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Don't Pay Relatives or Friends Before You File for Bankruptcy

It's normal to feel differently towards some people you owe-like friends and relatives. But acting on loyalty to such special creditors can cause both of you problems.

You've Got to Treat Personal and Conventional Creditors the Same

Being "fair" to all your creditors means that-in the eyes of bankruptcy law-all creditors must be treated the same. That is, they must be treated the same as long as they are legally the same. Of course creditors can be legally different in many ways. For example, a secured creditor which has a right to repossess your vehicle can be treated very differently from creditors that have no such right, and creditors such as ex-spouses owed child support must be treated very differently than conventional creditors because child support cannot be discharged in bankruptcy. But if you owe a debt to your favorite aunt on a personal loan and one to a bank on a credit card, those two debts are likely both "general unsecured" debts that for most purposes are treated the same in a Chapter 7 or Chapter 13 case.

This Equal Treatment Applies (Somewhat) Even Before Bankruptcy

Most of bankruptcy law applies to you and your financial life starting on the day your bankruptcy case is filed. That is when you start being protected from your creditors, the point in time that the bankruptcy system cares about your assets, and such. But certain very limited aspects of bankruptcy law also look at your financial life before filing.  Accordingly, this idea of treating creditors the same if they are legally the same spills over into your payments to creditors before you file.

To a limited but potentially dangerous extent, the bankruptcy trustee can undo certain payments you made to creditors before your filing. Those creditors could be required to take the money you paid to them and pay that money to the trustee.

What Are the "Preference" Timing Rules?

A "preference" is described as a payment of money or a transfer of something of value either made voluntarily or involuntarily (such as a garnishment) to pay a debt, made within one year before your bankruptcy filing.  This one-year period only applies to creditors who are "insiders"-basically your relatives, friends, and business associates. For other conventional creditors, the look-back period is much shorter-only 90 days before filing.

Why This Is Such a Headache

This feels so unfair. You pay a friend or relative because you really care about him or her, probably when money was very tight, maybe even because you DON'T want that person involved in your bankruptcy case.  Then after you file bankruptcy your bankruptcy trustee contacts that person to make him or her pay to the trustee whatever amount that you paid that person within the one year period before filing, so that the trustee can distribute that money among all your creditors. Then once your friend or relative pays that money to the trustee, your continued loyalty to that person may induce you to make him or whole, by paying him or her again a second time to make up for the money the person had to surrender to the trustee.

What Justifies this Unfair Result!?

The reason for this seemingly unfairness is the basic bankruptcy principle introduced at the beginning of this blog about being "fair" to all your creditors.  This principle applies for this purpose not just as of the moment your bankruptcy is filed but beforehand for two reasons:

1) to discourage debtors-before filing bankruptcy-from giving the last of their money and assets to favored creditors instead to everyone equally; and

2) to discourage creditors from being overly aggressive and driving people into bankruptcy, since the last money such creditors force out of a person who flies bankruptcy may have to be surrendered to the trustee.

You Can Usually Prevent this Problem

The good news is that "preferences" are not all that common because they can usually be prevented. First, in advance of filing bankruptcy avoid making payments on a debt during the one year beforehand to any friends, relatives or business associates. And if you already have paid something to one of these kinds of creditor, wait to file the bankruptcy case until more than a year has passed.

"Preferences" are also less often a problem than you might think because there are some helpful exceptions. We can't cover them in any detail here, but here are two examples:

1) payments to secured creditors (those who have rights to collateral) are usually not "preferences"(because their right to collateral distinguishes these creditors from unsecured ones); and

2) payments have to total $600 or more to any single creditor for the trustee to be able to pursue them.

Conclusion

You may understandably feel like paying certain special creditors during the months while you are considering filing bankruptcy. But as this blog has explained, who you pay and when can come back to haunt you. Call us when you first start thinking about filing bankruptcy to set up an initial appointment so that you avoid the "preference" headache.

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