401k Loans and Bankruptcy

[Guest Una M]

If a participant has a 401k loan and files for personal bankruptcy, is he required to default on that loan rather than be seen to be paying himself for a loan? This is what his atty. has said but it seems wrong to me. If he is getting a paycheck, then shouldn't he continue to pay the loan off? Also isn't bankruptcy somehting that can't touch on your 401k plan, but doe that apply to loans? Thanks for any input.

[jpod]

The bankruptcy courts have, for the most part, ordered that participants stop repaying their plan loans. While recognizing that a plan loan default triggers adverse tax consequences and adds further salt to the participant's wounds in a bankruptcy situation, the courts' attitude is that a plan loan is in reality a fiction and money should not be going into the participant's plan account that could go to his/her creditors. If you can find the May/June 2000 edition of the Compensation & Benefits Review (Sage Publications), you'll see an article on the subject at page 54.

[RCK]

I agree.

Upon receiving a bankruptcy notice, we automatically suspend loan payments and follow our normal loan default provisions. We will continue or restart loan payments only if requested to do so by the participant and approved to do so by the court.

[k man]

I am in agreement although the authority on the issue only comes from a couple of federal circuits. I would tend to agree that the participant's repayment would be a preference not allowed by the bankruptcy court or trustee.

[Medusa]

We recently received a bankruptcy notice instructing us to transfer loan payments that have been made since March (the effective date of the bankruptcy, I think) to the bankruptcy trustee. I do not think I have any basis to do this, has anyone seen anything similar?

[k man]

medusa, i think you have a problem on this one. the loan payments are what is known as voidable preferences. the participant is essentially favoring himself when paying back the loan to the detriment of other creditors. thus, i would immediately stop taking them in light of the pending bankruptcy proceedings. however, the money already in the plan is another question. on the one hand it was improperly contributed to the plan; but on the other hand it is a plan asset now so you have to be careful about taking it out.

Consequently, before taking any participant money out of the plan, I would request the the trustee obtain an order from the bankruptcy judge directing you one way or the other.

[Kirk Maldonado]

You might also want to solicit guidance from the DOL.

[Guest ERISAweasel]

Originally posted by k man

the loan payments are what is known as voidable preferences.  the participant is essentially favoring himself when paying back the loan to the detriment of other creditors.  thus, i would immediately stop taking them in light of the pending bankruptcy proceedings.

These loan payments might, or might not, be voidable preferences. It depends on facts and circumstances -- it is possible that the loan payments might, indeed, qualify for one of the many exceptions to the voidable preference rules. The debtor might be able to show that it meets an exception under 11 USC 547© -- many loan repayments qualify for the "ordinary course" of business exceptions under 11 USC 547©(2). So, unless the participant made unusually large loan repayments in the 90 days preceding bankruptcy and while the participant was insolvent, there's a good possibility that these loan payments were not voidable preferences.

[k man]

well whether or not they meet the definition of voidable preferences as such does not change that the ninth circuit is on the record as saying that the participants in bankruptcy cannot make payments to themselves at the expense of other creditors.

[david rigby]

Does it make a difference whether the loan is "to himself" or as an investment of the plan?

[Guest ERISAweasel]

Originally posted by k man

well whether or not they meet the definition of voidable preferences as such does not change that the ninth circuit is on the record as saying that the participants in bankruptcy cannot make payments to themselves at the expense of other creditors.

Without seeing the case you cite, I cannot comment as the underlying facts are unknown to me. Can you provide me with a cite?

[k man]

I think there are many arguments that can be made and there really is not alot of case law on the subject thats why i suggested getting an order from the bankrupcty court. here is an excerpt from the case i mentioned. it was actually out of the 6th circuit.

In addition, the court found that while the bankruptcy code exempts a debtor's interest in a qualified plan from the bankruptcy estate, this only applies to the funds already in her account, including the amounts she repaid on the loan prior to filing for bankruptcy. It does not apply, however, to money to repay the loan in the future. As a result, the bankruptcy plan was required to treat the loan repayments as part of the participant's disposable income in the bankruptcy estate and available to creditors, the court said.

see In re: Robert H. Harshbarger, et al., United States Court of Appeals, Sixth Circuit, No. 94-3090, September 19, 1995 (CCH cite ¶23,915Z)

[Guest ERISAweasel]

The 6th Circuit's decision makes absolute sense -- for Chapter 13 bankruptcies: future loan payments to a plan are essentially loan payments being made to an unsecured creditor and therefore must be treated like payments to any other creditor. In a Chapter 13 repayment plan, the court looks at the participant's "disposable income" and looks at the participant's proposed plan to see if it makes sense (if approved by the court, the debtor gets to 'cram down' the terms of the repayment plan on the unsecured creditors). If none of the debtor's other unsecured creditors are getting anything out of the bankruptcy estate -- then why should the participant be able to make loan payments (on an unsecured loan) which inure to the participant's benefit?

In the Chapter 7 situation, loan payments could continue to be made because the participant's income earned after filing for bankruptcy is not part of the bankruptcy estate and pre-bankruptcy creditors cannot go after the participant's future income.

None of the above addresses the question of voidable preferences in which the debtor/bankruptcy trustee tries to unwind "unusual" payments from the debtor to creditors during the 90 day period preceding bankruptcy. If the court were to find the loan payments were voidable preferences, certainly the court would issue an order to that effect. Now you've got a problem because ERISA and the Internal Revenue Code don't recognize the return of plan assets on account of voidable preferences under the Bankruptcy Code (unless the payments were mistake of fact or non-deductible contributions, right?).

It's an interesting question. I agree that the Department of Labor ought to be contacted for their view of the situation.