It is not a good idea to repay personal loans prior to filing bankruptcy.
“Personal loans” are, simply, amounts of money borrowed for personal and not commercial use from lenders which require fixed installment payments at some agreed-upon interest rate.
However, to many people, a “personal loan” is also an amount of money borrowed from someone of personal acquaintance—a friend or family member.
This article is concerned with that second definition of “personal loan.”
If you are considering filing a Chapter 7 or Chapter 13 bankruptcy, it may seem as though hurrying to repay money owed to a friend or family member is the right thing to do. After all, everyone wants to leave those closest “out of the bankruptcy.”
However, this can backfire in a serious way.
If you owe money to a friend or family member when you file a Chapter 7 or Chapter 13 bankruptcy, there is no way to “leave them out of it.”
In either form of bankruptcy, all debts must be disclosed under penalty of perjury. Money paid to creditors whether commercial or “personal” within certain time periods prior to the filing of the bankruptcy case must be disclosed under that same penalty of perjury.
When the creditor you’ve repaid is a spouse, family member, a boss, or someone else that the Bankruptcy Code (the Federal statute governing the bankruptcy process in the US) defines as an “insider,” that pre-filing time-period is longer than for commercial creditors.
In a Chapter 7 bankruptcy, personal loans repaid prior to filing the bankruptcy case can be recovered by the Chapter 7 Trustee as so-called “preference payments” in order that the funds repaid be equitably distributed amongst all of your creditors.
In other words, repaying a personal loan prior to filing bankruptcy can be a good, fast way to have your family member or acquaintance to whom you repaid the money sued by the Chapter 7 Trustee.
Chapter 7 and Chapter 13 Bankruptcy: All Unsecured Creditors Must Be Similarly Treated
The first thing to keep in mind when attempting to answer the “Why??” question is that, under the Bankruptcy Code, creditors are classified by the type of debt owed to them: secured (debts with collateral attached, such as a home loan or car loan), priority unsecured (debts with no collateral attached but which are given some priority by the Bankruptcy Code, such as child support or recent tax debts owed), and unsecured (debts with no collateral attached that are not given priority status by the Bankruptcy Code).
Within each classification of debt, the Bankruptcy Code requires all creditors to be treated similarly within the Chapter 7 or Chapter 13 bankruptcy case.
With regard to the non-priority unsecured debt class of creditors, in particular, if one such creditor is to receive $X amount from your bankruptcy case, ALL non-priority unsecured creditors must receive the same amount.
Personal loans from friends, relatives, and others are simply non-priority unsecured debts treated no differently under the Bankruptcy Code’s classification than credit card bills, medical bills, and other unsecured debts.
Just because you borrow $1,000 from your grandmother does not mean that that particular unsecured debt deserves any special treatment under the Bankruptcy Code.
Received “Preference” Payments Prior to Filing Can Be Pursued by the Chapter 7 Trustee
Thus, if any unsecured creditor is to receive any money from your Chapter 7 or Chapter 13 bankruptcy case, the Bankruptcy Code says that ALL unsecured creditors must receive the same amount.
So how does this affect the grandmother to whom you repaid $900 eight months prior to the filing of your Chapter 7 case?
Prior to the filing of the bankruptcy petition, there is a 90-day period of time known as the “preference period,” in which any payments larger than $599.99 made to unsecured creditors must be disclosed in the portion of the petition known as the Statement of Financial Affairs, or SOFA.
If the creditor is not a commercial creditor but a personal creditor, the preference period is not 90 days but 1 year.
A personal creditor, in Bankruptcy parlance, is known as an “insider.”
An “insider” is defined by the Bankruptcy Code as a family-member such as a mother or spouse or grandmother, a business enterprise which you have some involvement or ownership interest in, someone else who has influence over you, including, under certain circumstances, a personal friend.
If you have repaid $600 or more to an insider over the 1-year pre-filing preference period to an insider prior to filing a Chapter 7, the Chapter 7 Trustee assigned to the case has the power to recover this so-called “preference payment.”
In other words, the Trustee can demand the funds with the full power of Federal law and the US Bankruptcy Code behind him or her, and, if they are not turned over, can seek a judgment in Bankruptcy Court against your family member.
