shift the burden onto those creditors and suppliers who must demonstrate that their transaction was not a preference.
How to deal with a preference action, what constitutes “ordinary course of business” and what’s an insider are more complicated questions that should be discussed with an experienced bankruptcy attorney.
Contrary to a preference, a fraudulent conveyance (or fraudulent transfer) is all about the debtor and its intent or actions. Did the debtor make the transfer with the “actual intention to hinder, delay or defraud” any creditor of the debtor? A classic example might be where a debtor gives away valuable property to a family member or other insider as a way to keep the asset away from creditors.
However, under both bankruptcy and New York law, a trustee can void a fraudulent conveyance even if the debtor has no fraudulent intent. The trustee just needs to show either that a transfer was made for less than fair consideration at a time when the debtor was insolvent, or that the debtor was made insolvent by the transfer. An example might be when a debtor who will soon file for bankruptcy (perhaps without a bankruptcy attorney) is a little too generous in giving away valuable assets to a family member without awareness of the impact on their subsequent bankruptcy filing.
It’s also worth noting that a fraudulent conveyance action can be initiated either by a creditor or a trustee; a preference action can only be initiated by a trustee.
Rosenberg Musso & Weiner has extensive experience dealing with preference actions, fraudulent conveyances and other trustee actions, having worked for many years on both sides of the issue.