Creditors to Whom You Feel a Special Loyalty

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.

The last blog was about making a good decision about filing bankruptcy, one that sits well with you morally and serves your best interests legally. If you do decide to file bankruptcy, you usually also have the chance to decide how to deal with some of your creditors. Today’s blog is about creditors you would like to favor for some personal reason, usually because of a special relationship. Specifically, how you favor such creditors BEFORE your bankruptcy is filed is the subject of today’s blog.

The special creditors we’re talking about here are people you feel you must pay, whether out of family connection, loyalty to a friend, or any other personal reason. Your desire to pay this person can be an honorable moral obligation that just about trumps everything. For example, someone may have made a personal loan to you who now desperately needs you to pay it back.

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. Instead of you helping that person as you intended, he or she can get significantly inconvenienced and frustrated, or worse.  And after all that, you may feel obligated to pay that same amount of money a second time to that creditor if you still want to make him or her whole.

What’s the point of this seeming craziness? It goes back to that principle of treating creditors the same. For example, in the relatively rare Chapter 7 case in which you have assets at the time of filing that are not “exempt”—not protected—the trustee takes them, sells them, and distributes the proceeds to your creditors. 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.