Fully Secured Creditor May Still Face Preference Exposure

A recent, troubling decision by the United States Bankruptcy Court for the Southern District of California in Gladstone v. Bank of America (In re Vassau) concluded that alleged preferential payments made to a fully secured creditor might be recovered by a Chapter 7 Trustee from a junior, undersecured lienholder, even though the junior lienholder never received the alleged preferential transfers. The Bankruptcy Court also noted in passing that, as an alternative, the Chapter 7 Trustee might seek to recover the payments from the senior lienholder, even though the senior lienholder was fully secured.

The facts are as follows. Prior to the bankruptcy, the debtor’s residence was subject to two deeds of trust securing obligations to two creditors – a senior lienholder and a junior lienholder. The property was worth more than the claim of the senior lienholder, but less than the claims of the senior lienholder and junior lienholder combined. In other words, the senior lienholder was fully secured, but the junior lienholder was partially secured. The debtors fell behind on their payments to the senior lienholder, but within 90 days prior to the petition date, the debtors made 10 payments to the senior lienholder.

All of the transfers were made to the senior lienholder. Nevertheless, the Chapter 7 Trustee sought to recover the amount of the transfers from the junior lienholder as preferential transfers under Bankruptcy Code section 547(b). The Chapter 7 Trustee and the junior lienholder both moved for summary judgment. The Chapter 7 Trustee’s motion was granted solely on the issue of whether the transfers might be recovered from the junior lienholder.

In its decision, the Court first reasoned that the transfers satisfied the definition of a preferential transfer set forth in Bankruptcy Code section 547(b). The Court found that even though the transfers were not made to the junior lienholder, the transfers were “to or for the benefit of a creditor,” as required by the Bankruptcy Code, as the effect of the transfers was to increase the equity in the property available to secure the junior lienholder’s claim. The Court found it “irrelevant” that the debtor’s payments were intended to benefit the senior lienholder rather than the junior lienholder, as a debtor’s “intent” is not mentioned in the definition of a preferential transfer. Rather, the Court found that section 547(b)’s requirement that a transfer be “for the benefit of a creditor” merely requires that the transfer actually benefit a creditor — in this case, the junior lienholder.

The Court also reasoned that the very type of harm preference laws was designed to address did occur in the case, in that approximately $41,716.45 in cash which might have otherwise been available to pay unsecured creditors was transferred to the senior lienholder, and those transfers benefited the junior lienholder.

The Court next turned to Bankruptcy Code section 550, which provides that a trustee may recover preferential transfers from the “entity for whose benefit such transfer was made” or from an “initial transferee.” The Court recognized that “it may be seen as somewhat unfair to require a creditor such as Junior Lienholder to ‘return’ money it never physically ‘received.'”

Although the Court ruled the Chapter 7 Trustee might recover from the junior lienholder, the Court further noted that the Chapter 7 Trustee, if successful in establishing a preference, was not required to recover from the junior lienholder. Rather, the Court suggested (somewhat disturbingly for all the secured creditors out there) that the Chapter 7 Trustee might instead seek to recover the transfers from the senior lienholder.

Under the circumstances of this particular case, it made little difference from whom the Chapter 7 Trustee sought to recover the alleged transfers, as the senior lienholder and the junior lienholder were the same entity. Further, the Court granted summary judgment only on the issue of whether the transfers constituted preferential transfers as to the junior lienholder. The Court also did not, at the time, rule on the junior lienholder’s ordinary course defense, but deferred its ruling on that matter until it had received additional evidence on the issue.

Not clear from the Court’s opinion is how the senior lienholder might assert its own defenses in the event the Chapter 7 Trustee sought to recover the transfers from the senior lienholder. Also unclear is how a fully secured creditor might prevent a hypothetical cause of action such as occurred here, other than by contracting against the possibility of junior liens. Perhaps all that can be said is that under circumstances such as these, even a fully secured creditor can face preference exposure.