Bankruptcy doesn’t just stop garnishments and other collections. Sometimes you can make a creditor return money it recently took from you.
Bankruptcy’s “automatic stay” is one of the most immediate and powerful benefits of bankruptcy. It immediately stops almost all creditor collection actions against you, your income, and your assets. See Section 362 of the U.S. Bankruptcy Code.
But it does not go into effect until the moment you file your bankruptcy case. What if a creditor garnishes or otherwise gets your money right BEFORE you file bankruptcy?
Sometimes the creditor can be forced to give up such recently received money as well.
The Law of Preferences
This happens through the surprising and easily misunderstood law of “preferences.”
This law says that if a creditor takes money (or some other asset) from you within the 90 days before you file your bankruptcy case, the creditor may need to pay it back. It has to do so if keeping that money results in that creditor receiving a greater share of its debt than the rest of your creditors would get out of your bankruptcy case. See Section 547(b) of the Bankruptcy Code.
That second condition would often be met, especially in a consumer Chapter 7 “straight bankruptcy case.” So, most money grabbed by an unsecured creditor within 90 days before your bankruptcy filing can be “avoided.” The creditor can be forced to return it.
For example, let’s say an aggressive unsecured medical debt collector garnishes your checking account. You’ve just deposited your paycheck and the creditor grabs $2,000. You owed $5,000 so this creditor just got paid 40% of its debt. Then you file your Chapter 7 case a day after the creditor garnished your money. Assume you owe a total of $75,000 in general unsecured debts. If in that Chapter 7 case—as in most—all your assets were “exempt” (protected), those debts would receive nothing. So, the garnished $2,000 would be a preferential payment that could be reversed. That’s because it happened within 90 days before filing and resulted in the creditor getting 40% instead of nothing.
(There are a number of other conditions and exceptions to a preference, but they often don’t apply to consumer cases. However, preference law can sometimes get quite complicated. You need to talk with your bankruptcy lawyer to find out if you really have an avoidable “preferential payment.”)
The Principles behind Preference Law
Preference law serves two principles important to bankruptcy.
First, bankruptcy law tries to discourage overaggressive creditors. The risk that a creditor would have to return money grabbed just before the debtor files bankruptcy is supposed to be a disincentive for such a money grab.
Second, a lot of bankruptcy law focuses on maintaining fairness among creditors. Similarly situated creditors should be treated the same. No playing favorites unless there is a legally appropriate reason to do so. (On such reason would be if the debt is secured by collateral).
This fairness means that legally similar creditors need to be treated the same not just during your bankruptcy case but also shortly before the filing of your case. The period of fairness extends a bit before the bankruptcy filing so that overly aggressive creditors aren’t favored. Any available money or assets are spread among all the creditors more evenly and thus more fairly.
A Preference Benefitting You
It’s all well and good to punish a creditor for grabbing money from you shortly before you file bankruptcy. But what good does it do you if that money just goes to your Chapter 7 trustee? The trustee would just distribute that money among your other creditors, right?
Generally, yes. But in many circumstances this preference money helps you very directly. Next time we’ll show you how.