United States: Preferences: Surprise – Being Fully Secured May Not Be A Complete Defense

Last Updated: December 12 2013
Article by Vicki Harding

Gladstone v. Bank of America, N.A. (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal. 2013) –

A chapter 7 trustee sought to avoid payments made to a fully secured senior mortgagee within 90 days prior to bankruptcy as preferential to an undersecured junior mortgagee.

Property valued at ~$1.1 million was subject to a lien securing senior debt of ~$988,000 and a junior lien of ~$265,000.  The debtors made 10 payments totaling ~$42,000 to the senior mortgagee within 90 days before filing bankruptcy.

Everyone agreed that the senior lender was fully secured, so that the payments were not preferential as to the senior lender (since it did not receive more than it would have in a chapter 7 bankruptcy).  Everyone also agreed that the junior mortgagee was undersecured.  So, the trustee argued that the payments made to the senior lender were preferential as to the junior mortgagee since reducing the fully secured senior claim by $42,000 meant that an additional $42,000 worth of collateral was available for the junior mortgagee in the bankruptcy.

The elements of a preference claim under Section 547(b) of the Bankruptcy Code are that there is a transfer of the debtor's interest in property (1) to or for the benefit of a creditor, (2) for or on account of an antecedent debt, (3) made while the debtor was insolvent, (4) made within 90 days before bankruptcy (or between 90 days and one year before bankruptcy in the case of an insider), (5) that allows the creditor to receive more than it would receive in a chapter 7 bankruptcy.  The two elements at issue in this case were whether the debtor's payments to the senior lender were "to or for the benefit of" the junior creditor, and whether those payments allowed the junior creditor to receive more than it would in a chapter 7.

The junior mortgagee argued that non-insiders who indirectly benefit from a payment are not liable for a preference based on Section 547(i).  However, the court found that this section applies only to (1) transfers between 90 days and one year before bankruptcy, and (2) transfers relating to insiders.  So, it did not provide any protection for an indirect benefit to a non-insider for transfers made within 90 days of bankruptcy.

The junior mortgagee also argued that the payments were not made for its benefit since that was not the intent of the debtors.  However, the court held that the intent of the parties was not relevant.  Rather it is the effect of the transaction that is controlling.  Here the transfer benefited the junior mortgagee since reduction of the senior secured claim meant that the junior creditor's secured claim in the bankruptcy was correspondingly increased.

The court had a more difficult time with the requirement that the junior mortgagee received more than it would have in a chapter 7.  If this requirement was interpreted to mean assessment of a hypothetical liquidation where the trustee sells all assets and distributes the proceeds according to the priorities of the Bankruptcy Code, then the junior mortgagee received more than it would have in a chapter 7.

However, as a practical matter, if assets are over-encumbered in most cases a chapter 7 trustee will simply abandon the property to the debtor.  An abandonment is not a transfer but rather a reversion of property to the debtor subject to all liens, so the junior mortgagee would not really "receive" any payment of its debt in the chapter 7.

In evaluating which approach to adopt, the court noted that the primary purpose of a preference action is to discourage a race to the courthouse by creditors and to insure equal treatment for similarly situated creditors.  In other words, the harm that is being addressed is a payment made to one creditor at the expense of others.  That a harm occurred in this case:  regardless of whether the property was sold and proceeds distributed or the property was abandoned, there was $42,000 that otherwise would have been available to pay unsecured creditors that was removed from their reach (by the payments to the senior creditor and the corresponding increase in the junior creditor's secured claim).  Consequently, the court concluded that the prepetition payments to the senior secured creditor were a preference as to the junior secured creditor.

The court acknowledged that it could be seen as "somewhat unfair to require a creditor such as Junior Lienholder to 'return' money it never physically 'received.'"  However, in addition to noting that the junior creditor might have instigated the payments, the court pointed out that under Section 550 of the Bankruptcy Code a preference can be recovered from either (1) the entity for whose benefit the transfer was made, and (2) the "initial transferee."  In this case the senior and junior claims were held by the same entity.  "However, in cases in which they are separate, it seems that a trustee might find it simpler to recover the transfers from the direct transferee" – in other words, from the senior creditor.

As a general principle, creditors tend to accept money and worry about the consequences later on the theory that it is better to have cash in hand than not.  Normally, a creditor that is fully secured is not concerned about potential preference claims (since it would have been entitled to full payment in a chapter 7 proceeding, and thus one of the elements of a preference claim is not met).

However, this case illustrates that the analysis may be more complicated if there are junior secured creditors.  In that case, it may be worth structuring payments so that other defenses will also be available.  For example, in this case the court later determined that payments of ~$17,000 were made in the ordinary course of business, and thus not avoidable as a preference (although the rest of the payments were subject to avoidance).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki Harding
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