A counterparty’s bankruptcy can cause considerable expense, inconvenience, and business disruptions to a creditor depending on the circumstances of a given case. Adding insult to injury, the Bankruptcy Code allows a debtor in certain circumstances to recover payments that were made to creditors during the ninety-day period leading up to the debtor’s bankruptcy filing. It does so to promote equality of distribution among similarly situated claimants and to prevent a race by creditors to precipitously dismember a debtor during its slide into bankruptcy. The Code presumes that the debtor is insolvent during the ninety-day period preceding a debtor’s bankruptcy. During this preference period, certain creditors may be receiving payments on their claims while others are not. In a situation where the assets of a debtor are worth substantially less than its liabilities, unsecured creditors that are receiving payments during the preference period are generally being “preferred” over other similarly situated creditors because they are receiving more than they would receive in a liquidation of the debtor’s assets. Accordingly, the Bankruptcy Code allows the debtor or trustee to avoid and recover certain preferential transfers for the benefit of the estate and all creditors generally.
Typically, fully secured creditors that have received transfers of property during the preference period are immune from preference attacks because the transfers do not enable them to receive more than they would have received in a chapter 7 liquidation. This is because secured creditors are generally entitled to realize value in bankruptcy - on a secured basis - up to the value of their collateral. Therefore, debt payments to fully secured creditors do not operate as a preference. Further, when a secured creditor posts property for a pre-petition foreclosure sale, a debtor may decide to file bankruptcy in order to stay the foreclosure and attempt to realize (for the benefit of the estate) any material value in the property over the amount of the secured lender’s claim. However, in situations in which the secured creditor forecloses on property worth more than the amount of the creditor’s claim, the transfer may give rise to a preference claim in any subsequent bankruptcy of the borrower.
Secured lenders celebrated the U.S. Supreme Court’s decision in BFP v. Resolution Trust Corp., which held that a non-collusive foreclosure sale conducted in accordance with applicable state law conclusively establishes the foreclosure sale price as “reasonably equivalent value” for the subject property, for purposes of determining whether a transfer of property at foreclosure is avoidable as a fraudulent transfer. BFP v. Resolution Trust Corp., 511 U.S. 531, 545 (1994). As a result of BFP, bankers largely view properly conducted foreclosure sales as mechanisms to realize their collateral and extricate themselves from their borrowers with little to no future risk of avoidance litigation, even if the borrower subsequently files bankruptcy.
Since BFP, bankruptcy courts have wrestled with the issue of whether the BFP-protection applies to preference claims. Several bankruptcy courts in Texas have held that the legal protections provided by BFP v. Resolution Trust do not apply for purposes of determining whether a creditor received more than it would have received in a chapter 7 liquidation, for purposes of determining the avoidability of a transfer under the preference statute - 11 U.S.C. § 547. A number of cases have held that a secured creditor can be subject to a preference claim if the transfer of property at a foreclosure enables the creditor to receive more than it would have received in a chapter 7 liquidation.
Recently, in the case of Whittle Development Inc. v. Branch Banking Trust Co. (In re Whittle Development Inc.), 463 B.R. 796 (Bankr. N.D.Tex. 2011)), the bankruptcy court declined to dismiss a preference complaint when the debtor alleged that the secured creditor received property at foreclosure worth $3.3 million at a time when its claim against the debtor was $2.2 million. Whittle Development Inc., 463 B.R. at 798-800. The debtor argued that when a secured creditor receives more through foreclosure than it would have received in a hypothetical chapter 7 liquidation, a preference has occurred under the statute. Id. at 800. The bankruptcy court determined that the interest sought to be protected in BFP – the important state interest of securing titles to real property bought at foreclosure – is not implicated in dealing with avoidable preferences. Id. at 802. In the context of fraudulent transfers, all transfers at foreclosure would be at risk if the value was not deemed “reasonably equivalent” as a matter of law. Id. However, the court found that in the case of a preference claim, the purchaser of property at the foreclosure sale does not lose his property unless the purchaser is the creditor himself (because in the preference context, to be avoidable, the transfer must be to or for the benefit of a creditor of the debtor). Id. at 801-02. Accordingly, the court held that a transfer may be avoided as a preference, if a secured creditor receives the property at foreclosure for less than what it would have generated in a hypothetical chapter 7 liquidation. Id. at 802-03. See also, Villarreal v. Showalter (In re Villarreal), 413 B.R. 633, 642 (Bankr. S.D.Tex. 2009) (holding - based on plain language of section 547 - preference occurs when secured creditor receives more that it would have received in chapter 7 liquidation); Rambo v. Chase Manhattan Mortg. Corp. (In re Rambo), 297 B.R. 418, 431 (Bankr. E.D. Pa. 2003); In re Andrews, 26 B.R. 299, 306 (Bankr. M.D. Pa. 2001). But compare, Chase Manhattan Bank v. Pulcini (In re Pulcini), 261 B.R. 836 (Bankr. W.D. Pa. 2001) (holding BFP applies to preference claim); Newman v. FIBSA Forwarding, Inc. (In re FIBSA Forwarding, Inc.), 230 B.R. 334, 341 (Bankr. S.D. Tex. 1999) (same); In re Cottrell, 213 B.R. 378, 383 (Bankr. M.D. Ala. 1996).
Although the Whittle Development and Villarreal cases involve rather extreme examples of secured creditors receiving windfalls as a result of foreclosures on properties valued substantially in excess of the amount of the creditor’s claim, the implication of this line of cases on secured creditors is quite burdensome. Valuation evidence in bankruptcy cases is rarely undisputed, and as a result, secured creditors face the risk of post-foreclosure litigation – even on properties that have little or no value in excess of the amount of the creditor’s claim. Opportunistic chapter 7 trustees, debtors and/or creditors looking to extract a settlement, may be incentivized to challenge properly conducted foreclosure sales as preferences if they can find an appraiser willing to testify that the secured lender received a property valued in excess of the amount of its claim. Even so, a preference claim in this context is not without weakness. The claim assumes that the secured creditor is “over secured,” which normally entitles the creditor to accrue interest (which would accrue at the default rate in this context), costs and attorneys’ fees – on a secured basis – in bankruptcy. Accordingly, any marginal equity cushion would be quickly absorbed in a chapter 7 bankruptcy case, which means that the bankruptcy court would need to find a value for the subject property substantially in excess of the creditor’s claim in order to find, for preference purposes, that the creditor received more than it would have received in a chapter 7 liquidation.
- Tye C. Hancock and Rhett G. Campbell, Thompson & Knight LLP