A Stretch of Preference

April 29, 2014

By: Lisa Caplan, Partner & Victoria Baggett, Associate

Though our firm footprint is focused primarily on the Southeast, we found an interesting bankruptcy case from California that we believe is worth review since, in bankruptcy, cases can grow legs and run.

In Gladstone v. Bank of America (In Re Vassau), 499 B.R. 864 (SD Cal. 2013), the Chapter 7 Trustee brought an adversary proceeding to avoid payments that debtors made to the senior lienholder on the theory that the payments were preferential to the junior lienholder and were tendered within the 90 days preceding the petition date. The parties cross moved for summary judgment.

In Gladstone, Bank of America held both the first and second liens. Equity existed above the first but not enough to fully secure both liens. The Debtors were in arrears on the first. Within 90 days of filing the case, the Debtors made ten payments (“transfers”) to the first lienholder, totaling $41,716.45. The result, of course, was to reduce the balance of the first lienholders claim by the amount paid.

To avoid the Transfers as preferential, the Trustee must prove the elements of Bankruptcy Code §547(b). The Junior Lienholder admitted that a few of the elements were met ((b)(2), (3) and (4)) but argued that that elements (b)(1) and (5) were not.

§547(b)(1) states that the transfer may be avoided if it were to or for the benefit of a creditor. The junior lienholder argued that the Transfers were not “for” its benefit because the debtor did not intend the Transfers to benefit the junior lienholder. The Court ruled that the intent of the parties is irrelevant and this section only requires that the “transfer actually benefited the creditor”.

§547(b)(5) states that the transfer may be avoided if it enables such creditor to receive more than such creditor would receive if the case were filed under Chapter 7. The Court examined a couple of possible applications of this element and decided to go with a hypothetical liquidation approach. Because the Transfer reduced the amount of the junior lienholder’s unsecured claim and thus reduced the amount it would have been entitled to receive in liquidation, the elements of this section had been met.

Upon deciding to grant the Chapter 7 Trustee’s Motion for Summary Judgment, the Court discussed how the Trustee might collect the funds in light of the fact that a defendant junior lienholder may not have actually received the monies (though, in this case, the same bank holds both liens). The Court mentioned that §550 provides for recovery from the “entity for whose benefit such transfer was made” or “the initial transferee.” Thus, in a case with separate entity lienholders, the Chapter 7 Trustee could recover the transfer from the first lienholder.

Of note, the junior lienholder also asserted an ordinary course defense but did not provide strong enough evidence. The Court held this defense still viable, so it remains to be seen whether this defense will prevent the avoidance of the transfers down the line.