The "Preference" Problem

 Posted on April 14, 2017 in Bankruptcy Law

Avoid the frustrating surprise of having one your friendly creditors be challenged by your bankruptcy trustee with a preference action.

In the last two blog posts we’ve introduced “preferences.” Today we get into what we’re calling dangerous or bad preferences, ones you’d rather avoid.

Preference Law

A preference is a payment you make to a creditor before you file bankruptcy which the creditor must repay after you file bankruptcy. However, the money that you paid to the creditor does not come back to you. Instead it goes to your bankruptcy trustee, who then distributes it to your creditors under a strict priority system.

To be clear, most pre-bankruptcy payments you make to your creditors are not preferences. There are a number of timing and other requirements for a payment to be considered a preference. In fact, most consumer bankruptcy cases don’t have ANY preference issues.

But if a creditor in your bankruptcy case DOES get hit with an unexpected and unwanted preference demand, it can be awkward problem. That would especially be a shame because preferences are usually easily avoidable.

So today we show the kind of headaches a preference can cause. Then in our next blog post we’ll show you how to avoid them.

A “Bad” Preference

With most of your creditors you probably don’t care if your bankruptcy trustee wants them to pay back some money you’d paid them earlier. But if you have some special relationship with that debtor, you might deeply care. You probably made a point of paying that special creditor before you filed bankruptcy. So you’d understandably be unhappy if the creditor had to pay it to the trustee after you file.

We’re loosely calling a “bad” preference any in which you would not want the trustee to take back a payment you made to a creditor.

Stumbling into a Preference

Here’s how it usually happens.

You’re in financial distress. You may or may not be considering bankruptcy. But money is very tight so that you can’t pay all you debts as they come due. So you have to decide who you are going to pay at that point and who you are not.

So how do you prioritize? What if you owe a relative or friend some money? Maybe you don’t pay them because you tell them you’re having a tough time. You ask them to be patient.

But maybe you’re too embarrassed to do that. Or maybe you know that this person really needs the money. You may be thinking about filing bankruptcy. You’d rather the person not know about it if you do file, or not get hurt by it, or both. You may even think that it’s not legal to pay the person back after you file bankruptcy so you want to take care of it beforehand.

So some combination of pride and principle motivates you to pay him or her, even when it’s really tough to do. So you do.

Once You File Bankruptcy

Paying a debt to anyone who you want to favor during the one-year period before filing bankruptcy could result in that person being legally required to pay “back” to your bankruptcy trustee the amount you paid him or her. Look at our blog post of this last Monday about what conditions would make this happen. And then look at the very last blog post of Wednesday about why this happens less than you’d think.

Here’s what sometimes happens in real life.

There are a couple questions related to this in the formal bankruptcy documents that you file through your lawyer. These questions are about payments made to creditors before filing, including during the 365 day-period before filing the bankruptcy case. But you make not consider the person you paid a “creditor.” Or you may honestly forget that you paid this person 10-11 months ago.

But then the trustee asks you about this a month or so later at the “meeting of creditors.” You realize that friend or relative was indeed a creditor. Or you now remember that you made that payment. And now the trustee wants to make that person pay the amount you paid, “back” to the trustee.

Messing Up Your Intentions and Expectations

Preference law can be extremely frustrating. Instead of you coming across as responsible and considerate to your favored creditor—the result can be the opposite.

You wanted to pay off that debt and fulfill a moral and legal obligation to that person. You may have not wanted the person involved in, or even aware of, your bankruptcy case. You wanted to be good to the person, avoid a headache for him or her, and for yourself.

But instead your favored creditor gets mixed up in your bankruptcy case after all. And this happens in a way potentially embarrassing to you and harmful to him or her. The person may have to give up the money you paid months earlier, and has most likely been long spent. And so the person has to scramble to come up with the money demanded by the trustee.

Then after all this, your special creditor would again be out the money you paid. So at that point you may still feel that you have an obligation to make good on that debt. So you could end up paying that debt to him or her a second time, after your bankruptcy is over.

Clearly not a good result!

Avoid the Risk of a “Preference”

The good news is that you can avoid this situation. Our next blog post on Monday will explain how.