Payments to Senior Lienholder Avoidable as to Junior Lienholder

Posted by NCBRC - November 22, 2013

Payments made to a senior lienholder within 90 days of bankruptcy were avoidable as a preferential transfer in favor of the junior lienholder. Gladstone v. Bank of America (In re Vassau), No. 09-9536, AP 11-90280 (Bankr. S.D. Cal. Sept. 25, 2013). Relying on section 547(b), the trustee sought to avoid 10 payments totaling $41,716.45 made to the senior lienholder which reduced the amount of the senior lienholder’s secured claim, and, as a result, increased the portion of the junior lienholder’s claim that was secured. Because the unsecured creditors were to receive less than 100%, this shift from unsecured debt to secured debt resulted in a benefit to the junior lienholder. The trustee sought to avoid the transfers as preference in favor of the junior lienholder.

Conceding the benefit it derived from the transfers, the junior lienholder argued that the transfers did not meet all the elements of an avoidable transfer under section 547(b). Specifically, the junior lienholder argued that the transfers were not made for its benefit as required by section 547(b)(1) and that the requirements of paragraph (5) were not met.

With respect to subsection (b)(1), the court found that the junior lienholder misconstrued the language that the transfers must be “for the benefit of a creditor,” to include an element of intent. The court, citing In the Matter of Prescott, 805 F.2d 719, 723 (7th Cir. 1986), found that it was enough that a creditor benefit from the transfers to satisfy paragraph (1) without regard to the intent or motive of any party.

Section 547(b)(5) presented a more complex problem. That section provides that a transfer may constitute a preference if it allows the creditor to receive more than it would receive if:  “(A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.” The court recognized two reasonable interpretations of this language which would yield conflicting results. If the reference to a chapter 7 case is interpreted to require that the court consider the effects of a “hypothetical liquidation” the junior lienholder would stand to gain from the transfers because the greater the junior lienholder’s secured interest, the greater recovery it would make upon liquidation of the asset. But the court noted that in an actual chapter 7, under section 554(a), a trustee will abandon property that is oversecured because its sale will not benefit the estate. See, e.g., In re Preston Lumber Corp., 199 B.R. 415 (Bankr. N.D. Cal. 1996). Thus, the court had to decide whether to treat paragraph (b)(5) as creating a “hypothetical liquidation” or as a reference to a chapter 7 as it would actually unfold.

Finding no governing case law, the court relied on the philosophy behind the preferential transfer statute under which the goal of equality of distributions among creditors is paramount. Collier on Bankruptcy, 15thRevised Edition ¶ 547.01 (2006). It found that avoidance of the transfer would allow the transferred funds to increase the overall payout to unsecured creditors. Therefore, the transfers harmed the estate in the manner sought to be remedied by section 547. The court thus adopted the interpretation of section 547(b)(5) which looks at the “hypothetical liquidation” without regard to the reality that a chapter 7 trustee would abandon the asset in an actual chapter 7. Furthermore, even though the benefit actually adhered to the junior lienholder, under section 550, the trustee could recover the transferred funds from the senior lienholder as the “entity for whose benefit such transfer was made.”

(The court rejected the junior lienholder’s argument under section 547(i) because the transfers were not made between 90 days and one year prior to the bankruptcy and neither creditor involved was an “insider” as contemplated by that subsection).

Gladstone opinion


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