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The Extraordinary Tools of Bankruptcy: Avoid Hurting Your Favorite Creditor

If you’re careful it’s easy to avoid the rude surprise of hurting the friend, relative or other creditor you paid before filing bankruptcy.  


The last blog post was about using “preference” law to your benefit. Through this unusual law, your aggressive creditor can be required to give up money it grabbed from you BEFORE your bankruptcy case was filed, then DURING your bankruptcy that same money can instead go to pay another creditor that you need and want to be paid.

But what if the person or business that you paid before bankruptcy is a creditor you like or have a special relationship with? What if you paid that person or business out of a deep feeling of moral obligation? What if you made good on that obligation in part because you didn’t want this creditor to be affected by your upcoming bankruptcy case, or maybe even didn’t want him or her to know about you filing bankruptcy?

Under these circumstances it would sure be a rude surprise both to you and to your friendly creditor if he or she were later forced to pay to your bankruptcy trustee what you had paid him or her months earlier.  Fortunately this risk can be avoided, usually quite easily.

The Law of Preferences

Although most of bankruptcy law focuses on the point in time that your case is filed and afterwards, in contrast rules about “preferences” focus on payments you made either voluntarily or involuntarily (for example, by garnishment) during a definite period BEFORE your bankruptcy was filed. As the last blog post explained, that look-back period is 90 days for regular creditors.

So payments you made to your creditors, or money or other assets of yours that were seized from you by creditors, during the 90 days before your bankruptcy case is filed, are subject to being “voided” by your bankruptcy trustee. If that creditor received more than what other creditors did proportionately, then it is required to give the trustee back what it had received. The trustee can then redistribute that money according to the prioritization schedule proscribed by law.

However, this 90-day look-back period is much longer, a full YEAR, for creditors who are “insiders.” That’s essentially any creditor who you would have any reason to favor—especially relatives, friends, and business associates. (See the definitions of “insider” and “relative” in the Bankruptcy Code.)

The Practical Problems Caused by a Preference Paid to a Friendly Creditor

So, payments you make, or property you transfer in lieu of payment, during the entire year before filing bankruptcy, to a creditor you have special reason for favoring, are at risk of being undone.

You very likely would not want such special creditors to have to surrender the payment(s) you made to them. (This is true unless you no longer have a continuing personal relationship with nor a feeling of continuing obligation to that creditor.) When the trustee would demand return of the payment from the relative, friend, or business associate, the money you paid months earlier would likely be long gone. For your former creditor to come up with the money at that point may even be quite difficult.

Then once the money IS paid over to the trustee, you may well feel a sense of obligation to pay that amount again to your friend or relative to make them whole. Paying that debt twice will certainly not make you happy. And if you were hoping to keep your bankruptcy filing a secret from this friend or relative, he or she would find out about it in an especially unpleasant way.  

Avoid this Problem Altogether

The one-year look-back period is very unambiguous. So whenever you are contemplating filing bankruptcy, avoid paying or giving anything in payment to any creditor who you feel like favoring for any personal, moral, or similar reason. If you do not pay any “insider” creditor anything within the year before filing bankruptcy, you avoid this risk altogether.

Watch Out for Repaying “Gifts”

Think about the term “creditor” broadly. You may have a generous friend or relative who has been helping you out by giving you some money, either once or a number of times, without being clear about whether you had an obligation to pay it back or not. It may have been a loan or a gift, or may have started as a loan but then you were told you didn’t have to pay it back. Whether it’s a loan or a gift, you may not consider your benefactor to be a “creditor.” But you should err on the side of caution, assuming that he or she is a creditor, and avoid giving that person any money or other asset, so as not to have the risk of it being considered a preference later.

Also, if there is any chance that you would be filing a bankruptcy case within a year, talk first with an experienced bankruptcy attorney before paying anything to a relative, friend, or any other special creditor. It’s particularly important to do so if you are tempted to think that the person you are paying is not really a “creditor,” perhaps because there is nothing on paper and/or you think you can just avoid mentioning it. Get good advice about this instead of making false assumptions.

Wait to File if Necessary

If you’ve already made the payment(s) when you see your attorney for the first time, there are likely ways to get around it. Preference law is quite complicated, and there may be exceptions that can enable you to escape the problem.

Regardless, the most important thing you must do is be upfront with your attorney. If you’ve paid or given anything in payment to anyone during the 365 days before, disclose it to your attorney, and do so at your first meeting with him or her. It could well affect the timing of your bankruptcy filing and the rest of your game plan. Waiting a year from the payment or transfer may or may not be necessary, or worthwhile, to avoid the risk. This is a multifaceted decision that must be made carefully with competent and conscientious legal counsel.


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