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What Is An Insider Creditor In Bankruptcy?

Bankruptcy laws try to balance the rights of the debtor and those of creditors in the case. Some of these laws can seem unfair from the honest debtor’s perspective. One such section of the Bankruptcy Code permits a bankruptcy trustee (and sometimes a debtor) to force a creditor to turnover payments received from the debtor on the eve of bankruptcy.

The idea is that a financially troubled debtor tends to pay only certain “preferred” creditor obligations, whether out of loyalty or necessity, due to insufficient cash flow. Allowing the trustee to avoid preference payments, return the money to the bankruptcy estate, and distribute the funds equally is seen as promoting fair play and equality among all creditors.

Not all payments prior to bankruptcy qualify as preference payments. Section 547 of the Bankruptcy Code describes a preference payment. In a nutshell, a preference payment is:

  • A transfer
  • of an interest of the Debtor in property;
  • to or for the benefit of a creditor;
  • for or on account of an antecedent debt owed by the Debtor before such transfer was made;
  • made while the Debtor was insolvent (the Debtor being presumed to be insolvent within the 90-day period preceding the filing of a petition); and
  • made within 90 days before the filing of the bankruptcy petition (or within one year if the creditor was an insider); and
  • that enables the creditor to receive more than such creditor would have received in the case were a Chapter 7 liquidation proceeding

A preference payment is especially nasty business when a family member is involved. Family members are considered “insider creditors,” which the Bankruptcy Code defines as relatives, general partners, partnerships in which the debtor is a general partner, director, officer, person in control, affiliate, and insiders of affiliates of the debtor.

Can you void a preference payment?

Preference payments may be avoided if made within 90 days of a bankruptcy filing, but preference payments to insider creditors may be avoided for up to one year!

Suppose that you borrow $14,400 from your mother to purchase a car. Your mother does not make you sign a promissory note, and does not record herself as lien holder on the vehicle. You agree (orally) to pay your mother $400.00 each month for three years, and you faithfully follow through with your obligation. Unfortunately, after two years of payments you lose your job and are forced to file Chapter 7 bankruptcy.

The Statement of Financial Affairs included in your bankruptcy paperwork requires you to disclose all payments made to insiders within one year of filing bankruptcy.

Within that one year look-back period you have made $4,800 in total payments. The trustee asks you about the payments during your 341 meeting, and informs you that he will seek to recover those payments from your mother as preference payments to an insider creditor.

What can you do?

First, there are some threshold questions that may offer some relief. The first issues are practical concerns for the trustee. The trustee will send a letter to the creditor (your mother) and demand refund of all payments made within the one year preference period.

If the creditor is unable or unwilling to comply, the trustee has real work to do. Of course, if it is obvious that it is unlikely the money is collectible, the trustee may abandon his interest.

If the trustee decides to go forward, an attorney must be appointed to represent the bankruptcy estate (in some cases a trustee licensed by the state bar may be appointed to represent the estate).

There is also a concern about proper venue. Section 1409(b) of Title 28 of the US. Code states that for small dollar preference cases, the collection case must be litigated where the creditor does business and not necessarily where the bankruptcy case is pending (although there has been litigation over this matter with courts coming to different conclusions).

That means that if you live in Connecticut, and your mother lives in Rhode Island, the trustee must litigate the case in Rhode Island. The attorney prosecuting the case must also be authorized to practice in that court, and there is an added concern for the trustee regarding local court rules and customs that may be foreign to the trustee.

What happens after a lawsuit is filed?

Once the insider preference lawsuit is filed, the trustee must meet a burden of proof in order to prevail. The trustee must prove that:

Transfer: The Bankruptcy Code broadly defines a transfer as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor’s equity of redemption.”

Property of the Debtor: Excluded is property held by the debtor in trust for another. For instance, if your daughter paid you and you paid your mother.

To or for the Benefit of a Creditor: A creditor may be the recipient of an indirect transfer, such as payment by a debtor on a debt guaranteed by a third party.

Antecedent Debt: A debt that arose prior to the transfer. A debt is considered to arise at the time the debtor becomes legally obligated to pay it.

Insolvency: For preference purposes, a debtor is presumed to be insolvent during the ninety-day period immediately preceding the filing date. Insolvency of the debtor must be determined for each transfer in question.

Time of Transfer: The period applicable to insiders is one year prior to the bankruptcy filing.
Receipt of More Than Under Chapter 7. Secured creditors are immune from preference liability because valid and perfected liens are unaffected by the bankruptcy. However, if the debt is only partially secured, the creditor may receive a preference to the extent its secured position is improved during the preference period.

Finally, if the trustee is able to meet his burden for proving a preferential transfer, the there are defenses available. Three of the most commonly used in an individual bankruptcy are: the Ordinary Course of Business Defense, the Contemporaneous Exchange Defense, and the Small Commercial Preference Defense.

Ordinary Course of Business: In order to prevail with this defense the debtor must show that the debt was incurred in the ordinary course of business between the two parties, was paid according to the ordinary course of business between the two parties OR paid according to ordinary business terms as are customary in the industry.

A recent bankruptcy case out of the Eastern District of Wisconsin, In re Grisham, No. 12-25938 (February 2013), states that repayment of a personal loan to a family member could fall under the ordinary course defense.

The debtor in this case lost after providing evidence that it was in her ordinary course of financial affairs to borrow money from her uncle and repay it through wage deductions, but failed to present evidence that it was in her uncle’s ordinary course to make such loans.

Contemporaneous Exchange: This defense centers on when the preference payment was received. A preferential transfer may not be avoided if it was intended by the debtor and the creditor to be, and in fact was, a contemporaneous exchange for new value given to the debtor and the antecedent debt of the creditor was not affected by the debtor’s payment. An example of a contemporaneous exchange is a purchase situation: you pay your mother $2,000 and she gives you her car.

Small Commercial Preference Defense: Section 547(c)(9) of the Bankruptcy Code limits transfers could be avoided in a commercial case (currently amounts less than $6,225). This section specifically provides, “if, in a case filed by a debtor whose debts are not primarily consumer debts, the aggregate value of all property that constitutes or is affected by such transfer is less than [$6,225].” This section applies to an individual debtor who does not have primarily consumer debts.

The bottom line is this: when it comes to bankruptcy, preference issues are complex. Don’t turn over money requested by the trustee until your attorney advises you to do so.