The Avoiding Powers. Assignment 19 The Trustee s Avoiding Powers. Problem 1(a) The Strong- Arm Power

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1 Assignment 19 The Trustee s Avoiding Powers The Avoiding Powers Ch. 7 trustee can avoid (invalidate) certain transfers of property that had the effect of diminishing the bankruptcy estate Unperfected SIs ( strong-arm power) [ 544(a)] Preferential transfers [ 547] Fraudulent transfers [ 548, 544(b)] Unauthorized post-petition transfers [ 549] The debtor-in-possession can exercise these powers in a Chapter 11 case [ 1107(a)] 544 gives the bankruptcy trustee special status 544(a)(1): hypothetical lien creditor as to all of debtor s personal property 544(a)(3): bona fide purchaser as to debtor s land 544(a) then gives trustee the power to invalidate any transfer that these persons could have avoided under state law [such as 9-317(a)(2)(A)] The Strong- Arm Power Trustee as Lien Creditor 2013: Bank financed purchase of a pipe organ by Carr, took a SI in the organ Bank prepared a UCC-1, but never filed it Oct. 25: Carr filed Ch. 7 Oct. 31: Bank belatedly files UCC-1 covering pipe organ Could Trustee set aside Bank s SI in the organ under 544(a)(1)? Problem 1(a) 1

2 Problem 1(a) Key fact: was the pipe organ equipment or consumer goods in Carr s hands? If consumer goods, Bank had an automatically perfected PMSI [ 9-309(1)] on petition date; not avoidable under strong-arm clause If pipe organ was equipment, Bank s SI was unperfected on the petition date, Trustee may thus avoid that SI [ 9-317(a)(2)(A), 544(a)(1)] If pipe organ was equipment: Under Article 9, a lien creditor would take priority over an unperfected SI [ 9-317(a)(2)(A)] Trustee has status of lien creditor as of date of bankruptcy petition [ 544(a)(1)] Trustee can set aside Bank s SI if it was unperfected on petition date Bank s October 31 filing UCC-1 has no effect, b/c it violates the automatic stay [ 362(a)(4)] Bank will have only an unsecured claim Problem 1(b) Oct. 22: Bank loans $10,000 to Tanya s Treats LLC, to finance its purchase of candy-making equipment (in which PCB took a SI) Oct. 31: Tanya s Treats LLC files Ch. 11 petition Later on Oct. 31: Bank files UCC-1 covering the equipment Can Trustee avoid Bank s SI in the equipment under the strong-arm clause? Problem 1(b): Article 9 Analysis Under Article 9, Bank would have had priority over an intervening lien creditor 9-317(e): PMSP can file UCC-1 w/in 20 days after debtor takes possession and get relationback priority over intervening lien creditors Bank filed w/in 20-day grace period, so intervening lien creditor would be subordinate to Bank s perfected SI [ 9-317(e)] 2

3 544(a), 546(b), and the Stay Ordinarily, filing a UCC-1 after the petition date would violate the automatic stay [ 362(a)(4)] But Bank s filing (act of perfection) doesn t violate the stay in this situation [ 362(b)(3)] Code doesn t stay act of perfection to extent the trustee s avoiding power is subject to 546(b) 546(b) makes trustee s avoiding power subject to state law relation-back priority rules! Bank s valid filing perfected its SI, which can t be avoided by bankruptcy trustee [ 9-317(e)] 546(b)(1). The rights and powers of a trustee under sections 544, 545, and 549 of this title are subject to any generally applicable law that (A) permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection; or (B) provides for the maintenance or continuation of perfection of an interest in property to be effective against an entity that acquires rights in such property before the date on which action is taken to effect such maintenance or continuation. 2012: Bank loaned $12,000 to Simpson, taking SI in her six saxophones Bank filed UCC-1 covering the saxophones in MO, where Simpson resided Oct. 31, 2014: Simpson files Ch. 7 petition in Wisconsin, to which she has moved Can Bank file a UCC-1 in Wisconsin at this point? Would it do them any good? Problem 1(c) Q: Was Bank s SI perfected on petition date? Bank had 4 months of temporary perfection after Simpson moved to WI [ 9-316(a)(2)] If Simpson moved to WI before June 30, 4 month grace period has lapsed, Bank s SI was unperfected on petition date, and Trustee could avoid its SI If Simpson moved on/after July 1, Bank s SI was still perfected on petition date; Trustee (who obtained status of lien creditor on that date) couldn t set aside Bank s perfected SI If Simpson moved after July 1, does Bank need to file a new UCC-1 in WI? 3

