Are You Allowed to Be More Fair to Some Creditors than Others?

In bankruptcy you can at times treat your creditors differently, but only if you follow the rules very carefully.

My last blog was about making a good decision about filing bankruptcy, one that both feels right morally and serves your best interests legally. And if you do decide to file bankruptcy, you will often 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 before you file bankruptcy, and to do so for some personal reason, usually because of a special relationship.

Special Feeling of Obligation

You may have people you feel you must pay, whether out of family connection, loyalty to a friend, or some other personal reason. You just can’t see not paying them, no matter what you do to your other creditors. You believe you have an honorable moral obligation that you just can’t break.

For example, someone may have made a personal loan to you who now truly needs the money. Or you believe that you would be irreparably harming a family, romantic, or friend relationship if you did not “do the right thing.”

So What’s the Problem?

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 this principle 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 may have to be returned, month later. And returned not to you but rather the person you paid can be forced to pay “back” to your bankruptcy trustee whatever you paid to that person, IF that payment was made by you during a certain period of time before your bankruptcy filing.

This Could Hurt

The practical consequences of this can be terrible. After you make a special effort to pay someone that you care about (when it’s likely quite a financial challenge for you to do so), you later risk having your bankruptcy trustee make that person pay whatever you paid “back,” but now to the trustee (for the purpose of distributing that to your creditors as a pool).

Since this can happen many months after you’ve paid that person, the money you paid probably has long ago been spent. So, unless that person is financially well off, having to come up with that money to turn around and pay it “back” to the trustee could well be challenging, or even a hardship for that person.

So, instead of you helping that person as you had very much intended, he or she would get inconvenienced and frustrated, or worse. And if you were also hoping for that person to avoid knowing about your bankruptcy filing, he or she will be informed about it in the worse way!

Then, after all that you might still feel obligated to make that person whole, by paying that same amount of money a second time to that creditor.

What’s the Reason for All This?

The point of this seeming craziness is related to that principle of treating creditors the same.

It is most easily explained from the perspective of a Chapter 7 case in which you have assets at the time of filing that are not “exempt”—not protected. (That’s relatively rare.) If so, the trustee takes those unprotected assets, sells them, and distributes the proceeds to the 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 “preferences.” The idea is that had you not made those payments, that money would have been available to distribute to the creditors overall.

The Preference Rule

So what’s the rule about this so that you can avoid the problem? There are many twists and turns to it, but the basic rule is reasonably straightforward AND often can be used to avoid making preference payments. The rule: a preference is a payment (usually money, but it can be any asset) made 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. The preference can be voluntarily made on your part or involuntarily (such as a wage garnishment). That 90-day period before filing is instead expanded to a full year for payments made to “insiders”—basically relatives, friends, and business associates.

How to Avoid Preferences

When you know 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 bankruptcy long enough to get past those time periods.

Plus there are other aspects that make this less trouble than it might sound. Payments to most secured debts (on your home or 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 $6,225 for a business debtor. And there are various other exceptions.

Conclusion

Overall, it’s dangerous to pay creditors to whom you feel a special loyalty before filing bankruptcy. The basic 90-day/1-year rule does have some complications 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. How to do so is the subject of the next blog.