Weathering the Storm: A Routine Foreclosure May Be A Preferential Transfer

08/09/2011

As many creditors have unfortunately discovered, the Bankruptcy Code allows a debtor to sue the creditor for certain payments – called preferences – that the creditor received from the debtor prior to the bankruptcy. The creditor is deemed “preferred” over other creditors if the transfer resulted in a payment on the creditor’s claim against the debtor that was larger than the payment the creditor would have received if the transfer had not been made and the creditor had instead participated in distributions from the debtor’s bankruptcy estate.1 Although maddening to the creditor – who is already likely to receive less than full payment on its claims against the debtor and now faces the possibility of having to return previous payments back to the defaulting debtor – the intent of this portion of the Bankruptcy Code is to promote the overarching bankruptcy policy of “sharing the pain” by providing for equal distributions to all creditors of the debtor.

A bankruptcy judge in Dallas recently issued an opinion2 that exposes foreclosing lenders who credit bid to possible attack. The court in Whittle ruled that a lender that credit bid to purchase its collateral at a foreclosure sale prior to the bankruptcy of the borrower could be sued for a preference to recover the purchased property, even though the debtor could not bring a fraudulent transfer suit regarding the foreclosure sale.

The facts in Whittle were straightforward. The lender was owed $2.2 million when it foreclosed and purchased the property by means of a $1.2 million credit bid. Shortly thereafter, the debtor filed bankruptcy and sought to set aside the foreclosure sale – not as a fraudulent transfer but rather as a preferential transfer. The lender moved to dismiss the complaint, stating that the debtor could not prove that the lender had recovered more as a result of the foreclosure than the lender would have recovered in a hypothetical Chapter 7 liquidation if the foreclosure had not been made.3 According to the debtor, this element was met through its allegation that the property was actually worth $3.3 million.4 In a hypothetical Chapter 7, the lender would have only been entitled to payment of the full amount of its claim, $2.2 million, with the remaining proceeds from the sale of the property going to the debtor’s estate. However, by purchasing the property through a below-market credit bid prior to the bankruptcy, the lender was able to recover more than $2.2 million: namely the property, with a value net of the credit bid of $2.1 million, plus a deficiency claim of $1.2 million, for a total recovery of approximately $3.3 million.

In reply, the lender relied heavily on the Supreme Court’s decision in BFP v. Resolution Trust Company.5 In this frequently-cited opinion, the Supreme Court declared that the price paid at a regularly conducted (pursuant to state law) foreclosure sale was per se “reasonably equivalent value.” As a result, a credit-bidding lender at such a foreclosure sale will always be protected from a fraudulent transfer suit by a subsequent debtor, no matter what the debtor alleges the property’s true value may have been. According to the lender, the rationale in BFP should be applied to a preference suit as well, and thereby prevent the debtor from arguing that the value of the property was anything other than the amount received through the foreclosure.

The Whittle court rejected this argument finding the lender’s reliance on BFP “misplaced.” The court reasoned that BFP dealt with the meaning – as a matter of law – of the statutory phrase “reasonably equivalent value”: “No such legal issue presents itself in avoidance actions under section 547(b)(5)(A) since the operative question is simply whether the creditor did, in fact, receive more than it would have had the transfer [foreclosure] not occurred.”6 The Whittle court also rejected the lender’s argument that exposing lenders to preference liability despite a regularly conducted foreclosure sale would undermine the strong state policy goals of ensuring the integrity and security of real property titles, which was one of the underpinnings of BFP: “If an otherwise valid foreclosure sale is found to enable a creditor to obtain more than he would in a Chapter 7, then the additional amount of benefit conferred on the creditor is simply brought back into the estate. The purchaser of the real estate at the foreclosure sale does not necessarily lose its property unless the purchaser is the creditor himself. This approach furthers the state’s interest in maintaining the security of titles without subverting the policy of the Code of maintaining equality among the creditors.”7 Absent the application of BFP, there could be no doubt on the facts alleged that the lender had received more as a result of the foreclosure than it would have in a hypothetical Chapter 7, and therefore the court, relying on a literal reading of the statute, denied the motion to dismiss – allowing the debtor to continue its suit to attempt to unwind the foreclosure sale and recover the property. This reasoning is questionable, since it is inconsistent to hold that a regularly conducted foreclosure sale conclusively establishes value for purposes of fraudulent transfer but does not do so for purposes of a preferential transfer.

