Easily Preventable Mistakes to Avoid–Don’t Be Nice to Special Creditors

Acting honorably towards a favorite creditor or two before filing bankruptcy can make you anything but their favorite.

Paying Your Favorite Creditor Before Filing Bankruptcy

Although bankruptcy law fixates on what you own and who you owe at the moment your bankruptcy case is filed, there are some important ways that the law can look into the past. “Preferences” are an example where the bankruptcy system can potentially look into and upset a certain limited piece of your past.

If during the 365 days 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 that favored creditor could be required to give to your bankruptcy trustee the money that you had paid to this creditor. So for example, if you paid your mother $1,000 to pay off a debt you owed her, and then six months later filed a bankruptcy case, your trustee could likely require her to pay that $1,000 to the trustee. That $1,000 would then be divided by the trustee among your creditors as prescribed by law (with your mother likely getting just a tiny portion of it, based on her pro-rata share of all your debts).

That $1,000 is called a “preference” or a “preferential payment,” which the trustee can undo, or “avoid.” You are considered to have paid that creditor in “preference” to your other creditors.

The Harsh Practicalities of Preferences

The result is that your good intentions backfire. You want to be considerate to a special creditor—often a family member, your long-time family doctor, or some other kind of favored creditor–by paying off that debt and keeping it out of your bankruptcy case. You may have wanted this creditor not to know about you filing bankruptcy. Or you may have just wanted to take care of your moral obligation.

But the result becomes the opposite. Your favored creditor gets mixed up in the bankruptcy case, and in a way more embarrassing than would have been otherwise. He or she has to give up the money you paid—and may have to scramble to come up with it somehow after having spent it. After that, you may well continue to feel that you have a family or moral obligation to make good on that debt, so you end up paying that debt to your favored creditor a second time, after your bankruptcy is over. And finally, if your bankruptcy is a Chapter 13 case then you would not even be allowed to do that until the case was over 3 to 5 years later. A mess all around.

The Good News—It’s Preventable

This mess can be avoided altogether if you get legal advice from an experienced bankruptcy attorney before you make the preferential payment(s) to your favored creditor. Or even if you’ve already made the payment(s) by the time you see your attorney for the first time, there are often ways to get around it.

Careful, though, because the law about preferences is complicated. Section 547 of the Bankruptcy Code on preferences is a head-scratcher. It’s about 1,300 words long, containing 56 sub-sections and sub-sub-sections. Take a look at it and you’ll see it’s certainly not clear.

What is clear that if there is any chance that you may be filing a bankruptcy case within a year, before paying anything to a relative, friend, or any other special creditor that you feel obligated to pay, talk first to an experienced bankruptcy attorney. Especially do so if you figure this does not apply to you because you don’t consider the person you are paying to be a “real” creditor—because it’s a “personal debt,” was never put into writing, or nobody knows about it.

And most importantly, if you’ve already made such a payment before you see your attorney, absolutely be sure that you disclose that to him or her, and do so right away, early at the first meeting. It could well affect your game plan, and maybe the timing of your bankruptcy filing.

Preferences are mostly a problem when they only come to light AFTER your bankruptcy is filed. Be sure to be candid with your attorney so that does not happen to you. Avoid that and most likely preferences will not be a problem for you.