It is never a good thing when a borrower files for bankruptcy protection. Borrowers often blame their lenders for having to file and expect their lenders to finance their reorganization. At least the lenders, being fully secured, don’t have to worry about being attacked for preference actions, right? Not necessarily.

Preferential transfers claims are claims that a creditor received more during the 90 days prior to the bankruptcy filing that it otherwise should have, i.e., that the particular creditor was “preferred” over other similarly situated creditors. Sections 547 and 550 of the United States Bankruptcy Code permit a debtor to recover preferential transfers from creditors to be redistributed on a pro rata basis to all creditors, including the creditor who was the subject of the preferential transfer (assuming that the preference is repaid).

Secured creditors are ripe targets for preference claims because (a) they have deep pockets, and (b) they often receive large payments or foreclose on valuable collateral during the 90 days prior to a bankruptcy case. These claims are “property of the bankruptcy estate” and, therefore, belong to the debtor, but they are more often pursued by unsecured creditor committees or Chapter 7 trustees looking for any funds to distribute to their constituents (or to pay the administrative claims of the professionals retained by the estate or the Chapter 7 trustee).

Fortunately for secured creditors, the Bankruptcy Code – following common sense – provides a fairly high level of protection from such claims. So long as the lender is simply foreclosing on its collateral, the lender should not be liable for a preference because, in that circumstance, the lender is not being “preferred”; rather, it is receiving the same funds or collateral that it would have received had it waited for the collateral to be liquidated by the debtor in the bankruptcy case.

As with everything in life, however, there are exceptions to the general rule. The primary exception comes into play when the lender’s claim is only partially secured. That is, that the dollar value of its secured claim, including interest, fees and expenses, exceeds the value of the collateral securing the claim on the date of the transfer. This is usually – but not always – the case when a borrower has to file for bankruptcy protection.

In cases where a secured lender’s claim is only partially secured, courts limit the amount of its secured claim to the value of the collateral on the petition date, with the remainder of the claim receiving unsecured status and on even footing with other unsecured creditors, including vendors, suppliers and service providers. (Courts are split as to whether the proper date for determining whether the lender is unsecured is the petition date or the date of the transfer, with the majority of jurisdictions using the filing date.) The unsecured portion of the claim is commonly referred to as the lender’s “deficiency claim”. Some courts have held that any transfer made to the lender in the 90-day window will be deemed to have been made on account of the unsecured portion of the lender’s claim, thus opening the otherwise secured lender to preference liability.

The important distinction in such cases is whether the payment or seized property is subject to the undersecured creditor’s lien. The most common case where this distinction plays a key role is when the lender’s security interest fails to cover cash and accounts. If the payment made during the 90-day period is from an account not subject to the lender’s lien, the lender may be liable for a preferential transfer, forced to return the amount of the transfer, and have the remainder of its claim denied.

An example may be helpful. In a case decided in 2010, a lender had a claim in an amount of approximately $500,000 secured by the borrower’s personal property. Prior to filing for bankruptcy protection, the borrower made a payment to the lender in an amount of $5,000. The monthly payment, pursuant to the terms of the loan agreement, was approximately $3,000. The payment was made more than five months late.

The bankruptcy case was originally filed as a reorganization under Chapter 11 of the Bankruptcy Code and was subsequently converted to a liquidation under Chapter 7 of the Bankruptcy Code after the lender had successfully lifted the automatic stay and liquidated its collateral, and a Chapter 7 trustee was appointed. The Chapter 7 trustee filed and prevailed on a motion for summary judgment to recover the $5,000 payment without even a trial.

There are many defenses to preference actions, including the “new value” defense and the “ordinary course” defense, and this entry is not intended to address those specifically. This entry is intended only to put lenders on notice that transfers made during the 90 days prior to when the borrower files for bankruptcy protection may come under scrutiny. With that in mind, it is still far preferable to have the money in hand – and deal with the possible consequences later – than to reject the funds over concerns that a troubled borrower may eventually resort to the protections of the Bankruptcy Code.

Disclaimer

The materials made available in this Blog have been prepared by Greensfelder, Hemker & Gale, P.C., are for general informational purposes only. The information contained in this Blog is general in nature and does not constitute legal advice or an opinion of counsel. Each legal problem is different, and past performance does not guarantee future results. You should not act on any of the information contained in this Blog without first consulting legal counsel. The choice of a lawyer is an important decision and should not be based solely upon advertisements.