Creditors to Whom You Feel a Special Loyalty or Fear

Posted by Kevin on July 11, 2012 under Bankruptcy Blog | Be the First to Comment

In bankruptcy it’s okay to FEEL differently towards some creditors than others. You can also sometimes ACT differently, but only if you very carefully follow the rules.

OK.  You are in financial difficulty.  You may or may not even have thought seriously about bankruptcy, however.  You have lots of creditors and a small amount of money.  Some of those creditors are family members- and you have to take care of them.  Others are people that you do with business.  You would like to take care  of them because you want to keep up that relationship.  Are there any hidden land mines if you bankruptcy after paying back your cousin, Vinnie, of your main supplier?

The problem with favoring certain creditors is that doing so flies in the face of one of the basic principles of bankruptcy law—that creditors which are legally the same should be treated the same. Mostly that applies to how creditors are treated DURING the bankruptcy case itself. But in certain limited but crucial ways this principle spills over into the time BEFORE your case is filed. Payments you made to a creditor can be undone—the creditor can be forced to pay to the bankruptcy trustee whatever you paid to the creditor within a certain period of time before your bankruptcy filing.

The practical consequences of this can be devastating. You make a special effort to pay someone that you care about, likely when you don’t have much money, only to later risk having your bankruptcy trustee make that person pay that money “back,” not to you but rather to the trustee. Since this can happen long after you paid that creditor, the money you paid probably has long ago been spent, often leaving that creditor scrambling.

If you pay a creditor not long before filing the bankruptcy case, the theory is that you “preferred” that creditor over others. The inappropriate payments are called “preference payments,” or simply “preferences.” The idea is that had you not made those payments, there would have been money to distribute to the creditors overall.

So what are the rules about this so that one can avoid them? If you’d like very effective sleep-inducing bedtime reading, here is Section 547 of the Bankruptcy Code explaining preferences. Nearly 1,400 words, in 57 subsections and sub-subsections!

But the good news is that the basic rule is both reasonably straightforward and often easy to work around if you understand it. So here it is.  A preference is a payment (usually money, but it can be any asset) made (voluntarily or involuntarily such as a garnishment) on a prior debt to a creditor (anybody to whom you legally owe money) during the period of 90 days before the filing of a bankruptcy.  That period of time stretches out to a full year before filing for payments made to “insiders”—basically relatives, friends, and business associates.

So how do you work around this? Well, if you know about the rule in advance, you avoid paying creditors you care about during those 90-day and 1-year periods before filing, whichever is applicable. And if you’ve already made those payments, you avoid the problem by waiting to file long enough to get past those time periods.

There are other aspects that make this easier than it might sound. Payments to most secured debts (on your home, vehicle) don’t count. The trustee can’t chase payments to a single creditor totaling less than $600 in the case of a consumer debtor or less than $5,000 for a business debtor.  And there are various other exceptions.

The bottom line is that overall it’s dangerous to pay creditors who you feel a special loyalty to before filing bankruptcy. The basic 90-day/1-year rule is rather simple, but it has lots of twists and turns so it’s safer to just avoid the issue whenever possible. Often it’s better to wait until after you file your bankruptcy case to pay these people. That’s the subject of the next blog.