A bankruptcy trustee may recover for the bankruptcy estate so-called "preferential transfers"—certain payments made by the debtor within 90 days before the commencement of a bankruptcy case. To prevail, the trustee must show (among other things) that the creditor received a greater amount as a result of the transfer in question than such creditor would have received in a hypothetical liquidation under Chapter 7, had the challenged transfer not occurred.
This test, set out in Section 547(b)(5) of the Bankruptcy Code, is referred to as the "greater amount" test. In Schoenmann v. Bank of the West (In re Tenderloin Health), 849 F.3d 1231 (9th Cir. 2017), the U.S. Court of Appeals for the Ninth Circuit considered whether a bankruptcy court may account for hypothetical preference actions within a hypothetical Chapter 7 liquidation when determining whether a debt payment made by a debtor to its secured lender meets the "greater amount" test, such that it could be avoided by the trustee. Answering in the affirmative, the court held that bankruptcy courts may permissibly engage in such "hypotheticals within hypotheticals" so long as the inquiry is factually warranted and is supported by appropriate evidence, and provided further that the hypothetical action would not contravene any other provision of the Bankruptcy Code.
Bank of the West extended a $200,000 line of credit to Tenderloin Health, an AIDS clinic, along with a subsequent loan of $100,000, both secured by a lien on all of Tenderloin's assets, including its cash. Among the collateral was a deposit account at the bank, which were subject to set-off rights under state law and Section 553 of the Bankruptcy Code.
Tenderloin subsequently decided to cease operations and liquidate its assets, which included a sale of its only real property for $1,295,000. The day the real estate sale closed, Tenderloin directed the escrowed net sale proceeds to be distributed as follows: first, Tenderloin paid the bank $190,595.50, fully satisfying Tenderloin's outstanding loan obligations to the bank; second, Tenderloin deposited the remainder of the net sale proceeds ($526,402.05) into its deposit account with the bank, thereby subjecting the funds to the bank's setoff rights.
About a month later, Tenderloin filed for protection under Chapter 7 of the Bankruptcy Code. The bankruptcy court appointed E. Lynn Schoenmann as Chapter 7 trustee of Tenderloin's estate. Shortly thereafter, the bank voluntarily relinquished to the trustee the funds remaining in Tenderloin's account, without setoff. However, the trustee brought an action against the bank seeking also to avoid the payment of $190,595.50 as a preferential transfer under 11 U.S.C. Section 547(b). To prevail under that section, the trustee was required to show that the bank received more as a result of that $190,595.50 payment than it would have received in a hypothetical Chapter 7 liquidation case. The bankruptcy court granted summary judgment in the bank's favor, reasoning that the trustee had failed to meet Section 547(b)'s "greater amount" test because the bank had a right of setoff in the account funds—which were well in excess of the $190,595.50 payment made to the bank. Consequently, the bankruptcy court concluded that, as a secured creditor, the bank would have been entitled to payment of the same amount in a hypothetical liquidation. The district court affirmed, and the trustee appealed.
In her appeal, the trustee argued that a hypothetical trustee in a hypothetical Chapter 7 liquidation could have avoided the entire $526,402.05 deposit as a preferential transfer, leaving only $37,713.87 in the account against which to exercise its setoff rights. The trustee pointed out that, under this hypothetical scenario (in which the bank would not have received them $190,595.50 payment), the bank's only recourse would have been a post-petition setoff against the diminished account funds. In response, the bank argued that it would be improper for a bankruptcy court to consider a hypothetical preference action (to avoid the $526,402.05 deposit into the account) within an already hypothetical Chapter 7 liquidation in applying the "greater amount" test.
The Ninth Circuit Court began its analysis by looking at the text and legislative history of Section 547(b)(5). The section allows a trustee to avoid any transfer that enables the recipient creditor "to receive more than such creditor would receive if—the case were a case under Chapter 7 of this title; the transfer had not been made; and such creditor received payment of such debt to the extent provided by the provisions of this title." In other words, and according to the court's review of the legislative history, the transfer must have garnered the creditor a greater percentage of its claim than such creditor would otherwise receive under the distributive provisions of the Bankruptcy Code. The court emphasized that "the provisions of this title" refer to the entire Bankruptcy Code, including Section 547's preference provisions. Consequently, the court found no basis in the statute for prohibiting a "greater amount" inquiry that includes a hypothetical preference action within the broader context of a hypothetical Chapter 7 liquidation.
