Sometimes in bankruptcy doing the honestly right thing can cause you major problems. Making preference payments is a good example of this.
The Understandable Inclination to Pay a Favored Creditor
If you’re having financial problems and considering bankruptcy, you might feel compelled to first take care of a special debt. You may owe a relative or friend who is in real need of the money. You may feel deep and legitimate pressure to pay part or all of it in spite of your own financial problems. You may figure, accurately or not, that you won’t be allowed to pay this person after filing bankruptcy. Or for various reasons you may not want to involve this person in your bankruptcy case. You may not want to have him or her know about it. So you figure the best way to do that is to pay off or settle the debt beforehand.
But your intentions—good or otherwise—could significantly backfire, if you don’t know the law and don’t get good advice.
The Dangerous, but Avoidable, “Preference” Payment
“Preference” payments are among the most frustrating situations in bankruptcy. They seldom happen but are a major headache when they do.
Because of the trouble they can cause, trouble that is often easy to avoid, “preferences” are worth understanding.
The Law on “Preferences”
So what are “preferences” and why are they a problem?
Bankruptcy law say that if during the 365 day-period BEFORE filing a bankruptcy case you pay a creditor more than you are paying at that time to your other creditors, then AFTER your bankruptcy is filed that favored creditor could be forced to surrender to your bankruptcy trustee the money that you had paid to this creditor earlier. (See Section 547 of the U.S. Bankruptcy Code on “Preferences.”)
In other words if you pay a special creditor during the year before filing bankruptcy, that person (or business) could be required to return that money.
The money would usually be returned not to you but to your bankruptcy trustee, to be re-distributed among your creditors. So instead of having a satisfied favored creditor, you would likely have a very unhappy one. You had wanted to fulfill your moral obligation to the creditor. Instead he or she would get a legal demand by your trustee to cough up the money you’d paid. Your friend/relative would have to scrape up the money you paid to him or her months earlier—very likely spent by then—to pay to the trustee.
After this would happen you may even feel morally compelled to pay that person yourself a second time. You might want to make up for the money the trustee took away from him or her.
The Point of “Preference” Law
What could possibly be the point of this 1-year “preference” rule? It is meant to promote one of the basic principles of bankruptcy law—legally equal treatment of creditors. This principle applies mostly DURING your bankruptcy case. However, to a limited extent the law also looks 1 year backwards from the time you and your bankruptcy lawyer file your case.
So people in financial trouble are discouraged from playing favorites among their creditors for a year before filing bankruptcy. This is supposed to make the situation more financially fair to all the creditors.
Here’s an example to help make sense of this odd concept.
Imagine that you’ve owed your sister $3,000 for money she lent you so that you could pay your rent. You haven’t had the money to pay any of it back. She now really needs the money. Plus you really don’t want her or the rest of your family to know you’re filing bankruptcy. You’ve stopped paying other creditors for a while so you’ve scraped together the money to pay off this debt. You intend to pay it off and then file bankruptcy right after because you’ve recently been sued by a creditor. You know your paycheck is getting garnished in a few weeks if you don’t stop that by filing bankruptcy.
But here’s what would happen if you paid off your sister and then filed bankruptcy (within a year after).
A month or two after filing bankruptcy your bankruptcy trustee would very likely demand that your sister pay $3,000 to the trustee. If she didn’t pay, the trustee would likely sue her to make her pay. Once she did pay, that $3,000 would be divided among your creditors according to a set of priority rules. Your sister would be out $3,000. You may then feel obligated to pay her that, again. She (and probably your whole family) would know about your bankruptcy filing. Everybody would be unhappy.
It’s Usually an Avoidable Problem
This “preferences” mess can be avoided simply by not paying your favored creditors anything during the year before filing. This includes both money and anything else of value.
And if you do pay anything to such clients, hold off on filing bankruptcy for a year after.
That’s easier said than done when you have creditors suing or creating other collections problems. Your lawyer could likely help keep these creditors at bay. More broadly he or she would put together your best game plan for dealing with all of this.