Creditors You Want to Pay in Spite of Needing to File Bankruptcy

You’re human: you’re likely going to feel more loyalty towards some of your creditors than others. That’s especially true if you owe money to friends or family, or to any creditor with whom you have a personal or long relationship. Bankruptcy laws have some say about how much you can express that loyalty through payment to these creditors even BEFORE you file bankruptcy.

A Key Principle of Bankruptcy: Treating Creditors the Same

One of the most basic principles upon which the entire bankruptcy laws are based is that creditors which are legally the same must be treated the same. There’s no playing favorites with a creditor unless there’s a legal basis for doing so. Without getting into all the ways in which there could be a “legal basis” for treating creditors differently, be aware that if there is any kind of distribution to your creditors in your bankruptcy case, most of your ordinary unsecured creditors (meaning they don’t hold any collateral) would share equally based on whatever amount you owed them. They’d get a pro-rata share of whatever amount is being distributed.

This Principle of Equal Treatment Affects What You Can Do Before Filing

The NEXT blog will be about how you can favor certain creditors after you’ve filed bankruptcy, but today’s is about doing so before filing. One of the most surprising and occasionally frustrating aspects of bankruptcy is its limited but still strong power over some events in the months before the case is even filed.

What strong power? People sometimes have a hard time believing this, but certain payments you made to creditors can be undone—“avoided.” That is, the creditor can be forced to pay to the bankruptcy trustee certain payments that you made to the creditor. Specifically, the payments that could be required to be paid “back” are those made within a certain period of time before your bankruptcy filing.

If those payments were made to a friend or relative or any other creditor you felt especially loyal to, you can see how much this could go against what had wanted. Here you are trying to pay a debt that you really want to pay, out of some special sense of obligation, and doing so when money’s probably very tight, and maybe even paying it to avoid having that debt included in your future bankruptcy case, only to risk having a bankruptcy trustee later force that favored creditor to pay to the trustee whatever you paid within a certain period of time.

How Could This Make Sense!?

It goes back to the basic principle of treating creditors the same. The point of going back in time to before the bankruptcy is filed is to try to prevent people from gaming the system. The idea is that if you owned something valuable at the time you filed bankruptcy which would be sold and distributed pro-rata to all your creditors, and instead you gave that valuable asset to just one of your creditors, your other creditors would be harmed by being cut out of their “share” in that valuable asset or money. The law says you “preferred” that creditor over the rest of your creditors. Those favored payments are called “preferences.” The theory—as impractical as it might be in real life–is that if you not made those “preference” payments, you would have had money to distribute out to all the creditors.

What Are the Preference Rules?

The basic rule is this: A preference is a payment of money or a transfer of an asset, made (or forced, like a garnishment) on a debt owed to anybody to whom you legally owe money during the period of one year before the filing of a bankruptcy. That one year period of time applies to “insiders”—basically relatives, friends, and business associates. With normal creditors, the period of time is only 90 days before filing.

Working with This Rule

You can prevent “preference” problems two ways. If you know about the rule before paying your special creditors, you avoid paying them anything during those 90-day and 1-year periods before filing. And if didn’t know about the rule and have already paid something to your special creditor, you can wait to file the bankruptcy case in order to avoid having any payments within those time periods.

There is more to the “preference” rule that goes beyond what we can cover here, but certain exception can make this odd area of bankruptcy law less troublesome than it seems. For example, usually payments to most secured creditors (where there’s collateral) are not a problem, there’s a safe harbor of payments totaling less than $600 for consumer debtors and less than $5,000 for a business debtor, and a number of other potential exceptions.

Conclusion

It’s understandable and normal to feel differently towards some creditors than you do towards others. But you have to be very careful about paying creditors you feel special loyalty to during the year before filing bankruptcy. Be completely upfront with your attorney so that he or she can help you use the law appropriately to avoid unintended surprises.