How Could Bankruptcy Affect A Payment Made Before You Filed For Bankruptcy?

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There are two main goals of bankruptcy law.

The first goal is to give the debtor (i.e. the person who owes money) a fresh financial start. It has a great pedigree: It’s in the U.S. Constitution, the Bible, ancient Roman law, the ancient Hittite Empire’s law, and in Hammurabi’s Code.

The second goal of bankruptcy law is to make sure that all creditors (i.e. the entities who are owed money) who are similarly situated are treated equally and fairly. There are two common ways in which debtors will sometimes violate this second goal.

The first way a debtor may violate the second goal is to purposely, or inadvertently, fail to list all creditors in the bankruptcy papers. Suppose, for example, that the debtor lists a creditor, and the debt to that creditor is discharged; but doesn’t list another creditor and instead pays the debt owed to that other creditor. The creditor who didn’t get paid can legitimately complain about the unfair treatment. As a result, the law requires a debtor to list all creditors in the bankruptcy papers.

The second way a debtor may violate the second goal is to make preferential payments to a given creditor in anticipation of bankruptcy, perhaps with the intention of currying favor with that creditor, or because the creditor is a relative. The trustee assigned to the case (or the debtor in possession in a Chapter 11 bankruptcy) is empowered to prosecute an action to undo the unfair transfer and recover the funds so that the money is available to pay all the creditors. In other words, the action voids the transfer — which is why it is called an avoidance action.

If a debtor makes a preferential payment to a creditor in anticipation of bankruptcy, the debtor must wait to file the bankruptcy petition. Otherwise, the trustee can avoid that preference and seize the money from the creditor. The length of waiting time depends on the kind of creditor — either ordinary or insider.

In the taxonomy of debt, there are different ways to break things down. One way is to distinguish between ordinary creditors and insider creditors. An insider creditor is a creditor who is either a family member — up to three degrees of consanguinity — or a close business associate (close in a way that subsection 101(31) of the Bankruptcy Code makes precise). All other creditors are ordinary creditors.

On the one hand, payments totaling more than $600 to an ordinary creditor during the 90-day window immediately prior to the day the debtor files the bankruptcy petition constitute an avoidable preference. On the other hand, payments of any size to an insider creditor during the one-year prepetition period constitute an avoidable preference. This means that if a debtor has been making payments to a relative, prepetition aging may be necessary so that the trustee doesn’t go after that relative. While the Bankruptcy Code has a few defenses to preference avoidance actions, it’s safest not to make preferential payments. “Don’t make payments prior to filing,” is the slogan that I give to clients who are thinking about filing for bankruptcy protection.

Finally, per a U.S. Supreme Court case, date of the preference is not the day the check is written, but the day the check is honored by the bank.

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