The court next looked to the actual practice under the Bankruptcy Code. Several bankruptcy courts, according to the Tenderloin court, have engaged in similar "nested hypotheticals" in applying other provisions of the Bankruptcy Code. For example, in the context of plan confirmation, Section 1129(a)(7)(A)(ii) requires a bankruptcy court to create a hypothetical Chapter 7 liquidation to ensure that impaired classes of creditors will not receive less under a proposed reorganization plan than they would in the hypothetical liquidation. According to the Tenderloin court, bankruptcy courts have looked at hypothetical preference actions within the hypothetical Chapter 7 liquidation in applying Section 1129(a)(7)(A)(ii). The court saw no reason why the same practice could not apply in the context of Section 547(b)(5).
Having determined that such a hypothetical preference action within a hypothetical Chapter 7 case is permissible, the court next addressed the bank's argument, based on the court's previous decision in In re LCO Enterprises, 12 F.3d 938 (9th Cir. 1983), that hypothetical liquidations constructed for purposes of "greater amount" analysis, must be based on the "actual facts of the case." Because the trustee had not avoided the $526,402 deposit in the "real" Chapter 7 case, the bank argued that it would be an impermissible deviation from the "actual facts" for the trustee to rely on a hypothetical liquidation that included such a nonfactual avoidance action.
The court disagreed and distinguished LCO on its facts. In LCO, after assuming a lease under Section 365 of the Bankruptcy Code, the trustee sought to avoid payments under the lease, relying on a hypothetical situation in which the lease had either never existed or had not been assumed. The LCO court found that such assumptions simply did not "reflect the facts at any time." In contrast, the trustee in Tenderloin still had the option of bringing an avoidance action to recover the deposits when the bankruptcy court performed its hypothetical analysis. Thus, the bankruptcy court would not have impermissibly contradicted actual facts by assuming in the hypothetical case that the trustee had pursued such an action. The court further distinguished LCO on the basis that straying from the facts in that case would have entailed allowing the trustee to recover payments that it was obligated to make under other provisions of the Bankruptcy Code. Importantly, the Tenderloin court found no similar "statutory collision." Applying this reasoning, the court examined what impact the hypothetical avoidance of the $526,402 deposit would have on the bank's hypothetical recovery. First, the court determined that the hypothetical bankruptcy court would decide the trustee's preference action before addressing the bank's right of setoff against the account funds. Next, the court determined that, because the deposited funds would have increased the bank's setoff rights substantially, the bank thereby received a "greater amount" than it would have absent the deposit. Consequently, the hypothetical trustee would have been able to avoid the deposit, leaving the bank with only $37,713.87 remaining in the account against which the bank could seek to set off its $190,595.50 claim (which hypothetically had not been paid off pre-petition).
Accordingly, the court held that, once the hypothetical preference action was introduced into its analysis, the trustee could show that the bank received significantly more through its receipt of the $190,595.50 than the $37,713.87 post-petition setoff to which it would otherwise have been entitled to a hypothetical Chapter 7 case. In so holding, the court concluded that a bankruptcy court may entertain a hypothetical preference action within Section 547(b)(5)'s hypothetical liquidation scenario so long as such an inquiry is factually warranted, is supported by evidence, and would not result in "statutory collision" with other sections of the Bankruptcy Code. Accordingly, the court reversed the judgment below and remanded the case for further consideration by the bankruptcy court.
The Tenderloin decision creates significant uncertainty for creditors, as it could result in creditors becoming entangled in multiple layers of litigation within a hypothetical Chapter 7 case. Such "hypotheticals within hypotheticals" are likely to become even more protracted in more complex bankruptcy cases. To "avoid" the hypothetical, creditors are advised to take adequate security at the time credit is extended, whether through a lien on real estate, cash or other assets. Although the bank had some security in the form of a lien on Tenderloin's cash, that lien was only perfected with respect to the limited funds already in the deposit account at the bank, leaving the bank undersecured before Tenderloin made the deposit. The bank might have achieved a different outcome in Tenderloin had it, for example, imposed a minimum cash balance on the deposit account at the time of the loan. In other words, following Tenderloin, creditors must take fully perfected security contemporaneously with the extension of credit, or risk facing surprise clawbacks in the event their debtors should file for bankruptcy protection.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. Chad E. Odhner is an associate at the firm in the Philadelphia office and practices in the area of financial restructuring and bankruptcy law.
Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.