The bankruptcy debtor is always in the best position to know his or her financial condition. Because the debtor thinks, worries, and sometimes obsesses over unpaid debt, occasionally a light bulb goes off that appears to fix a financial problem. The remaining question is whether the bankruptcy law will permit the debtor’s clever idea, or will acting on this idea make matters worse.
In theory, giving a security interest before bankruptcy can protect otherwise non-exempt property during the bankruptcy case. For example: suppose the debtor “borrowed” money from mom to buy a car. No lien was ever recorded (because good sons always repay their mothers!). On the eve of bankruptcy, the debtor owes mom $8,000 and the car is worth $8,000 (or $5,000 more than his state’s exemption law will allow him to protect). So, the debtor can simply give his mother an $8,000 secured interest in the car, right? Then the Chapter 7 trustee would have to pay mom $8,000 should he liquidate the car. In other words, the car is fully secured, mom’s secured interest survives the bankruptcy (and the debt may be reaffirmed by the good son), and there is no longer an equity issue. A light bulb moment if there ever was one!
Unfortunately, this type of secured interest given on the eve of bankruptcy is a preferential transfer that the trustee can avoid. The trustee can sell the property without paying mom (who would be just a general, unsecured creditor after the lien is avoided). If you give a security interest to friends or relatives, you must wait to file bankruptcy (three months or a year for friends, one year for relatives) or the trustee can sue them to cancel the security interest.
When you are in financial trouble and considering bankruptcy, speak with your attorney before acting on a “bright idea.” There is no prohibition against pre-bankruptcy planning to ensure that you protect your property and discharge your debts. In fact, it is expected and even encouraged by the courts. However, moving assets around and securing property without legal advice before bankruptcy can result in trouble during the case.