California Bankruptcy Court Holds Junior Lienholder Liable for Payments Debtors Made to Senior Lienholder as Preferential Transfers

by Snell & Wilmer

Section 547 of the Bankruptcy Code allows a bankruptcy trustee to recover transfers from creditors that are labeled “preferences.” To avoid a transfer as a preference, the trustee must generally demonstrate that the transfer: (1) was of an interest of the debtor in property, (2) was made to or for the benefit of a creditor, (3) was made on account of an antecedent debt owed by the debtor, (4) was made while the debtor was insolvent, (5) was made within 90 days before the petition date (within a year if the creditor was an insider) and (6) enabled the creditor to receive more than the creditor would receive if the case were a case under chapter 7 and the transfer had not been made. Section 550 of the Bankruptcy Code then allows a trustee to recover the preferential transfer from the initial transferee, the immediate or mediate transferee of the initial transferee or the person for whose benefit the transfer was made.

Since 2001, the Ninth Circuit has held that pre-petition transfers to fully secured creditors are not preferential because “the secured creditor is entitled to 100% of its claims.” See In re Smith Home Furnishings, Inc., 265 F.3d 959, 964 (9th Cir. 2001). The Ninth Circuit noted that an exception from this rule may exist when a transfer changes the status of a creditor from being partially secured to fully secured at the time of the filing of the bankruptcy petition. Id.

Gladstone v. Bank of America (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal. 2013), represents a departure from the rule that a pre-petition payment to a fully secured creditor cannot be avoided as a preference. In Vassau the Debtors’ real property was subject to a first priority lien and a second priority lien in favor of Bank of America. Bank of America’s first priority lien was, at all times, fully secured, and its second priority lien was only partially secured. During the 90 days before the bankruptcy, Debtors made ten payments to Bank of America on account of its first priority lien. The Trustee sued Bank of America, in its capacity as the holder of the junior lien, to avoid the transfers because they benefited Bank of America by increasing the equity in the property that secured the junior lien. 

The Vassau Court granted the Trustee’s motion for summary judgment, stating that the payments: “which would otherwise be available to unsecured creditors ha[ve] been removed from their reach to the benefit of the Junior Lienholder.” The decision ultimately rested on two things. First is the way the Court approached section 547(b)(5), which inquires whether the transfer enabled the creditor to receive more than it would receive if the case were a case under Chapter 7. The Court sided with other circuits and used the “simple hypothetical liquidation” approach. Under it, the property would be liquidated, the senior lienholder would be paid in full, and the remaining proceeds would be paid over to the junior lienholder. Had the payments not been made, “the secured claim of the Senior Lienholder would be larger” by the amount of the payments, less would be available to the junior lienholder on its secured claim, and the amount of the unsecured claim would be greater. Thus, the payments resulted in the junior lienholder receiving more in the chapter 7 case than it would had the payments not been made. Second, the Vassau Court held that the payments could be recovered from Bank of America in its capacity as the second lienholder because it received the benefit of the transfers.

The court’s opinion in In re Vassau raises a number of questions. For instance, would the result have been different if the lienholders were different? The Vassau Court’s interpretation of Bankruptcy Code section 550 suggests that the result would not have been different if the lienholders were separate entities. Vassau also arguably eviscerates Smith Home Furnishings in cases where multiple creditors have liens against the same collateral by opening the door for trustees to allege that payments made to the senior lienholder were preferential to the undersecured junior lienholder and then recover the transfer from the senior lienholder because it was the initial transferee.   

Moreover, if a trustee elects under Bankruptcy Code section 550 to recover from a junior lienholder, it is unclear whether a junior can seek an award from the senior lienholder for the value of the amount received. Similarly, it is unclear whether a junior lienholder can preemptively avoid disgorging money it never received by asking the court to marshal the award, thereby forcing the trustee to recover from the senior lienholder. Vassau offers no guidance on these issues.  

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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