Lender Beware: Your Foreclosure Might be a Preference

January 16, 2012

Content originally posted on MGLAW.net

If a foreclosure is going to push a business or individual into bankruptcy, a secured lender would much prefer to conduct the sale prior to the filing of the petition. After all, conventional wisdom suggests that a pre-petition foreclosure would eliminate the lender's secured claim (unless other property was collateralized) and limit its involvement in the bankruptcy to managing the treatment of its unsecured claim. This conventional wisdom holds true if the foreclosure yields a purchase price equal to or above fair market value. But what if the winning bid is for less than fair market value? Is the lender facing claims litigation with respect to its unsecured claim? Is the foreclosure a fraudulent transfer? Can the foreclosure be set aside as a preferential transfer? Some lawyers have attempted to avoid a pre-petition foreclosure as a preferential transfer if the purchase price was less than fair market value. This article addresses the consequences of a below fair market value foreclosure, to specifically include whether a pre-petition foreclosure can be avoided.

I. Background

There is no question that a foreclosure can trigger a bankruptcy filing. Most lenders have internalized this and accept the fact that their ability to prevent a bankruptcy is limited. The focus is therefore often on maximizing the recovery in the short term by foreclosing on the property and pursuing a deficiency. Unfortunately for lenders, based on the abundance of available property and depreciated property values, and to mitigate its deficiency losses, lenders are forced to be involved in the sale process as a potential bidder.

Traditionally, absent a third party bid amount that satisfied the lender, the lender's goal was to credit bid at the lowest possible amount to purchase the property. This approach maximized the deficiency balance and potentially enabled the lender to acquire an asset for less than market value. In 2010, however, the Tennessee legislature enacted a law that fixed the deficiency at an amount equal to the debt less fair market value of the collateral securing the lender's note. See Tenn. Code Ann. § 35-5-118. The current law presumes that a winning bid establishes fair market value, but permits borrowers to prove by a preponderance of the evidence that the property sold for an amount materially less than the fair market value. This law now causes lenders in Tennessee to take one of three approaches when no other bids satisfy the fair market value requirement: (i) bid below fair market value and force the borrower to prove that the deficiency should be less, (ii) bid an amount that passes a reasonable, business judgment test, or (iii) bid at or very near what a willing buyer would actually pay in the economic climate (i.e., true market value).

II. Pre-Petition Foreclosures and Bankruptcy

Historically, a pre-petition foreclosure has not concerned a lender when a borrower subsequently files for bankruptcy. The worst-case scenario would be that the lender's unsecured claim (already valued at only pennies on the dollar) would decrease if the debtor/trustee proved by a preponderance of the evidence that the sale yielded less than fair market value. Aside from litigation surrounding its unsecured deficiency claim, the lender did not expect to defend its actions. It certainly did not realistically expect that a debtor-in-possession would name it in an adversary proceeding to unwind the foreclosure sale...until recently, that is.

a. Fraudulent Transfers (11 U.S.C. § 548).

For good reason, lenders have embraced the Supreme Court decision of BFP v. Resolution Trust Corp., 511 U.S. 531 (1994). In BFP, a third party purchased the debtor-in-possession's property at a pre-petition foreclosure for $433,000. The foreclosure was properly noticed and conducted. After the debtor filed for bankruptcy, it sued to avoid the transfer because it allegedly constituted a constructively fraudulent transfer pursuant to Section 548 of the Bankruptcy Code (11 U.S.C. § 548). The Supreme Court affirmed summary judgment in favor of the lender and against the debtor, holding that a "fair and proper price, or a 'reasonably equivalent value,' for foreclosed property, is the price in fact received at the foreclosure sale, so long as all the requirements of the state's foreclosure law have been complied with." This one portion of the opinion provides two key takeaways. First, for purposes of Section 548, the fair market value of foreclosed real estate is equal to the foreclosure sale price. The Court reasoned that any other outcome would interfere with the state's interest of conveying legal title in foreclosed upon property. Second, a foreclosing entity must still comply with state law; i.e., if the deficiency provisions of Tennessee Code Annotated §35-5-118 are not satisfied, the argument can be made that BFP does not apply. To date, BFP remains good law in fraudulent transfer avoidance actions.

b. Preferential Transfers (11 U.S.C. § 547).

