In an interesting decision recently entered by the United States Bankruptcy Court for the Southern District of California, the bankruptcy court held that pre-petition payments made to a fully secured senior lender which benefited a partially secured junior lender could constitute preferential transfers to the junior lender. The court further ruled that such preferential transfers could be recoverable from either the junior lender or the fully secured senior lender. In re Vassau, 499 B.R. 864 (Bankr. S.D. Cal. 2013). Thus, a fully secured creditor that receives payments on its loan may not be protected from avoidable preferential transfers if such creditor shares collateral with a partially secured subordinate creditor.

Sections 547 and 550 of the Bankruptcy Code

Generally speaking, under Section 547(b) of the Bankruptcy Code, a trustee in bankruptcy (including a debtor in possession) may avoid any transfer of an interest of the debtor in property that (1) is made to or for the benefit of a creditor; (2) is for or on account of an antecedent debt owed by the debtor; (3) is made while the debtor was insolvent (which insolvency is presumed for the 90 day preference period before the filing of a bankruptcy petition); (4) is made (A) on or within 90 days before the filing of the petition or (B) between 90 days and one year before the filing of the petition if such creditor at the time of such transfer was an insider; and (5) enables such creditor to receive more than such creditor would receive in a chapter 7 case of such debtor if such transfer had not been made.

While Section 547 of the Bankruptcy Code sets forth the criteria to determine whether a transfer to a particular creditor constitutes an avoidable preferential transfer, such Section does not determine from which parties an avoidable transfer can actually be recovered. Recovering an avoidable preferential transfer under Section 547 often involves a two-step process. The first step in the process is to determine whether a transfer constitutes an avoidable preferential transfer in the first instance under Section 547 of the Bankruptcy Code. In the event the transfer constitutes an avoidable preferential transfer under Section 547, then the second step in the process is to determine, under Section 550(a) of the Bankruptcy Code, whether the avoidable transfer can be recovered only from the initial transferee or whether other parties may also be liable to disgorge or pay back the benefit received by the preferential transfer.

Section 550(a) of the Bankruptcy Code specifies, generally speaking, that if a transfer is avoided as a preference under Section 547, then the debtor or bankruptcy trustee can recover “the property transferred, or, if the court so orders, the value of such property, from … the initial transferee of such transfer or the entity for whose benefit such transfer was made.”

Summary of Case

In the In re Vassau case, the debtors, husband and wife, had two loans outstanding at the time they filed bankruptcy, a senior loan to a senior lender (the “Senior Lienholder”) and a subordinate loan to a junior lender (the “Junior Lienholder”). Both loans were secured by the same real property of the debtors. The property securing the loans was worth more than the loan owed to the Senior Lienholder, but less than both loans combined. The amount owed to the Senior Lienholder was $987,920, the amount owed to the Junior Lienholder was $267,717.21 and the property securing the loans was valued at $1,100,000. Thus, the Junior Lienholder was only partially secured by the debtors’ property.

Prior to filing bankruptcy, the debtors fell behind in payments to the Senior Lienholder, but paid the Senior Lienholder $41,716.45 in a series of ten payments (the “Transfers”) within the 90-day preference period under Section 547(b) of the Bankruptcy Code. The debtors did not make any payments to the Junior Lienholder on the junior loan during the preference period. After filing bankruptcy, the bankruptcy trustee commenced an action against the Junior Lienholder, alleging that the $41,716.45 payments made to the Senior Lienholder during the preference period actually resulted in avoidable preferential transfers to the Junior Lienholder. (Although the Senior Lienholder and the Junior Lienholder where the same institution in this case, the trustee’s avoidance action named such institution as a defendant in the preference action only as Junior Lienholder on the junior loan.)

The bankruptcy trustee argued that the payments of $41,716.45 made to the Senior Lienholder during the 90-day preference period were in effect “for the benefit of” the Junior Lienholder for purposes of Section 547(b) of the Bankruptcy Code, on the basis that the payments resulted in the undersecured Junior Lienholder’s claim benefitting from $41,716.45 more in security. As explained by the court: “That is, had the [$41,716.45] Transfers not been made the amount of the fully secured claim of the Senior Lienholder would be $41,716.45 greater. That $41,716.45 would reduce the amount by which the claim of Junior Lienholder was secured dollar for dollar. The Transfers reduced Senior Lienholder’s secured claim and correspondingly increased that of Junior Lienholder dollar for dollar.” In re Vassau, 499 B.R. at 867. Thus, the bankruptcy trustee asserted that the $41,716.45 payments made to the Senior Lienholder resulted in avoidable preferential transfers to the Junior Lienholder for purposes of Section 547(b) because such Transfers were for the benefit of the Junior Lienholder and enabled the Junior Lienholder to receive more than it would in a chapter 7 liquidation case of the debtors if the Transfers had not been made.

