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Preferences - Safe Harbors

Preference - Safe Harbors

Preferential transfers to creditors can be avoided by the bankruptcy trustee, forcing creditors to pay back their preference payments to the bankruptcy estate. However, there are many exceptions to preferences that allow the debtor to engage in ordinary financial transactions so that the debtor can pay what the government considers priority payments.

  •  Contemporaneous Exchanges

A contemporaneous exchange is one in which the debtor receives immediate value for the payment. In a contemporaneous exchange, the debt incurred is not considered to be antecedent even if there is a slight delay between payment and the receipt of the value paid for. For instance, if a debtor goes into a store and purchases an item, then the payment would be considered a contemporaneous exchange. If the debtor paid by check, then this would still be considered a contemporaneous exchange even though the check probably will not be honored for at least a day, since the check is being used as a means of payment and not as an extension of credit. The second criteria required for a transaction to be considered a contemporaneous exchange is that it was intended to be a contemporaneous exchange, and that it was, in fact, such an exchange.

  •  Ordinary Course Payments

Many debtors are either business entities or are debtors operating a business to earn income. Since a business must continue making payments to remain viable, §547(c)(2) provides an exception for ordinary business transactions, or ordinary course payments, which are payments made in the ordinary course of business. Specifically, the Code requires that the debt incurred must have been for an ordinary transaction between the debtor and the transferee, or the payment of the debt was in the ordinary course of business or according to terms common to the business. The Supreme Court has ruled that ordinary course payments can be for either short-term or long-term debt, and has extended ordinary course payments to include transactions that were modified because of the debtor's lower creditworthiness.

  •  Purchase Money Security Interests (PMSI)

A purchase money security interests (PMSI), is the property interest held by a creditor that lent the debtor money to buy specific property, and where, by contract, the property serves as collateral for the debt. Since the debtor obtains new value by purchasing the property, §547(c)(3) excepts PMSIs from avoidable transfers as long as the debtor uses the new value to obtain the collateral specified in the security agreement.

However, to be protected from avoidance, the federal law—which trumps any conflicting state law—requires that the security interest must be perfected within 30 days after the debtor receives the collateral. If the creditor fails to perfect its security interest within the 30 days, then the transaction may become avoidable if the date of perfection falls into the 90-day period before bankruptcy, since the transfer is deemed to have occurred when the security interest is perfected.

  •  Net Result Rule

The net result rule, §547(c)(4), applies to a creditor that lent money to the debtor, then, after receiving payment for that loan within the time period for avoidable transfers before the debtor files for bankruptcy, extends another loan to the debtor. In most cases of this kind, the creditor extended the second loan because the debtor repaid the first, but if the debtor had not repaid the first loan, he probably would not have gotten the second loan. Without the net result rule, both the entire repayment made by the debtor for the first loan and the payments made for the second loan would be avoidable; with the net result rule, only payments for the second loan are avoidable.

For instance, suppose a creditor extends a loan to the debtor for $4,000, which the debtor repays within the 90 days before he eventually files for bankruptcy. Since the debtor repaid the loan, the creditor makes, at the request of the debtor, a second loan for $3,000. Without the net result rule, the repayment of $4,000 could be avoided as a preferential transfer, so the creditor would have to file a claim for the $4,000 avoided (paid back to the trustee) and the $3,000 claim for the second loan, for a total of $7,000. With the net result rule, the $4,000 repayment cannot be avoided, so the creditor only has to file a claim of $3,000 for the second loan.

Because of the net result rule, creditors are more likely to deal with a debtor in financial difficulty, which may help to prevent bankruptcy, especially if the debtor is a business. Furthermore, the debtor is in a better position because of the subsequent loan because the creditor gave the debtor new value without the debtor having to return any value before the bankruptcy.

  •  Floating Liens on Inventory and Receivables

Many businesses borrow money to finance their inventory and repay the loan with its receivables, which is the income received after the inventory is sold. To receive the loan, the business must sign a contract with the lender that gives the lender a floating lien on the inventory that automatically attaches to any new inventory received. The loan is reduced continually by the amount going into the account receivables or is increased by a new extension of credit based on the same floating lien.

