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What is a Preferential Transfer to an Insider in Bankruptcy?

When a Chapter 7 or Chapter 13 bankruptcy are filed with the bankruptcy court, the voluntary petition, schedules, and the statement of financial affairs and all the other documents that are submitted to the bankruptcy court are signed under penalty of perjury by the debtor, or debtors in cases in which the couples are married, affirming that the information contained in the documents is true, accurate and complete.  The bankruptcy petition requires full,  accurate and complete disclosure of all assets, and there are a series of questions in what is called the statement of financial affairs that asks the debtor to list any transfers or payments made to any possible insiders, along with other questions asking about possible business interests, prior addresses of the debtor, if bank accounts were closed in the last year or questions of that nature.

For purposes of this discussion, we will be focusing on the bankruptcy petition section called the statement of financial affairs, specifically question number 7, titled payments to insiders (1 year).  The question reads “within one year before you filed for bankruptcy, did you make a payment of a debt you owed anyone who is an insider?” In my decades of practicing consumer bankruptcy in the Detroit bankruptcy court, I’ve noticed that payments to insiders that occur pre-petition, or before the bankruptcy is filed, happen quite frequently, probably in the range of about 1 out of every 25 cases.  Chapter 7 bankruptcy trustees are especially interested and often focus on this question when conducting their oral examination of the debtor pursuant to the bankruptcy section .341 Meeting of Creditors. Such a pre-bankruptcy payment will commonly be referred to as an insider transfer or a preferential transfer but both mean the basically the same thing, a payment on an antecedent debt (a loan, usually) from a family member.  The primary duty of the Chapter 7 trustee is to liquidate non-exempt assets of the debtor and reduce those to cash for the benefit of creditors of the bankruptcy estate.  Another duty of the trustee is to recover certain pre-bankruptcy transfers.  To accurately answer this question, we need to know and understand the definition of “insider” for bankruptcy purposes.  The US Bankruptcy Code actually gives us a definition of the term in section 11 U.S.C. § 101(a)(31).  It says that if a debtor is an individual, as opposed to a business, the term “insider” includes: relatives, any partnership in which the debtor is a general partner, any general partner of the debtor or any corporation in which the debtor is a director, officer, or person in control.  For purposes of our focus on personal bankruptcy, in which most debtors do not have an interest in a corporation, we will discuss those transfers to insiders who are relatives.

It is a common scenario. Most people don’t file a bankruptcy petition at the first sign of an economic set back such as job loss, disability due to medical issues, or a divorce for example.  Most of my clients try to make things work after suffering financial hardship hoping that things will soon change for the better.  Quite often, during the year before a bankruptcy is filed, my clients and debtors in general will borrow money from family and close friends who are willing to give them small loans to help them through their difficult financial struggles.  Sometimes those relatives or “insiders” are paid all or a portion of the loan they gave to the debtor within a year of filing the bankruptcy petition.  When I prepare a bankruptcy petition for a client, I go through each of the questions on the statement of financial affairs, line by line. When we get to question 7, I usually ask them if they have paid any close friends or family members any money back, or paid back a credit card or loan on behalf of the same person.  Most clients answer in the negative and sometimes say something like “My relatives don’t have any money to lend to me” or something along those lines.  Clients who have borrowed and paid back relatives or someone close to them are often perplexed at the question and wonder what having paid back a family member within the past year has anything to do with filing a bankruptcy petition now.  “I wanted to pay back my mother, I didn’t want to include her in my bankruptcy” is what I understandably often hear.  “Did I do something wrong?” “Will I get in trouble?” , are the questions that typically follow.  In return, I stress to them “You didn’t do anything wrong and you won’t be denied a bankruptcy discharge.  All you did was pay back a family member.” So why would a bankruptcy trustee be interested in that?

Bankruptcy Trustees have a fiduciary duty to your creditors to recover non-exempt assets as well as certain pre-petition transfers that may have occurred prior to your bankruptcy filing.

  Remember that bankruptcy laws aren’t strictly for the benefit of the debtor, but are also there to ensure that there is an orderly distribution of assets of the bankruptcy estate, if there are any, and for all creditors within a particular class, to be treated fairly.  A common scenario we see, especially in the Detroit area with the large amount of UAW workers in the region, is that when a large bonus, profit sharing, contract signing bonus or income tax refund comes in, debtor’s will pay back family members who helped keep them afloat during tougher times in the previous year.  When a bankruptcy is later filed, question 7 requires they list the name of whom they paid, the payment dates, the amount repaid, any amount still owing and the reason for the payment.  Chapter 7 trustees will often ask for the address of those insiders who were paid within the last year, but usually only if the amounts repaid amount to more than $600.00.  Because the bankruptcy laws are meant to treat creditors of the same class equally, the trustee has a duty to recover those funds paid to mom and make an equal distribution to all the creditors from the money recovered.  For example,  let’s say you have one credit card, Capital One, to which you owe $10,000 which you charged up in the last year due to being laid off.  During that same time, your mother was kind enough to lend you $10,000 to get you through those difficult months after your unemployment checks ran out.  The following spring, you receive a $5,000 income tax refund and you pay your mother back the money you borrowed from her.  In the eyes of the bankruptcy court,  mom and Capital One are both simply unsecured creditors of yours.  Paying mom the back wasn’t fair to Capital One, even though we know that they are a corporation worth billions of dollars and can easily absorb the loss.  In Michigan, and likely in other bankruptcy districts across the United States, Chapter 7 trustees will likely pursue recovery of those funds from the insider to whom they were paid, to make an even distribution of those funds on a pro-rata percentage basis to each creditor depending on their classification. Chapter 13 bankruptcy trustees in Michigan usually do not pursue such preferential payments unless extraordinarily large because in a Chapter 13, creditors are being paid either all or more likely a portion of the debt that is owed to them, and so long as the proposed plan proposes an amount that would equal what they would be paid had a Chapter 7 trustee recovered the money and made distributions to the creditors, they won’t pursue recovery of the money.  In the Detroit bankruptcy court, where I practice, most of the trustees really don’t want to pursue family members for recovery of a pre-petition insider repayment.  They usually would much rather work out a settlement and typically contact my office asking if my client would like to work something out, and most clients are happy to do so because they don’t want their family members involved in their bankruptcy.  

Earlier in this post I mentioned that I also ask my clients if they have paid any close friends back any money they owed them in the past year.  The reason I ask this is that Chapter 7 bankruptcy trustees will often ask this question because there is bankruptcy case law that allows recovery of preferential payments made to what are called non-statutory insiders or people with whom the debtor has a very close relationship with such as a fiance’.  For an interesting analysis and discussion of insider preference law read this case opinion written by our own Detroit Bankruptcy Judge Mark Randon In re: Peggy Lynn Torpey