A question that often arises in the context of bankruptcy preparation has to do with debts owed to family members or close friends. What happens if you repay your brother/sister/mother/father the $2,000 that was loaned to you six months ago? What about a repayment to a friend or employer?
The Bankruptcy Code addresses the issue of payments prior to bankruptcy at Section 547. In the Bankruptcy Code, a payment to someone prior to bankruptcy is called a “preference,” and the rules depend on both the nature of the debt and the payee.
The formal definition of a preference in a consumer case is a payment in the amount of $600 or more for the benefit of a creditor made while the debtor was insolvent for an “antecedent” (pre-existing) debt.
For insiders (spouse, relatives, related businesses), any payment made within one year prior to filing, your payment will be considered a preference. For non-insiders, such as credit card companies, judgment creditors and other third parties, any payment made within 90 days may be considered a preference.
If a debt payment falls within the definition of “preference,” the Chapter 7 trustee in your case has the power to file a lawsuit in bankruptcy court to compel the recipient of the preferential payment to refund the money to the trustee for distribution to creditors.
Here are some examples of preferences:
Example 1: Over the past five years, Tom occasionally had trouble with his mortgage payment. Over the years, Tom’s parents lent him $6,000. Every year, when Tom got his tax refund in May, he gave the his refund of $1,100 to his parents.
Analysis: In this case, Tom’s repayment of $1,100 to his parents is a preference because he was paying on an old debt and the evidence is likely to show that Tom was in financial distress (insolvent) when he made the payment. However, repayments made more than a year ago would not be preferences.
Example 2: By last October, Sally was two payments behind to her mortgage company, plus she was due for October. The mortgage company sent her a letter threatening foreclosure. Sally took too part time jobs and cut back on expenses, plus she finally received a past due child support payment. On October 20th, she sent in the missing two payments plus the October payment. On December 5, Sally decided that she could not continue working 20 hours a day and she filed for bankruptcy.
Analysis: This is not such a clear cut case. On one hand, Sally made her October 20 payment within the three month preference “look back” period. The question here is whether the two missed payments were “antecedent debts” as required by the statute. There is also the question of whether Sally was “insolvent” at the time she made the payment.
Here, the Chapter 7 trustee in Sally’s case would have to decide whether to pursue a preference action against the mortgage company. Finally, there is the question of whether one or more of Sally’s payments to the mortgage company were ordinary course of business payments for current debtor or were they payments on old debts.
Since a preference action filed by the Chapter 7 trustee is filed against creditors, the debtor will most likely not be personally affected. However, you may find that your friends, family or trusted vendor will not be very happy to defend a trustee preference action.
Therefore, when you meet with your bankruptcy lawyer, make sure to tell him about any and all payments of $600 or more to anyone during the year prior to your possible filing date. Your lawyer can advise you who qualifies as an “insider” and whether any of the other defenses to a preference action exist in your case.
by Jonathan Ginsberg, Ginsberg Law Offices
Jonathan Ginsberg, Esq.
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Last modified: November 9, 2012