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Making Sense of Bankruptcy: Avoid Dangerous “Preference” Payments

Be careful about trying to be nice and paying back relatives and friends in order to keep them out of your bankruptcy case.

Here’s the sentence that we’re exploring today:

You may be tempted to pay certain special creditors before filing bankruptcy—such as relatives or friends, but if you do so within a year before filing under certain circumstances they may need to pay back what you paid, not to you but to your other creditors, confounding your and their intentions, even if those intentions were good; so avoid paying relatives, friends, or anybody else special before filing, and if you already have done so consider delaying your bankruptcy filing.

Paying Your Favorite Creditor Before Filing Bankruptcy

If you owe a friend or relative money, you may have a desire to pay all or part of that debt before filing bankruptcy.

The person may really need the money, and may be urgently asking for it. You may also be embarrassed to have the person find out about you filing bankruptcy and so you want to not have him or her be a creditor at the time you file. You may have some money or some other asset available to pay or give to the person and you’d rather give it to him or her than to your conventional creditors. You may even think that it’s not legal to pay the person back after you file bankruptcy so you want to take care of it beforehand.

But if you do pay this person for some of these reasons you’d be doing so out of some major misconceptions. And you’d likely be causing a problem instead of solving one.

The One-Year Preference Rule

Paying a debt to anyone who you want to favor during the year before filing bankruptcy could result in that person being legally required to pay back whatever you paid him or her. The basic rule is that if during the 365 day-period before filing a bankruptcy case you pay a creditor more than you are paying at that time to your other creditors, then that favored creditor could be ordered to surrender to your bankruptcy trustee whatever money or assets that you had paid or given to this creditor in payment of the debt.

The purpose of this rule is to prevent people in financial trouble from dissipating their assets by paying one or two special creditors to the detriment of their remaining creditors. Its other purpose is to dissuade creditors from being overly aggressive in collecting from financially hurting debtors, given the risk of having to pay back the money if the debtor is forced into bankruptcy soon after. Both conflict with one of the most important principles of bankruptcy law: fair and equal treatment of creditors.

How can the bankruptcy system intervene in transactions that happen before there’s a bankruptcy case filed? Bankruptcy does usually focus on your financial condition at the time your case is filed. But it also does have the power to look backwards in time to address certain perceived abuses that may occur. This preference law is one example.

The 90-Day Preference Rule

The period of time before a bankruptcy filing that is subject to being paid back is actually only 90 days for most creditors. So payments made voluntarily or involuntarily (say, by garnishment of your wages) to ordinary creditors may also have to be paid back by the creditor. (More on such non-friendly preference payments in our next blog post.)

It’s a full year look-back period only for payments received by “insiders.” This includes relatives and business associates, and for practical purposes anybody to whom you owe money and feel virtually any special personal, family, business or moral obligation.

Debt Payment Paid Back But Not to You

Notice that if the person you paid is required to pay back what you paid, it’s paid back not to you but rather to your bankruptcy trustee. The trustee then distributes the money to the pool of your creditors.

That distribution takes place according to a prioritization schedule laid out in the law. So most of the money received by the trustee may actually go mostly to a creditor or two which you would benefit from being paid—such as recent income taxes or child support arrearage—because you would have to pay these yourself otherwise. But most of the time the money just goes to creditors you wouldn’t otherwise need to pay.

Foiling Your Intentions and Expectations

This preference law can be extremely frustrating. Instead of you coming across as you intended—responsible and considerate to your favored creditor—the result is the opposite.

You wanted to pay off that debt and fulfill a moral and likely legal obligation to that person. You may have not wanted him or her involved in, or even aware of, your bankruptcy case. You wanted to be good to the person, avoid a headache for him or her and for yourself.

But instead your favored creditor gets mixed up in your bankruptcy case, and does so in a way potentially embarrassing to you and harmful to him or her. The person may have to give up the money you paid months earlier, has most likely spent it in the meantime, and so has to scramble to come up with the money demanded by the trustee.

Then after all this, given that your special creditor would again be out the money you paid, you may continue to feel that you have a moral obligation to make good on that debt. So you could end up paying that debt to him or her a second time, after your bankruptcy is over. Clearly not a good result!

Good Intentions Are Irrelevant

You may figure that if you were not intending to hurt your other creditors when you paid your friend or relative then the “preference” law shouldn’t apply to you. Or it shouldn’t especially if you had no intention of filing bankruptcy at the time you paid your special creditor, but only decided to do so many months later when your circumstances significantly changed. Why should you be penalized for something that involved no bad intention?

In the eyes of the law your intentions don’t matter here. This is seen as an issue of fairness among creditors, a way of making the situation fairer among them. And also a disincentive for creditors—friendly or not—to not put undue pressure on financially struggling debtors to pay a debt, given the risk of having a bankruptcy trustee force the creditor to pay it back if the debtor ends up filing bankruptcy soon thereafter.

Avoid the Risk of a “Preference”

The good news is that this mess can be avoided altogether by simply not paying your favored creditors anything during the year before filing. Once a friend or relative finds out how counterproductive getting paid on the brink of you filing bankruptcy can be for him or her, most likely he or she and you will be able to come up with a better alternative. Your attorney can explain the situation to your favored creditor and negotiate a solution.

Delay Filing Bankruptcy

If you’ve already made one or more potentially preferential payment it may be worth waiting past the 90-day or 1-year look-back periods before filing your bankruptcy case. You definitely need to talk with an attorney about this to determine if your payment(s) will indeed be considered legally preferential, what if any risks you run in delaying your bankruptcy filing, and everything else relevant to the decision.

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