4 Bank wouldn t have to file in WI to get priority vs. Ch. 7 trustee (no retroactive loss of priority upon lapse vs. lien creditors like the bankruptcy trustee) [ 9-316(b)] But Bank would need to file if there had been other intervening third party purchasers (i.e., other secured parties or buyers) During remaining 4-month grace period, Bank can file in WI without violating the automatic stay [ 362(b)(3), 546(b)(1)(B)] (trustee s avoiding power is subject to re-perfection rules) 546(b)(1). The rights and powers of a trustee under sections 544, 545, and 549 of this title are subject to any generally applicable law that (A) permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection; or (B) provides for the maintenance or continuation of perfection of an interest in property to be effective against an entity that acquires rights in such property before the date on which action is taken to effect such maintenance or continuation. October 1, 2014: Bank loaned Moore $20,000 to buy a used BMW, took SI in the BMW October 23, 2014: Moore filed Ch. 7 petition October 25, 2014: Bank applied to have its lien noted on the title certificate for the BMW (more than 20 days after October 1) Can Trustee avoid Bank s SI in the BMW? Problem 1(d) Note: Missouri s certificate-of-title act allows for a 30-day relation-back period The notice of lien is perfected as of the time of its creation if the delivery of such notice to the director of revenue is completed within thirty days thereafter, otherwise as of the time of the delivery. [RSMo ] Contrast 9-317(e) (which provides for 20-day grace period for purchase money secured party to obtain relation-back priority over an intervening lien creditor) 4

5 B/c Bank complied with MO s COT act within the 30-day grace period of : Bank s delivery of application to titling agency did not violate automatic stay [ 362(b)(3); Bank take act to perfect a lien on property of the estate to the extent done within applicable relation-back grace period under 546(b)] Bank s delivery of application on October 25 means Bank deemed perfected as of October 1 Trustee thus cannot avoid Bank s SI [ 544(a), 9-317(a)(2)(A)] Suppose Debtor has assets worth $100, but owes $100 to A and $100 to B Debtor is insolvent (liabilities >> assets) Debtor pays A in full, pays B nothing Outside of bankruptcy, states law generally gives no remedy to B Presumption: A, B are each capable of protecting their own interests! Preferences A Debtor Assets = $100 Liabilities = $200 B Preference Avoiding Power Bankruptcy [ 547] allows trustee (or debtor in possession in Chapter 11 case) to set aside certain pre-bankruptcy transfers that were preferential Rationale: preserves integrity of collective bankruptcy process, preserves bankruptcy distribution scheme Discourages creditors from making last minute grabs at the debtor s assets to detriment of other creditors A $100 (preference) $50 bankruptcy distribution Trustee $50 bankruptcy distribution B Problem 2 Bank loaned Daddy Day Care, Inc. (DDC) $100K on an unsecured basis; earlier this year, DDC went into default Bank agreed to give DDC an extension of due date on loan; in exchange, DDC granted Bank a SI in its play equipment Bank immediately filed a proper UCC-1 Nov. 1, 2014: DDC filed Ch. 7 petition 5

6 Elements of a Preference (1) Transfer of property of the debtor [ 547(b)] (2) To/for benefit of a creditor [ 547(b)(1)] (3) On account of antecedent debt [ 547(b)(2)] (4) Made while debtor insolvent [ 547(b)(3)] (5) Made w/in 90 days prior to bankruptcy (or 1 year, if creditor was an insider ) [ 547(b)(4)] (6) Creditor better off than if it had instead been paid only in a Ch. 7 liquidation proceeding [ 547(b)(5)] Problem 2 By obtaining a SI to secure a previously unsecured debt, Bank is made better off than it would ve been in a Chapter 7 liquidation In Ch. 7, as an unsecured creditor, Bank would ve gotten only a pro rata dividend (<< 100%) If it had valid SI, Bank would get 100% repayment on the debt (up to the value of the collateral) SI gives Bank a last minute grab at DDC s assets, to satisfy an already-existing debt Transfer by Debtor? To/for Creditor? Antecedent Debt? W/in Period? Debtor Insolvent? Creditor Better Off? Problem 2 SI in play equipment SI granted to Bank Debt had been unsecured Otherwise unsecured! Insolvency [ 547(b)(3)] If debtor isn t insolvent at time of transfer, transfer isn t preferential (b/c there are still enough assets to pay all other creditors) Insolvent [ 101(32)] means liabilities >>> assets Debtor is presumed insolvent during 90 days prior to petition date [ 547(f)] Burden on recipient of transfer to prove that debtor was solvent at time transfer occurred 6