All told, you’re better off listing your grandmother as a creditor and repaying her later on, after you’ve filed, than hurrying to repay her before you file your petition.
Preference Payments Already Made: Chapter 7 Bankruptcy Options
Regularly, however, such repayments have already occurred prior to the debtor seeking the counsel of an experienced bankruptcy attorney.
Even 10 months ahead of an initial consultation with a bankruptcy lawyer, you may have already repaid a personal loan simply because you planned on doing so anyway, without any knowledge that, nearly a year later, you might consider a Chapter 7 bankruptcy.
There are options available when this has occurred.
The most obvious is to wait until 1 year + 1 day has passed from the date you repaid the personal loan before filing. However, this option may not be available to many who seek the protection of the Bankruptcy Court in order to stop a collection lawsuit or wage or bank account garnishment.
The next option is to disclose the transfer of funds in your Chapter 7 petition, file anyway, and—hope for the best.
If the amount is just at the $600 level, or just above, it is possible that the Chapter 7 Trustee will not view this as worth pursuing.
If this is not the case, it is also possible, at the point that the Chapter 7 Trustee expresses an interest in pursuing the preference recovery, to negotiate a settlement of the Chapter 7 Trustee’s cause of action on behalf of grandmother so that she is left alone.
Otherwise, there are several defenses to a Trustee’s ability to pursue a preference payment or alleged fraudulent transfer. It is possible to resist the Trustee’s preference recovery powers, under certain circumstances.
However, it is important to remember that, ultimately, a preference recovery action by a Chapter 7 Trustee is a legal contest involving 2 parties: (1) the Trustee; and (2) the person you repaid the money to.
Who is left out of the equation? You.
You have no legal “standing” to defend the preference recovery action of a Chapter 7 Trustee. It’s grandmother’s fight, at that point. Your bankruptcy lawyer, further, will not be able to represent grandmother in her defense of the preference recovery action: it is a legal conflict of interest. You are your bankruptcy lawyer’s client, not your grandmother!
Your grandmother will need to hire her own lawyer to exercise the various legal defenses to a preference recovery action.
Finally, a further option is to file a Chapter 13 bankruptcy rather than a Chapter 7 bankruptcy if you have a serious preference payment issue and cannot wait to obtain the protection of the bankruptcy process.
A Chapter 13 bankruptcy is not a “liquidation” bankruptcy in which assets are pursued and recovered in order to be distributed to creditors as is a Chapter 7.
In a Chapter 13 bankruptcy, you “fund” the bankruptcy process with monthly payments over 3-5 years instead. Creditors are repaid some of what they are owed through the payments you make in a Chapter 13 bankruptcy.
Thus, the Chapter 13 Trustee is not legally empowered to pursue preference payments or other asset liquidation.
Although the bankruptcy petition still requires that such payments are disclosed, your grandmother will never be pursued by a Chapter 13 Trustee.
Personal Loan Preference Payments Prior to Chapter 7 or Chapter 13 Bankruptcy Filing: The Bottom Line
Following a Chapter 7 bankruptcy or a Chapter 13 bankruptcy, you may repay any debt you choose regardless of the fact that it has been formally discharged in bankruptcy.
There is nothing in the US Bankruptcy Code or Michigan state law which prevents you from voluntarily repaying a debt that has been discharged in bankruptcy. Therefore, debtors with outstanding debts to friends or family-members for personal or other types of loans do not lose the ability to repay those loans.
The bottom-line is that the possibility of preference payments to relatives made prior to filing affecting other people you care about after you file for bankruptcy is one of the primary reasons why you should consult an experienced Michigan bankruptcy attorney before proceeding into a Chapter 7.
Attorney Walter Metzen has represented over 20,000 consumers in Chapter 7 and Chapter 13 bankruptcy cases in Michigan. A Board Certified Bankruptcy Expert, Attorney Metzen has dealt with Chapter 7 Trustee and preference payment issues for over 20 years.
The Law Offices of Walter A. Metzen & Associates offers free consultations for those interested in the bankruptcy process and is experienced in determining and advising as to the best course of action when filing a Chapter 7 or Chapter 13 bankruptcy in Michigan.