Many practitioners presume that the BFP decision stands for the proposition that, in general, a properly conducted foreclosure yields a purchase price equal to fair market value. See, e.g., Manhattan Bank v. Pulcini, 261 B.R. 836 (Bankr. W.D. Pa. 2001), In re FIBSA Forwarding, Inc., 230 B.R. 334 (Bankr. S.D. Tex. 1999). The Court in BFP ruled on fraudulent transfer grounds, but it has been presumed by some that the same analysis would be used to defeat a preference action seeking to set aside a pre-petition foreclosure. The argument would be that the plaintiff could not prevail on the Section 547(b)(5) preference element, which states: "the trustee may avoid any transfer of an interest of the debtor in property...that enables such creditor to receive more than such creditor would receive if...the case were a case under chapter 7 of this title[.]" The reasoning is that if the foreclosure yields fair market value, then the secured lender receives exactly, but not more than, what it would receive in a chapter 7 liquidation. Lenders have hung their hat on this position, but is it a logical extension of BFP? Several courts now answer this question in the negative.

c. Recent Case Law

In July 2011, the case of Whittle Development, Inc., v. Branch Banking & Trust Co., 11-03150, 2011 WL 3268398 (Bankr. N.D. Tex. Jul. 27, 2011) determined that a chapter 11 debtor stated a claim to avoid a pre-petition foreclosure on the grounds that the foreclosure constituted a preference. The facts are straightforward. The parties stipulated that the foreclosure complied with the state's procedural requirements. The debtor owed approximately $2.2 million on the property, which it alleged was valued at $3.3 million. After the lender credit bid for $1.22 million and filed a $1.18 million deficiency claim, the debtor filed an avoidance action to set aside the foreclosure on the grounds that it constituted a preference under Section 547(b) of the Bankruptcy Code. The lender conceded that all the 547(b) elements were satisfied except for subsection (5), which requires a finding that the creditor received more than it would have under chapter 7. The lender, relying on BFP, argued that the $1.22 million foreclosure bid determined the fair market value, and that it therefore would not receive more in a liquidation. The debtor argued that the net value of the property ($3.3 million property value less $1.22 million credit bid) plus the $1.18 million deficiency claim would result in the lender receiving more than it would in a liquidation.

The court sided with the debtor and refused to dismiss the avoidance action. The court addressed the argument that the lender would not do better in a liquidation by concluding that a bankruptcy trustee can market and sell the property under fundamentally different circumstances in order to increase the value of the sale. Thus, a market sale within a chapter 7 would result in more proceeds than a foreclosure sale. Assuming the truth of this belief, the court held as follows:

If a creditor executes on secured property and obtains the property for what is found to be less than what it would have garnered in a hypothetical liquidation, then the transfer may be avoided under the plain meaning of section 547(b)...Thus, a chapter 11 debtor-in-possession can avoid a pre-petition foreclosure on the grounds that the foreclosure constituted a preferential transfer, even though the foreclosure complied with state law and was non-collusive.

See also In re Villarreal, 413 B.R. 633, 642 (Bankr. S.D. Tex. 2009) (concluding that the foreclosure transaction was avoidable as a preference, despite compliance with state procedural law, when property appraised for $4 million sold for $70,000). The Whittle and Villarreal courts acknowledged that courts may be divided on this issue, but determined that the fraudulent issue before the Supreme Court in BFP was wholly different than the preference claim at issue in Whittle. Whittle, 2011 WL 3268398 at *5 ("If the court had ruled differently in BFP all transfers of real estate in a foreclosure sale could be declared fraudulent since the transfer would not, as a matter of law, yield "reasonably equivalent value in exchange."); see In re Andrews, 262 B.R. 299 (Bankr. M.D. Pa. 2001).

III. Conclusion

As set forth above, lenders could still face fraudulent transfer actions and claim litigation if they conduct a foreclosure that yields a sale price materially below fair market value. It now appears that based on Whittle, Villarreal, and Andrews, lenders or other creditor-purchasers should be aware of potential preference liability unless true market value is obtained. These cases highlight the need for lenders to scrutinize their bidding and bid-acceptance procedures. The risk of a below fair market credit bid or sale price directly implicates the possibility of losing a portion of a claim. Maybe more importantly, it also risks an expensive bankruptcy proceeding that could ultimately unwind the foreclosure and place the lender in the position it occupied pre-foreclosure. Although there is no Sixth Circuit case on point to provide guidance, debtors-in-possession and/or trustees should consider using these cases cited in this article as a sword when a lender is believed to have either purchased, or permitted the purchase of, a foreclosed property for less than fair market value.