It’s usually safer to pay debts you owe to special creditors after your bankruptcy case is over, not before.
It happens about once a week. Last week I was consulting with Ellen from Lexington (not her real name), who told me about $5,000 she borrowed from a friend, a debt she did not want to “include” in her bankruptcy case. The week before, a couple from Newberry owed a $1,200 bill to the doctor who had been treating their family for years. They wanted to make sure he would still see them if they filed bankruptcy.
It’s common for people to want to pay certain special creditors, even if the legal obligation is wiped out in bankruptcy. Frequently it’s possible to do so, but the timing is critical.
Two somewhat contrary principles of law are at play here. First, section 524(f) of the Bankruptcy Code clearly states that a discharge in bankruptcy does not prevent a debtor from voluntarily repaying any debt.
Second, though, the code also contains a strong policy of fairness — that is, equal treatment of all creditors of the same kind. A debtor’s resources, says the law, should not be applied to pay some unsecured creditors while others get little or nothing.
To implement this policy, the code allows bankruptcy trustees to reverse (“avoid”) certain payments and other transfers that occur in the time leading up to a bankruptcy case. These are called preferential transfers, or simply preferences, because their effect is to give preferred treatment to one or more creditors. The trustee can take back (“recover”) the money or property from the recipient (“transferee”) and apply it to all creditors according to the usual rules of distribution.
The details of preference law are complicated, but two fairly simple points are important. First, the trustee can only recover transfers within 90 days before the bankruptcy case is filed; however, if the recipient is an insider — a relative, close friend, or business associate of the debtor — the look-back period is one year. Second, if the debtor has mostly consumer debt, the trustee can only recover transfers worth $600 or more ($5,850 or more if most of the debts are business-related).
So let’s say Ellen decides to pay her friend half of what she borrowed ($2,500) and files a Chapter 7 bankruptcy case a couple of months later. Her trustee will be able to get that payment back from the friend and divide it equally among her creditors.
That’s especially unfortunate, because Ellen may have been able to prevent the trustee from taking the money had she not paid her friend. Every debtor can claim certain exemptions — the right to protect certain kinds and amounts of property from a trustee. Depending on what else Ellen owns, she could well have protected that $2,500 if it were sitting in her bank account. But once she voluntarily paid it to her friend and the trustee recovered it, no exemption can apply.
It doesn’t take a genius to figure out what Ellen should have done: hold onto the money until she files, exempt it, wait until the bankruptcy case is over (or at least until the trustee has released her assets), and then repay her friend.
But let’s say Ellen has already paid her friend and is about to file her bankruptcy case. Strangely enough, it may be possible to save the $2,500 by having her friend lend it to her again. Under the “new value” exception to the preference rule, the trustee now can’t recover the original $2,500 repayment from the friend. If Ellen has sufficient exemptions available, she can protect the money, now back in her own hands, from her trustee — and pay her friend back later with it.
The lesson here is that, when considering a possible bankruptcy, a debtor should consult an experienced bankruptcy lawyer before deciding to pay substantial amounts to anyone, especially a favored creditor.