Bankruptcy Preferences in Colorado

December 19, 2010

By: David M. Serafin

As a creditor who is legally owed and later paid a valid debt, it can be quite daunting to be required by a bankruptcy trustee to turn over these funds back to the bankruptcy estate, even if there’s no implied or express allegation that you did anything wrong.

Under Section 547 of the Bankruptcy Code, a trustee in Colorado can ‘avoid’ a transfer of any property or money over $600.00 for an already owed debt if such transfer was made prior to 90 days or less of a debtor’s bankruptcy filing (whether in chapter 7 or chapter 13) if the creditor received more than it would have than through filing a Proof of Claim in the bankruptcy matter.

The theory behind the law against avoidable preferences is that all unsecured creditors should be treated equally and that the trustee has the right to avoid certain preferential payments made to a given unsecured creditor to the detriment of other unsecured creditor with the same priority of claim. This provision especially applies in cases where by the debtor picks and chooses certain creditors over others to pay just before filing for bankruptcy. (Note that the law against avoidable preferences does not generally apply to secured debts, such as a monthly home or vehicle payment.)

The 90 day preference period increases to one (1) year in cases where the recipient of an avoidable preference is an “insider.” An insider typically is a relative, business partner or estate planning instrument such as a revocable trust (but not typically a friend). The theory behind this Bankruptcy Code provision is that debtors are naturally inclined to transfer property to an insider (or friendly creditor) rather than a credit card company or collection agency.

In chapter 7, the recovery of an avoidable preference primarily legally affects the receipt of the property as opposed to the bankruptcy debt (who is often in the unusual position of being an innocent third party). But, the existence of a preferential payment in chapter 13 may adversely affect a debtor who (particularly if the trustee cannot or chooses not to avoid the preference) will be required to pay back the preference amount over $600 over a 36 to 60 month payment plan (in addition to any Priority tax debt and/or disposable income determined by the Means Test).

In what I believe to be an issue of first impression in Colorado, one legal question I’m currently facing on behalf of a client in a pending Bankruptcy Court case is whether wages earned but not paid until weeks later can be avoided by the trustee. One exception to the trustee’s avoiding power is for “substantially contemporaneous” exchanges (such as for wages earned) while another closely related exception is for payments on debts incurred in the ordinary course of business or financial affairs of the debtor. (The chapter 7 debtor is a corporation which paid wages to my client, who was sued by the bankruptcy trustee.) Another issue is whether my client was an employee or independent contractor such that a regularly paid employee would have a stronger defense against the trustee’s avoiding powers.