14 Oct Undoing Preferences before a Bankrupcty
Unlike fraudulent conveyances, which often can not be undone, avoidable preferences can often be “fixed” before a bankruptcy. The issue sometimes arises when a debtor pays back a family member before a bankruptcy case. This is unwise because if a bankruptcy case is filed within a year of the transfer, the trustee can avoid it by taking the money back from the family member and distributing it to creditors in accordance with the priorities of the bankruptcy code.
The way to avoid this result is found in 11 U.S.C. 547(c)(4), the so-called “new value” exception to the avoidance powers of the bankruptcy trustee, which is common in the commercial revolving credit context. This section can also be utilized to undo a preference by having the family member extend a new unsecured loan to the debtor in the amount that was repaid. This effectively unravels the preference before the bankruptcy. For this to be worthwhile, however, the debtor must have some exemptions available to protect the money (or must spend it in the usual course of living before the bankruptcy is filed).
Attempting to fit oneself into the new value exception after making an unwise debt payment to a family member is not without risk. Loans between family members are often not documented. So, if the existence of the original loan is based only on the word of the debtor and his family member, the trustee may argue that no legal debt ever existed and that the original transfer from the debtor was not a loan payment but a gift transfer, and therefore subject to reversal under the law of fraudulent conveyances.
It always makes sense to run any thoughts about transfers or loan repayments by your lawyer. They often contain hidden and counter-intuitive dangers.
Nicholas Ortiz, Boston Bankruptcy Attorney
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