Although other courts have considered (and disagreed on) this issue, the Whittle court’s ruling may come as an unwelcome surprise to lenders that are accustomed to relying on the protection provided by BFP to prevent the avoidance of a regularly conducted foreclosure sale. Although BFP prevents the debtor from second-guessing the value received through the foreclosure process through the means of a fraudulent transfer attack, courts following Whittle will in effect permit the debtor to obtain the same result by means of a preference suit.8 Lenders should therefore be cautious when credit bidding at a foreclosure sale, and remain aware of the possibility of a preference action if the debtor files bankruptcy in the following 90 days.

In the event that a lender becomes subject to a preference complaint in the mold of Whittle, all is not lost. First, as noted above, courts have split on the application of the BFP defense to preference actions, and in the absence of a binding circuit court ruling the issue remains open for debate. In the Southern District of Texas, for example, different judges have ruled differently on this issue. Additionally, the parties in Whittle did not address the other elements of the preference statute. Among these are the requirement that the transfer be made on account of an antecedent debt.9 Had the lender paid cash for the property at the foreclosure, the transfer would not meet this requirement, as it would only be on account of the new funds paid by the lender. The corresponding application of the proceeds received by the lender to pay down the lender’s claim, on the other hand, would be on account of an antecedent debt but would not result in the lender getting more than it would receive in a Chapter 7 (as the purchase price would not exceed the amount of the lender’s claim). As a result, neither transfer would be subject to avoidance as a preference. A lender could argue that it is inconsistent, therefore, to hold that a credit bid can be an avoidable preference, since a credit bid is simply a mechanism to avoid the time and expense of the two-step process above.10 Similarly, a lender could also argue that the borrower’s right to receive any surplus in the foreclosure is an “interest” in property which was independently transferred at the foreclosure. Since the right to receive the surplus was not transferred “on account of” an antecedent debt, the transfer of the right to receive the surplus (which is essentially what the debtor in Whittle was suing to recover) would not be preferential.

Ultimately, until the split in these decisions is resolved, it is impossible to predict how an individual preference suit will be determined, and lenders should consider their preference risk prior to credit bidding at any foreclosure proceeding.

For more information, please contact any of the lawyers listed below. You may also view the alert in the PDF linked below.

Robert D. Albergotti
214.651.5613
robert.albergotti@haynesboone.com

 

Robin Phelan
214.651.5612
robin.phelan@haynesboone.com

 

 

 Ian T. Peck
817.347.6613

ian.peck@haynesboone.com

Charles A. Beckham, Jr.
713.547.2243
charles.beckham@haynesboone.com

 

 

Trevor Hoffmann
212.659.4993
trevor.hoffmann@haynesboone.com

PDF - Weathering_Preferential_Transfer.pdf

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1 This requirement is found at 11 U.S.C. § 547(b)(5), and is one of several elements of a voidable preference.
2 Whittle Dev. Inc. v. Branch Banking & Trust Co. (In re Whittle Dev. Inc.), Case No. 10-37084-HDH-11, Adv. No. 11-03150 (Bankr. N.D. Tex. July 27, 2011) (docket no. 21).
3 The lender and the debtor stipulated that all of the other elements of a preference were present.
4 Because this issue was decided in the context of a motion to dismiss, the debtor’s alleged $3.3 million valuation was assumed to be true.
5 511 U.S. 534 (1991).
6 Whittle at p.9.
7 Id.
8 It may be of some small comfort to lenders, however, that generally only transfers within the 90 days prior to bankruptcy can be avoided as preferences. Fraudulent transfers have a longer “look-back” period of at least two years. It is also worth noting that § 547(e)(2) provides that if the purchaser does not perfect the transfer within 30 days of the sale, the transfer will be deemed to have occurred not on the sale date, but instead on the perfection date (or on the petition date, if the transaction is never perfected). Lenders should timely perfect such transactions as failure to perfect could bring the transfer back inside the 90-day preference window.
9 11 U.S.C. § 547(b)(2).
10 This argument is similar, though slightly different, than that raised by the Ninth Circuit in Ehring v. W. Moneycenter (In re Ehring), 900 F.2d 184 (9th Cir. 1990). In Ehring (and in Whittle), the court noted that there would be no preference liability if the purchaser at the foreclosure sale were a third party, as the transfer would not be on account of an antecedent debt. According to Ehring, there is no reason for preference liability to turn solely on the fact that the purchaser was also the lender. Id. at 188-89. This policy argument has been rejected by several other courts, but may be persuasive in a given case.

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