The court agreed with the bankruptcy trustee and held that the $41,716.45 Transfers made to the fully secured Senior Lienholder at a time when the Junior Lienholder was only partially secured could constitute avoidable preferential transfers to the Junior Lienholder under Section 547(b) of the Bankruptcy Code, notwithstanding that the Junior Lienholder did not receive the payments. While the $41,716.45 payments to the Senior Lienholder may not have been made by the debtors with the intent of benefitting the Junior Lienholder, the court held, “it is well established that the intent of the parties is irrelevant to the preference analysis. …. Rather, ‘for the benefit of a creditor,’ merely requires that the transfer actually benefitted the creditor. In the case at hand it is clear that the Junior Lienholder benefitted from the [$41,716.45] Transfers.” Id. at 868. After a lengthy discussion of certain elements of Section 547(b), the court further concluded:

Looking at our case from the impact of the estate side perspective, we see that the very harm preference law was designed to address did occur in this case. Within the three months before this case was filed, $41,716.45 in cash which might have otherwise been available to pay unsecured creditors, was transferred to Senior Lienholder and those transfers benefitted Junior Lienholder. Whether [for purposes of the Section 547(b) analysis] the Property is sold and the proceeds distributed to the Senior Lienholder and Junior Lienholder, or the Property is abandoned, the result, from the perspective of the estate, is that $41,716.45 which would otherwise be available to unsecured creditors has been removed from their reach to the benefit of Junior Lienholder.

Id. at 871.

The court thus held that the Transfers of $41,716.45 made to the Senior Lienholder within the preference period satisfied the conditions under Section 547(b) of the Bankruptcy Code for the transfers to be preferential to, and avoidable from, the Junior Lienholder. The court “recognize[d] that it may be seen as somewhat unfair to require a creditor such as Junior Lienholder to ‘return’ money that it never physically ‘received.’” Id. at 872. However, this recognition did not change the result that the Transfers of $41,716.45 made to the Senior Lienholder at a time when the Junior Lienholder was only partially secured could constitute avoidable preferences made to the Junior Lienholder, notwithstanding that the Junior Lienholder did not receive any of the payments.

After finding that the $41,716.45 Transfers made to the Senior Lienholder satisfied the requirements of Section 547(b) of the Bankruptcy Code as they applied to the Junior Lienholder, the court then addressed from which parties the Transfers could potentially be recoverable based on Section 550(a) of the Bankruptcy Code. The court stated that the bankruptcy trustee “is not required to recover from the Junior Lienholder. Under § 550, the Trustee may recover from the ‘entity for whose benefit such transfer was made,’ or the ‘initial transferee.’” Id. at 872. Thus, the court held that the avoidable preferential transfers to the Junior Lienholder could be recoverable from either from the Junior Lienholder, as the “entity for whose benefit such transfer was made,” or from the fully secured Senior Lienholder, as the “initial transferee” of the payments. The court also noted that the trustee “might find it simpler to recover the transfers from the direct transferee.” Id.

Remaining Issues

The Junior Lienholder had also argued in the case, as a defense to the bankruptcy trustee’s preference action, that the $41,716.45 Transfers made to the Senior Lienholder should not be avoidable preferences because the payments were made in the “ordinary course” of business between the debtors and the Senior Lienholder and according to ordinary business terms as specified in Section 547(c)(2) of the Bankruptcy Code. Generally speaking, Section 547(c)(2) specifies that the debtor or bankruptcy trustee may not avoid a transfer as a preference under Section 547(b) of the Bankruptcy Code if such transfer was made in the ordinary course of business between the debtor and a creditor and according to ordinary business terms.

The court noted that this “defense remains viable,” but that “the Court will need additional evidence on the issue.” Id. Thus, whether the $41,716.45 payments were made in the ordinary course of business between the debtors and the Senior Lienholder and according to ordinary business terms, and thus protected from avoidance by Section 547(c)(2) of the Bankruptcy Code, will be determined in a later proceeding in the case. It may be relevant to this analysis, however, that the court noted early in its opinion that the debtors “fell behind” in payments to the Senior Lienholder and within “90 days prior to the petition … made ten payments to the Senior Lienholder.” If the late payments were not made in the ordinary course of business between the debtors and the Senior Lienholder under Section 547(c)(2) of the Bankruptcy Code, then the payments would constitute avoidable preferences to the Junior Lienholder, which could be recoverable from either the Junior Lienholder or the Senior Lienholder.

Also, as noted above, the trustee’s complaint and the court’s current opinion did not involve the Senior Lienholder under the senior loan as a defendant in the preference action. Thus, it is unclear from the decision, in the event recovery of the Transfers is actually sought from the Senior Lienholder, whether the Senior Lienholder could assert any defenses to such recovery.

The significance of the In re Vassau decision, however, is not only that payments made to a fully secured senior lender may constitute avoidable preferential transfers to a partially secured junior lender sharing the same collateral, but also that the avoidable transfer made to the junior lender could be recovered from the fully secured senior lender.

Additional Information 

For more information on this and other bankruptcy questions, please contact Bruce A. Wilson or your Kutak Rock attorney.