7 Presumption of Insolvency Debtor is presumed insolvent during 90 days prior to petition date [ 547(f)] Burden on recipient of transfer to prove debtor was solvent at time transfer occurred Rationale: Debtors usually are insolvent in run-up to bankruptcy filing; would be bad policy to require trustee to incur expense necessary to reconstruct debtor s balance sheet to prove insolvency (would eat up funds that could otherwise pay creditors) Result thus depends on timing: when did the transfer of the SI occur relative to petition date? If SI was granted to Bank less than 90 days prior to bankruptcy petition, Bank s SI = preferential transfer DDC presumed to have been insolvent in that time [ 547(f); burden would be on Bank to prove that DDC was not insolvent at the time SI was granted to Bank] If SI was granted more than 90 days prior to petition date, then the trustee cannot set aside the SI as a preference Insider Preference If the creditor receiving the transfer was an insider of the debtor (e.g., an officer, director, partner, spouse, etc.), preference period is extended to 1 year [ 547(b)(4)] Rationale: creditor that is insider of debtor could manipulate timing of transfers and timing of bankruptcy petition to avoid 90-day claw-back period Problem 2(b) Bank also loaned DDC $10,000 to buy a giant screen TV and a theater system Bank prepared a UCC-1, but it was returned for lack of a proper filing fee Bank properly filed the UCC-1 the following month Nov. 1, 2014: DDC files Ch. 7 petition Is Bank s SI in the TV/theater a preferential transfer avoidable by the Trustee? 7

8 At first blush, DDC s granting of SI doesn t appear to have the practical effect of preferring Bank vs. other creditors of DDC Here, Bank extended credit to DDC to enable DDC to acquire the TV/theater (which it didn t have otherwise), e.g., an enabling loan Thus, Bank was extending purchase money credit (a new debt), not taking a SI to secure a pre-existing (antecedent) debt Late Perfection Concern: by not perfecting in a timely fashion, Bank may have misled third parties dealing with near-bankrupt debtor DDC Third parties dealing with DDC during delay in perfection wouldn t have known the TV/home theater were subject to a SI in favor of Bank Ostensible ownership/constructive fraud 547(e) Timing Rules Timing of Transfers To apply 547 (which applies to transfers w/in 90 days prior to bankruptcy), court must determine the date a transfer took place For a payment of money, this is easy For the granting of a security interest, however, there are two possibilities: Date SI was granted (attachment), or Date SI was perfected (notice to 3rd parties) Under 547, a transfer of SI is deemed made : At time of attachment, if SI is perfected at that time or w/in next 30 days [ 547(e)(2)(A)] At time of perfection, if SI is perfected >> 30 days after attachment [ 547(e)(2)(B)] On the petition date, if not perfected on/before petition date [ 547(e)(2)(C)] SI is perfected for purposes of 547 when a judicial lien creditor can t acquire a superior interest [ 547(e)(1)(A)] (thus, perfected under Article 9 = perfected under 547(e)) 8

9 Problem 2(b): Timing Rule If Bank filed UCC-1 w/in 30 days of attachment, SI deemed to have been granted at time of attachment Thus, Bank s SI would NOT have been on account of an antecedent debt no preference! If Bank filed its UCC-1 >> 30 days after attachment of SI, SI is deemed granted on date of perfection! Thus, Bank s SI would be deemed to have been granted on account of an antecedent debt! If that date was << 90 days prior to bankruptcy, then Bank s SI would be subject to avoidance under 547(b)! Problem 2(b): Rationale? Delay in perfection created ostensible ownership problem; 3d parties could have been misled into dealing with DDC in the interim Concern isn t really that Bank got preferred, but that delayed perfection created the potential for constructive fraud on other creditors 547 timing rule makes this a preference, to deal most effectively w/the secret lien problem Problem 3 Carter s Café (Carter s) borrowed $50K from Atlantic Commercial Finance (ACF), which has perfected SI in Carter s kitchen equipment Oct. 15: Carter s makes $10K payment on loan (balance of loan reduced to $40K) Nov. 1: Carter s files Ch. 7 petition Can the Trustee make ACF disgorge the $10K loan payment as a preferential transfer? Transfer by Debtor? To/for Creditor? Antecedent Debt? W/in Period? Debtor Insolvent? Creditor Better Off? Problem 3 $10,000 payment Paid to PCB Debt repayment Yes, 15 days pre-petition Presumed insolvent 9

