Paying a certain favored creditor within the year before filing bankruptcy can cause major headaches. Here’s how to avoid them.
The Law of Preferences
Most of bankruptcy law focuses on the present—your financial life as of the moment you file your bankruptcy case. But “preferences” look into and can actually undo a bit of your past. Specifically certain creditors can be required to disgorge payments you made to them before your bankruptcy case was filed. You may not want such creditors to have to surrender the payments you made to them, especially if you have a continuing personal relationship with and a feeling of obligation to that creditor.
Here’s the law: if, during the one year before you file a bankruptcy, you pay a creditor more than you are paying at that time to your other creditors, then after you file bankruptcy under certain circumstances that favored creditor is required to give to your bankruptcy trustee the money that you had paid earlier to that creditor. (The look-back period is only 90 days for conventional creditors; the one-year period applies to “insiders”—basically family members, friends, and business associates.)
The creditor you paid may be someone you had intended to favor, perhaps someone you wanted to get paid before you filed bankruptcy. That creditor may be a relative or close friend who you owe on a personal loan. You would probably be unhappy if that relative or friend were forced to turn around and pay to your bankruptcy trustee whatever amount you had paid months earlier. When the trustee would demand payment of that money by the relative or friend, the money you paid him or her is probably long spent. It may well be difficult for your friend or relative to come up with that amount of money now. You may even feel morally obligated to pay that amount again to your friend or relative if your bankruptcy trustee takes their money. Clearly, this is a situation to avoid. The following example shows how to do so.
The Example
Eleven months ago Martin received an unexpected windfall: $6,500 through an inheritance from his old high school best friend, who had died in a car accident. Martin was current on his debts at the time but financially struggling to stay current. He put $1,500 into seriously deferred maintenance on his older vehicle—tires and brakes, plus a clutch job. The remaining $5,000 he paid right away to his brother, Jeremy, to repay a long-overdue personal loan. Martin was very happy at the time to be able to repay this loan because Jeremy had previously lost his job, had just stopped getting unemployment benefits, and was starting to have trouble putting food on the table for his family.
Soon after that Martin and his wife separated, significantly increasing his housing and other expenses, so that he could no longer keep current on his credit cards. When sued by one of the credit card creditors, Martin went to see a bankruptcy attorney.
Solving the “Preference” Problem
Martin’s attorney advised him that his $5,000 debt payoff to Jeremy would likely be a preference as long as it had happened within the year before Martin filed bankruptcy. It had happened eleven months earlier. Martin absolutely did not want to have his bankruptcy trustee chase Jeremy for $5,000. So Martin was advised to wait for a month before filing.
But Martin was nervous about waiting because had just been sued by a credit card company and he didn’t want his wages garnished. But his attorney assured him that there could be no garnishment without a judgment being entered against him in the lawsuit, and that there were legitimate ways to prevent a judgment from being entered long enough for the one-year preference period to expire.
So Martin filed bankruptcy shortly after one year had passed since his payoff of the debt to Jeremy. As a result Martin’s trustee had no right to the $5,000 that Martin had paid to Jeremy. There was no preference, and the problems that would have arisen otherwise were prevented.