Why You Should Never Repay Money You Owe Mom Before Filing Bankruptcy

Avoid Making Preferential Payments to Insiders Before Filing BankruptcyGiven the choice of paying back debts to strangers, like credit card companies, and paying back a debt to a family member or other “insider,” nearly everyone would of course choose to pay back the family member first, right? Of course they would. Doing so within one year before filing bankruptcy, however, may be the single most damaging action a debtor can take before filing his bankruptcy case, at least as far as his family member is concerned. This is because the Bankruptcy Code, in Section 547(b), provides the bankruptcy trustee with the power to recover or “avoid” such “preferential payments” to creditors prior to a bankruptcy filing. With respect to “insiders” (including the bankruptcy debtor’s family members, business partners, and businesses owned by the debtor), the preference period is one year prior to the bankruptcy filing.

The concept underlying Bankruptcy Code Section 547(b) is supposed to be an equitable principle aimed at requiring a more “fair” distribution of a bankruptcy debtor’s assets to all of his creditors so that some creditors do not receive “preferential” repayment while others receive nothing.  Payments of over $600 to unsecured creditors who are strangers to the bankruptcy debtor, like credit card companies, can be “avoided” by the bankruptcy trustee if made within 90 days before the bankruptcy filing.  Creditors who are family members and other “insiders” of the debtor, however, who may not be in much better financial straits than the debtor himself, often suffer tremendous collateral damage because any money repaid to them within one year before the bankruptcy filing can be clawed back by the bankruptcy trustee.

Many years ago, I was contacted by a distraught elderly woman whose son had recently filed Chapter 7 bankruptcy in Southern California. She had recently received a tersely worded demand letter from the Chapter 7 trustee in her son’s bankruptcy case, in which the trustee demanded that she turnover $20,000 to the trustee or he would sue her. Several years before that, the son had borrowed twenty thousand dollars from his mother for a down payment on his home. In the intervening years, the son had renovated the property, and since this was in the early 2000s, he was able to sell the home at a small profit. Shortly after the sale, the son made good on his debt to his mother and repaid her the $20,000 in full. Unfortunately, he had no idea at that time that both he and his wife were about to lose their jobs (he was an independent contractor ineligible to receive unemployment), and just about nine months later, he and his wife found themselves filing Chapter 7 bankruptcy due to mounting credit cards and other debts.

Sadly, the son was not given good advice from his bankruptcy attorney, and it was never explained to him that the repayment of the loan to his mother, just nine months before filing his Chapter 7 case, would trigger a demand by the bankruptcy trustee that his mother return the money repaid to her.  Had the son received good advice from his bankruptcy lawyer, he could have waited just another three months before filing the Chapter 7 case, so that the trustee would have no power to recover the money repaid to the mother.

Fortunately, unlike so many bankruptcy cases just like this one, this story has a happy ending. I represented the mother against the Chapter 7 bankruptcy trustee, and we were able to defeat the trustee’s claim due to some very unusual circumstances. When the bankruptcy debtor’s mother received the $20,000 repaid to her, unbeknownst to the son, she deposited that money into an account for the benefit of her son.  For whatever reason, she was prescient at the time that her son might need that money again in the near future.  When the son and his wife lost their jobs, the mother had slowly given them money from that account to help support them over the subsequent months while the son and his wife looked for work. She never kept even one dollar of the money for herself.

In the end we traced checks written from that account for the entirety of the $20,000 paid back to the son.  He did not know at the time that this was the very same money he had repaid his mother, but this fact allowed us to defeat the Chapter 7 bankruptcy trustee’s claim to the money because under Bankruptcy Code section 547(c)(4), the son had received back “new value” equivalent to the preferential payment, and in fact, the mother had received no benefit at all.

These facts, however, are very rare. In most cases involving a preferential payment to an insider, the bankruptcy trustee wins, and the family member suffers. This is just another reason why, if you are thinking about filing bankruptcy, it is so crucial that you seek the advice of an experienced bankruptcy attorney.

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