The majority on a Ninth Circuit panel held that a bank has potentially large preference liability because the bankruptcy court should have decided whether there was another hypothetically avoidable preference. The majority’s opinion relies entirely on the elements of a preference under Section 547(b), and subsection (b)(5) in particular.
Sitting by designation, District Judge Edward R. Korman, from the Eastern District of New York, employed Section 553(b) to arrive at a substantially smaller recoverable preference. Judge Korman used the arguably better approach.
The opinions do not contain sufficient facts to know for sure whether the bank, at the end of the day, will have any preference liability at all. Both opinions may have analyzed questions that were not necessary to answer because the bank may have another complete defense to preference liability.
The analysis of the case is muddled because the plaintiff-trustee did not make an argument under Section 553(b), perhaps because a recovery under that section would have been substantially smaller than by reliance on Section 547 alone. The bank-defendant did not argue that its liability should be measured by Section 553(b), likely because it won a complete victory in the lower courts on a different theory.
The Facts
According to the March 7 majority opinion by Circuit Judge Milan D. Smith, Jr., the debtor sold its real property for about $1.3 million well outside of the preference period. The proceeds were held in escrow.
Ninety days before bankruptcy, the debtor’s deposit account at the bank held $173,000. The sale proceeds were released from escrow about five weeks before bankruptcy, within the preference period.
When the proceeds were released from escrow, the debtor paid off the $190,000 loan it owed to the bank. The debtor deposited the remainder, about $526,000, into its deposit account at the same bank.
The $173,000 that had been in the deposit account at the outset of the preference period declined to about $53,000 on the day the bank was paid off and the $526,000 went into the bank account.
The debtor paid some bills following release of the sale proceeds from escrow, leaving $564,000 in the bank account on the filing date.
Subtracting the disputed $526,000 deposit from the ending balance theoretically would have left about $38,000 in the account on the filing date, Judge Smith said.
Judge Smith said that the bank had a lien on personal property, including deposit accounts. His opinion also could be read to mean that neither the bank nor any other creditor had a security interest in the real estate that was sold.
Judge Korman, in contrast, said that that the bank’s personal property lien included general intangibles, including the contractual right to be paid the proceeds held in escrow. He also said that the bank’s security interest would have remained in the funds even if they had never been released from escrow.
If Judge Korman is correct, and if the bank had a lien on the escrow established at the time of the sale, then the bank’s lien would have attached to the sale proceeds outside of the preference period, making the bank a fully secured creditor not subject to a preference claim. However, that issue is not discussed in either opinion because it was not the basis for the decisions in the lower courts.
The Lower Court Holdings
On summary judgment, the bankruptcy court found that the bank had a right of setoff and that the $564,000 in the account on the filing date would have fully repaid the $190,000 bank loan. Since the bank did not recover more from the prepetition payoff than it would have received from a chapter 7 liquidation, the bankruptcy court held there was no preference because the trustee did not satisfy Section 547(b)(5).
The district court upheld the decision in the bankruptcy court, finding no preference. The trustee appealed.
The Majority’s Analysis
In the circuit, the trustee argued that the hypothetical chapter 7 liquidation analysis conducted in a preference suit under Section 547(b)(5) obliges the court, hypothetically, to unwind any other transfers that also would have been preferential, even if they were never actually avoided.
Reversing the lower courts, ruling for the trustee, and finding a preference, the majority held that the court “may account for hypothetical preference actions within a hypothetical chapter 7 liquidation analysis when such an inquiry is factually warranted, is supported by appropriate evidence, and the action would not contravene an independent statutory provision.”
In deciding whether the $190,000 loan payoff was preferential, the majority concluded that the $526,000 deposit also would have been preferential. Backing out the $526,000 from the deposit account on the filing date would have left the account with $38,000 on the petition date, “a sum far less than the [$190,000 that the bank] received.”
The majority remanded the case, evidently implying that the bank should be liable for receiving a preference of about $152,000 if there are no other defenses.
The majority said that its hypothetical-within-a hypothetical was supported by the statutory text, legislative history, and “current practice in bankruptcy courts.” More particularly, Judge Smith said that the statutory “test clearly does not directly forbid courts from considering hypothetical preference actions within a hypothetical chapter 7 liquidation.”
Judge Smith alluded to the best interests tests in confirming chapter 11 and 13 plans, where courts examine hypothetical avoidance actions in deciding whether the plans give creditors more than chapter 7 liquidations.
The majority then went on to decide that the $526,000 deposit also would have been preferential and thus should be deducted from the account balance on the filing date, leaving the account with insufficient funds to pay off the bank’s loan in full.
Judge Korman’s Dissent
Although technically a concurrence, Judge Korman’s opinion reads like a dissent.
He concurred in the decision to reverse. Significantly also, he concurred with the proposition that a hypothetical preference should be taken into the equation in deciding whether another transfer was a preference because the creditor’s recovery was larger than it would have been in chapter 7.
However, Judge Korman did not agree that the entire $526,000 deposit was preferential.
Instead, Judge Korman would have decided how much of the $526,000 would be preferential under Section 553(b). That section allows recovery of a setoff to the extent that the creditor has improved its position during the preference period.
Judge Korman saw the Section 553(b) analysis as “straightforward.” At all times, he said, the debt to the bank totaled $190,000. On the 90th day before bankruptcy, the account balance was $173,000, leaving an insufficiency of about $17,000, and allowing the bank “to recover at most [$173,000] in a hypothetical post-petition transfer.”
Judge Korman concluded that the trustee “made out a prima facie case” that $17,000 “is voidable as a preference.”
The majority did not conduct a Section 553 analysis because the trustee did not make the argument. Judge Korman said in a footnote that he nonetheless raised the issue given the importance of laying down the proper legal standards for courts to apply.
Assuming Judge Korman was correct and the bank’s lien attached to the sale proceeds when they were held in escrow outside of the preference period, there would be no preference. That issue is not addressed in either opinion. On remand, the bank might be able to raise the defense if it was not waived, and if Judge Korman was correct that the lien attached to the escrow account.
The opinion is Schoenmann v. Bank of the West (In re Tenderloin Health), 14-17090 (9th Cir. March 7, 2017).