Secured Lenders – Beware of Hidden Preference Issues Affecting Holders of Shared Collateral

A recent decision rendered by the Bankruptcy Court for the Southern District of California raises some interesting cautionary tales for secured lenders who share collateral.

In Gladstone v. Bank of America (In re: Vassau et. al.), 499 B.R. 864 (Bankr. S.D. Cal. 2013), two lenders shared collateral that had a value that exceeded the amount of the senior lienholder’s claim but was less than the combined amounts of the senior and junior lienholders’ claims. In other words, the senior lienholder was fully secured but the junior lienholder was under-secured, a very common set of facts.

Within the 90 day preference period, the debtor made payments of about $41,000 to the senior lienholder. The trustee for the debtor did not pursue a preference claim against the senior lienholder, presumably because the shared collateral had a value in excess of the amount of the senior lienholder’s claims at all relevant times. Rather, the trustee sued the junior lienholder for the $41,000 in payments made to the senior lienholder.

The trustee’s claim against the junior lienholder was based on the provisions in the BR Code (sections 547(b)(1) and 550(a)(1)) that allow for the recovery of preferences from the party for whose benefit the transfer was made even if that party didn’t actually get the payment. The Gladstone court held that, while the $41,000 wasn’t paid to the junior lienholder, the junior lienholder benefited from the payment to the extent it reduced the senior lienholders claim and, so, increased the value of the shared collateral available to the junior lienholder. The Gladstone court cited to one Circuit Court case, In re: Prescott, 805 F.2d 719 (7th Cir. 1986), which reached the same conclusion on similar facts.

While cases in which payments to a senior lienholder are recovered as preferences from a junior lienholder are not common, given the “for the benefit of” provisions of the Bankruptcy Code, the results in Gladstone and Prescott are not surprising. However, secured lenders should note two troubling aspects of the Gladstone and Prescott decisions, one of which applies to junior lienholders and the other to senior lienholders.

First, even if a payment to a senior lienholder increases the value of a junior lienholder’s interest in shared collateral at the time the payment is made (which seems to be the relevant analysis under Prescott) or as of the bankruptcy petition date (which seems to be the relevant analysis under Gladstone), that doesn’t mean the junior lienholder will ever realize that increased value. The shared collateral could decline in value (possibly to zero) between the payment date or the petition date (whichever is applicable), on the one hand, and the time the junior lienholder is able to realize on the collateral (whether through foreclosure, payment under a plan of reorganization or otherwise) on the other. And, if the shared collateral does decline in value after the relevant date, the junior lienholder could be in the worst of all worlds, having to repay the preference but not getting a corresponding increase in what it realizes from the collateral. A junior lienholder faced with a preference claim based on a payment to a senior lienholder should argue that its exposure is limited to the “benefit” it actually realizes rather than the hypothetical benefit measured as of the payment date or petition date.

Second, in dicta at the end of the Gladstone opinion, the court notes that, if a trustee is successful in establishing that a junior lienholder received a preferential transfer because it benefited from a transfer to a senior lienholder, the trustee is not limited to pursuing recovery from the junior lienholder. Rather, according to the Gladstone court, pursuant to section 550 of the Bankruptcy Code, once it is established that a preferential transfer occurred, recovery of that transfer can be obtained from either the entity for whose benefit the transfer was made (i.e., the junior lienholder) or, alternatively, from the initial transferee (i.e., the senior lienholder). In other words, the Gladstone court seems to believe that, even if a senior lienholder is over-secured when it receives a payment, that payment may be recoverable from the senior lienholder if an under-secured junior lienholder benefited from the payment.

While we are not aware of any case in which an over-secured senior lienholder was forced to repay a preference because the payment in question benefited a junior lienholder, the dicta in Gladstone seems to leave open that possibility.

For More Information

For more information on how these issues may affect your rights, contact Robert Lapowsky at 215.751.2866.

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