Chapter 7 bankruptcy is designed to treat all creditors of the same priority equally. This means that if a debtor favors a creditor by paying that creditor back more before bankruptcy than it would have received in the bankruptcy, then the bankruptcy trustee may be able to force that preferred creditor to give back the money for equal distribution to all the creditors. The look-back period for preferential payments is 90 days for general creditors and one year for creditors who are “insiders” as defined by bankruptcy law.

This preference issue commonly comes up when a debtor repays a family member (family members fall within the definition of an “insider”) within the one-year preference period. Debtors make these payments because they feel a stronger obligation to pay a family member ahead of unrelated creditors such as banks or credit unions. But, what if the payment is not made to a family member, but rather a close friend?

Bankruptcy cases have expanded the definition of “insider” to include someone with a sufficiently close relationship to the debtor to make the conduct of the debtor subject to close scrutiny. This is known as a non-statutory insider.

However, most cases that describe non-statutory insider preferences are business cases that are discussing business dealings and other business relationships. Even the few cases that have addressed the definition of “insider” when it comes to a close friend have been business cases discussing complex transactions and massive debts.

In 2012, the Arizona Bankruptcy Court issued an Order in an insider preference case that gives good guidance in regards to defining a non-statutory insider in consumer cases. The case is Manera v. Butcher (In re Alekson, Adv. Case No. 2:11-ap-01538-CGC (District of Arizona)).

The Debtor, Ms. Alekson, received $20,000 in proceeds from the sale of her home and used $15,000 of that to repay her close friend Ms. Butcher. The repayment occurred 91 days before Ms. Alekson filed Chapter 7 Bankruptcy. The Chapter 7 Trustee filed an action against Ms. Butcher to recover the $15,000 and argued that she was an insider.

The Bankruptcy Court considered eleven factors and ultimately concluded that the payment was not a preference.

Interestingly, the Court’s key piece of evidence in finding in favor of Ms. Butcher was evidence presented by the Trustee. It was a letter that Ms. Alekson wrote to Ms. Butcher stating that because Ms. Butcher was the only person to lend to her during her time of need, she deserved to get paid-in-full first. The Court noted that there was nothing in the letter suggesting that Ms. Butcher exercised any control over Ms. Alekson to influence the preferential payment. The Court felt that Ms. Alekson’s preference of Ms. Butcher was only due to a feeling of moral fairness. And, the Court held that  “friendship alone is not sufficient to establish insider status in absence of evidence that the friend dominated the debtor.”

It is best to avoid paying back close friends within one year of filing for bankruptcy. No debtor wants to expose a close friend to a lawsuit being filed against the friend by a Bankruptcy Trustee. However, when there is no choice but to file within a year of payments to a friend, use the factors in the Alekson case to convince the bankruptcy trustee that the creditor has to be more than just a friend to be an “insider.”