The avoidance of payments on floating lien transactions is limited by §547(c)(5) to the amount by which the creditor's position, quantified by the difference between the amount of the debt and the value of the collateral, was improved between the beginning of the avoidance period to the date of bankruptcy* For instance, suppose a creditor lends $10,000 to the debtor at the beginning of the avoidance period that is 50% secured by the collateral. After realizing that the debtor was having financial difficulty, the creditor requires that the debtor make enough payments so that the debt is 100% secured by the collateral. Then the debtor files for bankruptcy. Since at the beginning of the applicable period, the shortfall between the value of the collateral and the debt was $5,000 and at bankruptcy it was zero, the amount that can avoided is the $5,000 by which the creditor improved its position by requiring the debtor to make higher payments.

A major problem in determining the amount avoidable is determining the worth of the collateral. Depending on the type of business, the collateral could be determined by its contract value, collection value, face value, book value, or market value or on retail, wholesale, going-concern, or liquidation value. However, if the collateral increases in value during the comparison period, then the amount by which any shortfall was reduced by the increase in value is generally not avoidable, since the shortfall was not reduced by any payment from the debtor, and, thus, the shortfall reduction has not been to the prejudice of unsecured creditors of the debtor.

  •  Statutory Liens

Statutory liens are created automatically by the action of the relevant parties rather than from the specific action of creating a lien. The most common type of statutory liens is tax liens, and mechanics' or materialmen's liens. Statutory liens are governed by §545, and are not avoidable under §547.

  •  Domestic Support Obligations

Any payments on debts incurred for domestic support obligations are not avoidable.

  •  Small Transfers

When the payments are small, it is not cost-or time-effective to litigate such transfers, so Congress added aggregate small payments to the list of unavoidable transfers. Another reason §547(c)(8) and (9) were added was to prevent the trustee from obtaining small payments through the threat of litigation, where most creditors would be motivated to give back the payments since it would cost more to litigate than to pay.

Transfers from individual debtors that are primarily for consumer debts with an aggregate total of less than $600 are unavoidable. Implemented primarily for businesses, subsection (9) increases the unavoidable amount to $5,475 (updated April 1, 2007) for non-consumer debts, which, unlike the safe harbor for consumer debts, is adjusted every 3 years to the Consumer Price Index. Another code addition to prevent nuisance suits for relatively small payments is 28 U.S.C. §1409(b), which specifies the venue for preference litigation. Any preference litigation for a consumer debt of less than $16,425 or a business debt of less than $10,950 must be in the defendant's home district rather than in the trustee's district. This greatly reduces the cost of defending a preference suit by allowing the creditor to respond in its home court.

  •  Alternative Repayment Schedule Payments

A main goal in enacting the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) is to motivate the debtor to repay his bills. Hence, the BAPCPA requires that the debtor obtain credit counseling from an approved agency before the debtor can file for bankruptcy, and the debtor must submit any repayment plan with the bankruptcy petition. Consonant with these goals is §547(h), which exempts any such repayments from a preference avoidance. However, only such payments that were created by a nonprofit credit counseling agency that was approved by the U.S. Trustee will qualify under this subsection. Any payments negotiated by the debtor or by a non-approved agency are not protected by this safe harbor.


A creditor of a bankruptcy debtor that obtained a payment from the debtor during the preference period has numerous defenses to a Trustee’s claim. If you would like more information relating to defending against preference claims or any other banking or finance need, please do not hesitate to contact me at or by phone at 312-428-2740.

Very truly yours,

Adam B. Rome

*To calculate the amount that can be avoided one must analyze the following: (1) determine the start date for the first comparison, which is either the beginning of the avoidance period (1 year for insiders, 90 days for other creditors) or when new value was first given, whichever is later; (2) calculate the shortfalls where the value of the collateral is less than the debt on both dates; (3) subtracting the shortfall on the start date from the shortfall on the bankruptcy date equals the avoidable amount.

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