Unfair preference

In many legal systems, where a person or company transfers assets or pays a debt to a creditor shortly before going into bankruptcy, that payment or transfer can be set aside on the application of the liquidator or trustee in bankruptcy as an unfair preference or simply a preference. [See for example, section 239 of the Insolvency Act 1986 of the United Kingdom, which uses the term 'Preference' rather than 'Unfair Preference'; section 565 of the Corporations Act 2001 of Australia [http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/] ; and Sec. 547 of the U.S. Bankruptcy Code.]

The law on unfair preferences varies from country to country, but characteristically, to set a transaction or payment aside as an unfair preference, the liquidator will need to show that:
#the person or company was insolvent at the time the payment was made (either on the "cash-flow" test, or on the "balance sheet" test - it varies from country to country)
#the person or company then went into bankruptcy within a specified time thereafter, usually referred to as the "vulnerability period" [Most jurisdictions apply a variable vulnerability period, for example, in some countries the vulnerability period is 6 months normally, or 2 years of the creditor is a "connected person" such as a family relative, or a company in the same group.]
#the payment had the effect of putting the creditor in a better position than other unsecured creditors
#in some jurisdictions, it is also necessary to show that the bankrupt "intended" to grant a preference. [This is the position in the United Kingdom (although section 239(6) says that a preferential payment in favour of a connected person gives rise to a presumption of an intention to prefer), but in Australia and in the U.S., it is not necessary to show an intention to prefer]

In most countries an application to have a transaction set aside as a preference can only be made by the liquidator or trustee in bankruptcy (as the person making the payment must be in bankruptcy, and thus they are not normally liable to suits from other creditors).

The effect of a successful application to have a transaction declared as an unfair preference varies. Inevitably the creditor which received the payment or assets has to return it to the liquidator. In some countries the assets are treated in the normal way, and may be taken by any secured creditors who have a security interest which catches the assets (characteristically, a floating charge). [See "Re Oasis Merchandising Services Ltd" (1997) BCC 282, now superseded by legislation.] However, some countries have "ring-fenced" recoveries of unfair preferences so that they are made available to the pool of assets for unsecured creditors.

An unfair preference has some of the same characteristics as a fraudulent conveyance, [In the United Kingdom, see section 423 of the Insolvency Act 1986] but legally they are separate concepts. [ Most notably, the fraudulent transfer always reduces the net worth of the transferor while the preference does not. Also, procedurally, it is not necessarily for the paying party to go into bankruptcy to have a transaction which is a fraudulent conveyance set aside in most legal systems, and most legal systems do not require intention to defraud in order to establish an unfair preference.] There is not normally any requirement to prove an intention to defraud to recover assets under an unfair preference application. However, similar to fraudulent conveyance applications, unfair preferences are often seen in connection with asset protection schemes that are entered into too late by the putative bankrupt.

Many jurisdictions provide for an exception in the case of transactions entered into in the ordinary course of business with a view to keeping the company trading, and such transactions are usually either validated or presumed to be validated.

In individual jurisdictions

United States

A preference in U.S. federal bankruptcy law [ UnitedStatesCode|11|101 "et seq.", known as the Bankruptcy Code] is a transfer of property by a debtor to its creditor, on account of a pre-existing debt, that is made while the debtor is insolvent [Under the Bankruptcy Code, insolvency exists when the sum of the debtor's debts exceeds the fair value of the debtor's property, with some exceptions. It is a balance sheet test. Chapter 11 United States Code Sec. 101(32)] and gives the creditor more than it would obtain in a liquidation of the debtor's assets in a bankruptcy proceeding. It is primarily a creature of the U.S. Bankruptcy Code, [UnitedStatesCode|11|547] although some states have similar state laws. If the preferential transaction takes place within a specified period of time before the filing of bankruptcy by or on behalf of the debtor, then the debtor's trustee in bankruptcy is authorized to recover the property preferentially transferred. The mechanism of recovery is the avoidance of the transfer. [Chapter 11 United States Code Secs. 547(b) and 551] After such avoidance, the recovered property becomes property of the bankruptcy estate. ["Ibid", Sec. 551] The period is usually 90 days. However, if the preferential transfer is made to an "insider," then the period is one year. An "insider" is generally a relative or one who has the ability to control the activities of the debtor. [Chapter 11 United States Code Sec. 101(31)] The Bankruptcy Code provides some exemptions from these rules to accommodate transfers intended to be contemporaneous, made in the ordinary course of business or to the extent they are made for new value, and others. [Chapter 11 United States Code Sec. 547(c)]

All of the following examples assume that the requirements for a preference that are set out above exist at the time the transfer is made.

*Securing a previously unsecured debt.

*Substituting property of greater value as security for existing security property whose value is insufficient to completely secure repayment of the debt.

*Paying some but not all unsecured creditors.

*In a real estate transaction, delaying the recording of a mortgage for more than 30 days after the debt it secures is created. [Bankruptcy Code Section 547(e) provides that in real estate transactions, transfers take place at the time when they are made if they are perfected within 30 days thereafter. Otherwise, the transfer is deemed by the law to be made when it is actually perfected. With respect to mortgages, perfection usually requires the recording of the mortgage.]

witzerland

Under Swiss law, creditors who hold a certificate of unpaid debts against the debtor, or creditors in a bankruptcy, may file suit against third parties who have benefited from unfair preferences or fraudulent transfers by the debtor prior to a seizure of assets or a bankruptcy.

ee also

* Undervalue transaction
* Voidable floating charge

Footnotes