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Will Preference Actions be the Preferred Course of Chapter 7 Trustees?

by Stephanie Orrico
Orlans Associates, P.C. – USFN Member (MI)

Like the rest of the nation, Michigan has experienced an increase in bankruptcy filings. From 2007 to 2008, the total number of filings grew, and the percentage of Chapter 7 cases went from 71 to 79 percent. With the high number of Chapter 7 cases, trustees are becoming ever more innovative in their search for assets to liquidate for the benefit of creditors. As trustee creativity grows, the quantity of their letters warning of possible legal action increases. Lawsuits do not necessarily follow, but may in the future.  

The newest threat may be a preference action for money received by a mortgage company within 90 days of the debtor filing for bankruptcy protection. Courts have been reluctant to bifurcate or strip down a mortgage claim to the value of the collateral in either a Chapter 7 or a Chapter 13 case. See Dewsnup v. Timm, 502 U.S. 410 (1992), and also Nobelman v. American Savings Bank, 508 U.S. 324 (1993) [In re Nobelman, 968 F.2d 483 (5th Cir. Tex. 1992)]. However, if a mortgage creditor takes a property to a sheriff sale with a value bid and not a total debt bid during the bankruptcy, the claim may have been bifurcated by the creditor, and this may leave that creditor vulnerable to a preference action by a bankruptcy trustee.

Under 11 U.S.C. § 547(b) the trustee may avoid any transfer of an interest of the debtor in property:
      1. to or for the benefit of a creditor,
      2. for or on account of an antecedent debt owed by the debtor before such transfer was made,
      3. made while the debtor was insolvent,
      4. made on or within 90 days before the date of filing of the petition, and
      5. that enables such creditor to receive more than such creditor would have received if:
           A. the case were a case under chapter 7,
           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 situation typically seen goes like this: a debtor makes a lump sum $5,000 payment to credit card company #1 within 90 days of the debtor filing bankruptcy, but does not pay credit card companies #2 and #3. The trustee avoids the preference and recovers the money into the estate. After the trustee’s piece, the balance is distributed pro-rata among credit card companies #1, #2, and #3. 

The bankruptcy code provides exceptions to a preference action. The first exception is a contemporaneous exchange for new value. This is the situation where the debtor buys property and gives a mortgage. The contemporaneous requirement provides a 30-day safe harbor to perfect the mortgage. The second exception is for payments that are made in the ordinary course of business. The determination for ordinary course is the relationship between the specific creditor and the debtor, but it may be subject to industry standards. A payment may fall in this exception if it is the regular monthly mortgage payment or the mortgage payment plus the late payment if this debtor consistently makes the payments late.

Traditionally, preferences have not been a problem for mortgage creditors as the claims have been wholly secured and monthly payments made pursuant to the mortgage are exempt as ordinary course transactions. Today, however, property values have fallen dramatically in many locales, which may leave the claim under-secured and subject to a preference action. With homeowners attempting to reinstate their mortgages, they are making lump sum payments in excess of the monthly mortgage payment that are not in the ordinary course and are often insufficient to reinstate the mortgage. Foregoing the right to foreclose on collateral does not represent new value. See In re ABC-NACO, Inc., 483 F.3d 470 (7th Cir. 2007); In re Air Conditioning, Inc., 845 F.2d 293 (11th Cir. 1988); Drabkin v. A.I. Credit Corp., 800 F.2d 1153 (D.C. Cir. 1986). 

In a Michigan bankruptcy court, relief from the automatic stay can be obtained in 19 days. The foreclosure by advertisement can take 31 days. Illustrative is this hypothetical situation: a debtor could make one lump sum payment to the mortgage creditor with the intent to make several other large payments to reinstate the mortgage. After 30 days, the debtor decides that the house is unaffordable, files for bankruptcy, and surrenders the property. It is conceivable that within 50 days of the bankruptcy filing, the property would be sold at a sheriff sale. If the bid amount is not the total debt, the claim has been bifurcated into a secured portion that was indicated in the bid and an unsecured deficiency. With an unsecured claim in the form of a deficiency, the creditor may now be an unsecured creditor that received more than other unsecured creditors. That is, the creditor may have just turned itself into credit card company #1 referenced above. 

To date, the trustees have primarily only threatened to recover the money through litigation, and the situations have tended to involve relatively small amounts of money. If the Chapter 7 filings continue to increase, the trustees’ perseverance in seeking to find assets to liquidate could lead them to pursue this route. Given the current mood of the courts and the number of Chapter 7 trustees threatening preference actions, some intrepid trustee is likely to give it a try, especially if the amount of money at issue is significant enough.

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