Son must reimburse mother’s bankruptcy trustee

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As counterintuitive as it may seem to a client preparing for bankruptcy who has a debt guaranteed by a relative, the best thing he or she can do is to stop making payments on it.

The insolvent client may instinctively want to continue paying down that debt during the period preceding bankruptcy, so as to reduce the amount their relative will owe.

But any money repaid on such a loan is money wasted, and won’t reduce the sum total the relative must pay.

A recent opinion by U.S. Bankruptcy Judge Thomas Utschig holds that an entire year’s worth of a debtor’s payments to a creditor were preferential transfers to her son, who guaranteed the loan. So, not only is the son now on the hook to the bank for the balance of the loan; he also owes his mother’s bankruptcy trustee the entire year’s worth of payments that she made to the bank.

Utschig recognized that the result may be “unfortunate.” But he concluded that the Bankruptcy Code requires it, because the payments to the bank had the effect of benefiting him, while other creditors went unpaid. “[T]he code applies to all cases and requires the recovery of preferential transfers even where the [son] did nothing except receive a benefit Congress directed should be spread among all unsecured creditors,” he said.

When Carol Halling was unable to obtain a loan from Hiawatha National Bank to pay her late husband’s debts and funeral expenses, her son Greg Halling agreed to guarantee the loan and pledge his own real property as collateral.

Monthly payments were $342; accordingly, Carol Halling paid roughly $4,100 to the bank during the year prior to filing bankruptcy.

When Carol filed bankruptcy in 2010, the trustee filed an adversary action against Greg, seeking to recover the year’s worth of payments. On May 9, Utschig granted summary judgment in favor of the trustee, and ordered Greg to pay.

Normally, preferential transfers to creditors must be repaid to the bankruptcy estate only if they are made less than 90 days prior to filing for bankruptcy. But for payments made to insiders, a class that includes relatives, the period is one year.

The court acknowledged that the bank, which actually received the payments, is not an insider under 11 U.S.C. 101(31)(A)(i). But because Greg guaranteed the debt, and thus has a contingent right to repayment from Carol in the event the guarantee is called, Greg is also a creditor who benefited from his mother’s payments to the bank.

Greg argued he should not be deemed a creditor, because he would “never” attempt to seek repayment from Carol. But the court found that irrelevant.

“While that is an admirable sentiment, the bankruptcy code focuses upon what he has a RIGHT to do,” the court explained. “Certainly in the absence of a waiver of his subrogation rights, Mr. Halling has a contingent ‘right to payment’ from his mother. … Consequently, her payments to the bank were for his benefit because each reduction in the debt reduced his possible exposure to the bank.”

Accordingly, the court ordered Greg to reimburse the trustee more than $4,100 that his mother had paid the bank during the year prior to filing.

Analysis

When advising clients who wish to guarantee a relative’s loan, it would be wise to ask whether, if the relative were to default, they would exercise their subrogation rights.

If the answer is, as the son in this case said, “never,” a waiver of subrogation rights should be considered at the time of loan.

Arguably, the son is only a creditor under the Code because he did not waive his rights. If there were a waiver in this case, he technically would not be a creditor, and thus not liable to the trustee for the last year’s payments.

This may not work, however. The court noted that courts are divided on whether such waivers are enforceable, or are a “sham” that attempts to contravene the Code.

Nevertheless, if a client is certain that under no circumstances would he enforce his rights, or if he believes that any attempt to do so would be futile anyway, a waiver of his right to collect may actually save him money in the long run.

What the Court Held

Case: In re: Halling, No. 10-14488-7

Issue: Are a debtor’s payments to a creditor preferential transfers when a relative of the debtor has guaranteed the debt?

Holding: Yes. The relative is a creditor who benefits because each payment to the creditor reduces the relative’s potential exposure.

Attorneys: For Plaintiff: Randi Osberg, Christopher Seelen, Eau Claire; For Defendant: Robert Wertheimer, Hudson.

David Ziemer can be reached at [email protected].