What happens to a family loan when the borrower files for bankruptcy?

You lent your brother money, he signed a promissory note, and now a letter from a bankruptcy court has arrived. When a borrower files for bankruptcy, the loan becomes a claim in a federal court case, and the rules for collecting it change the day the case is filed. One of those rules can require a family lender to hand back money they already received.

This piece is written for relatives and friends who lent on a note. For the general mechanics, see our overview of promissory notes in bankruptcy. This is general information, and a bankruptcy attorney can tell you how the rules apply to your loan.

Stop asking for payment the day they file

Filing a bankruptcy petition triggers the automatic stay. The automatic stay is a court order that takes effect on its own and freezes most collection activity against the person who filed. The Bankruptcy Code lists what it blocks, including "any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case."

For a family lender, that covers more than lawsuits. A text asking when you will be paid, a reminder at a birthday dinner, or a request to a parent to lean on the borrower can all count as acts to collect. A creditor who willfully violates the stay can owe damages. The safest course is to say nothing about the loan until the case is over, other than through the court process.

Chapter 7 and Chapter 13 treat your loan differently

Most individuals file under one of two chapters. The chapter largely decides if you will see any money at all.

Chapter 7 is a liquidation. The U.S. Courts describe it as the sale of a debtor's nonexempt property and the distribution of the proceeds to creditors. In practice, the U.S. Courts note that most Chapter 7 cases filed by individuals are "no asset" cases, where nothing is left for unsecured creditors. At the end, the court grants a discharge. A discharge is the court order that wipes out the borrower's personal obligation to pay covered debts. An unsecured family loan is usually one of them.

Chapter 13 is a repayment plan. The borrower keeps their property and pays creditors in installments over three to five years, following a plan the court approves. An unsecured family loan is typically paid a share of what is owed through the plan, sometimes a small share, and the remaining balance is discharged when the plan is completed.

In either chapter, you usually have to file a proof of claim to be paid anything. Watch the court notice for the deadline and file before it passes.

The one-year clawback that catches family lenders

This is the rule most family lenders never hear about until it is too late. A bankruptcy trustee can recover certain payments the borrower made to creditors shortly before filing. These are called preferences. A preference is a payment that puts one creditor ahead of the others on the eve of bankruptcy, and the trustee can require the creditor to give it back so it can be shared among all creditors.

For an ordinary creditor, the look-back window is 90 days before the filing. For an insider, it is much longer. The Bankruptcy Code reaches payments made "between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider."

An insider is a person with a close relationship to the borrower. When the borrower is an individual, the definition of insider includes a "relative of the debtor." That means a parent, sibling, or other relative who was repaid on a family loan in the year before the filing can receive a letter from the trustee asking for that money back.

Some defenses exist. One protects payments of a debt incurred in the ordinary course of the parties' financial affairs, made on ordinary terms. Whether a family loan qualifies depends on the facts, and an attorney can tell you whether it applies. If a relative who is struggling offers to pay you back first before they file, understand that the trustee may later ask you to return it.

Co-signers usually stay on the hook

A discharge releases the borrower who filed. It does not release a co-signer or a guarantor, who generally remains liable for the full balance. If your note has a co-signer, you may be able to pursue them after the borrower's discharge.

Chapter 13 adds a wrinkle. It includes a codebtor stay, which pauses collection from a co-signer on a consumer debt while the case is open. The Bankruptcy Code says a creditor "may not act, or commence or continue any civil action, to collect all or any part of a consumer debt of the debtor from any individual that is liable on such debt with the debtor." The court can lift that stay in some situations, such as when the plan does not propose to pay the debt.

Some debts survive, but only if you act

Not every debt is discharged. A debt obtained through false pretenses, a false representation, or actual fraud can be excluded from the discharge. A loan made because the borrower lied about what the money was for, or about repaying it, may fall in that category.

That exception does not apply automatically. For fraud debts, the borrower is discharged unless the creditor asks the court to rule otherwise, after notice and a hearing. In practice that means filing a complaint in the bankruptcy case before a deadline set by the court. If you believe the loan was obtained by fraud, speak with an attorney quickly, because missing the deadline usually ends the argument.

Reaffirmation and voluntary repayment

A borrower can choose to keep owing a particular debt by signing a reaffirmation agreement. The law surrounds these agreements with safeguards, and the borrower can back out within a set period. You cannot pressure a relative to reaffirm, and pressure can create its own problems in court.

After a discharge, nothing stops a borrower from paying you back on their own. The Bankruptcy Code says plainly that its discharge provisions do not prevent "a debtor from voluntarily repaying any debt." Many families work things out this way over time. The choice belongs entirely to the borrower. You can accept a voluntary payment, but you cannot ask for one, demand one, or treat the old note as still enforceable.

What to do this week

First, stop every form of collection, including casual reminders. Second, read the notice from the court, which names the chapter, the case number, and the deadlines. Third, gather your records: the signed note, a ledger of every payment you received and when, and any messages about the loan. The payment dates matter because they decide whether the one-year clawback could reach you.

Then file a proof of claim if the notice says creditors should. If you received repayments in the year before the filing, or you think the loan was obtained by fraud, talk to a bankruptcy attorney before the deadlines run. If your loan is documented properly, you will also know exactly how long you would have had to collect outside bankruptcy, which can help if the case is dismissed rather than discharged.

Sources

• 11 U.S.C. 362, automatic stay (uscode.house.gov)
• 11 U.S.C. 547, preferences (uscode.house.gov)
• 11 U.S.C. 101, definitions including insider (uscode.house.gov)
• 11 U.S.C. 523, exceptions to discharge (uscode.house.gov)
• 11 U.S.C. 524, effect of discharge (uscode.house.gov)
• 11 U.S.C. 1301, stay of action against codebtor (uscode.house.gov)
• U.S. Courts, Chapter 7 bankruptcy basics
• U.S. Courts, Chapter 13 bankruptcy basics