10 If ACF was oversecured (if collateral s value is >> $50,000), ACF was NOT made better off by receiving the payment In Ch. 7 liquidation, ACF would ve been paid in full from proceeds of foreclosure sale anyway! If ACF was undersecured (if collateral s value was = $20,000), ACF was made better off In Ch. 7, ACF would ve gotten < 100% payment on the unsecured portion of its bifurcated claim Problem 4: After-Acquired Property ACF has a perfected SI in all of Carter s present and after-acquired equipment Oct. 25: Carter s buys a dishwasher for $5K Nov. 1: Carter s files Ch. 7 bankruptcy petition Can Trustee invalidate ACF s SI in the dishwasher as a preferential transfer? A. Yes B. No C. Maybe ACF s SI in new dishwasher may be a preference B/c dishwasher was after-acquired collateral, the SI in it is deemed to have been granted when Carter s acquired it [ 547(e)(3)], and thus deemed to have been granted on account of an antecedent debt Question: Did SI in dishwasher make ACF better off than it would have been in a Ch. 7 liquidation? This depends on the value of ACF s other collateral, relative to the debt If ACF was already fully secured, the additional collateral didn t make ACF better off However, if ACF s claim was otherwise undersecured, having the dishwasher as an additional item of collateral would ve made ACF better off (less undersecured = greater recovery!) Debt = $50K Other equipment = $30K Dishwasher = $5K In Ch. 7, ACF s unsecured claim would ve = $20K W/SI in dishwasher, ACF s unsecured claim = $15K Debt = $50K Other equipment = $60K Dishwasher = $5K In Ch. 7, ACF s unsecured claim = $ 0 (fully secured) W/SI in dishwasher, ACF s unsecured claim = $ 0 10

11 Preference Exceptions [ 547(c)] Certain transfers by the debtor literally satisfy the 547(b) test, but would not be preferential in their actual effect Congress protects these transfers through exceptions; trustee cannot avoid a transfer covered by one of the 547(c) exceptions Preference Hypothetical Oct. 1: Debtor buys computer from Seller on installment K Seller intended to take PMSI in computer, but Debtor signed agreement that did not describe the computer! Oct. 2: Seller catches the error; Debtor signs a new installment K that properly describes the computer Nov. 1: Debtor files a Chapter 7 petition Did Seller receive a preference? Technically, Seller has received a preference SI was not granted until Oct. 2 Debt was incurred on Oct. 1, so SI was granted on account of antecedent debt Had SI not been granted on Oct. 2, Seller would ve been unsecured, so getting the SI made Seller better off than it would ve been in Ch. 7 But, this transfer wasn t intended to be preferential in its effect; Seller meant to extend PM credit, which enabled Debtor to acquire additional asset! (not a last minute grab ) Contemporaneous Exchange Exception [ 547(c)(1)] A transfer that would otherwise be a preference under 547(b) cannot be avoided if the transfer: Was intended to be a contemporaneous exchange for new value given to the debtor, and Was in fact substantially contemporaneous This would likely prevent Trustee from being able to set aside Seller s SI as a preference 11

12 Enabling Loan Exception [ 547(c)(3)] Trustee can t avoid SI to extent it Secures new value given by secured party at or after signing of security agreement Secures new value given to enable the debtor to acquire collateral (and so used), and Was perfected on or before 30 days after debtor received possession of collateral Problem 5 In 2011, First Bank extended a line of credit to Austin Auto Parts, Inc. (Austin), secured by its present and after-acquired inventory (perfected by UCC-1 filing) On Nov. 1, 2014, Austin filed bankruptcy Trustee moves to set aside all of First Bank s SI in Austin s inventory as a preference. Why? Problem 5: The Problem If Austin is like many retailers, its inventory turns over (i.e., is sold and replaced) frequently Thus, it s likely that on the petition date, most/all of Austin s inventory will have been acquired by Austin within the previous 90 days Similar problem where collateral is present and afteracquired accounts B/c SI in after-acquired inventory doesn t arise until Austin acquires it, 547(e)(3) timing rule threatens First Bank s floating lien First Bank s SI in Austin s petition date inventory is deemed granted when Austin acquired it If debt was incurred in 2011, SI is on account of antecedent debt! SI in new inventory acquired within past 90 days nominally improved First Bank s position (if Austin s inventory had turned over within 90 days, it would have no collateral without the new inventory!) 12

13 Floating Liens in Bankruptcy It doesn t make sense to completely wipe out First Bank s floating lien in all of the inventory acquired in the prior 90 days Use of floating lien is not by itself a last minute grab by First Bank At same time Austin was buying new inventory, it was also likely borrowing more money under its line of credit (an offsetting extension of value) Floating Liens in Bankruptcy Trustee can only avoid floating lien on inventory/ accounts to the extent that transfers/payments improve creditor s secured position during 90-day period prior to bankruptcy [ 547(c)(5)] Two point net improvement test If Secured position(=petition date) > Secured position(=90 days prior to petition), trustee can avoid floating lien to the extent of improvement Intermediate fluctuations are irrelevant 2011: First Bank took, perfected a SI in Austin Auto Parts s inventory (incl. afteracquired) Nov. 1, 2014: Austin Auto Parts files bankruptcy petition Has Bank received a preference where: Date Balance Value Aug. 1 $140,000 $120,000 Sept. 1 $100,000 $120,000 Oct. 1 $120,000 $80,000 Nov. 1 $100,000 $150,000 Problem 5 Problem 5 First Bank s position 90 days prior: $120K (inventory) - $140K (debt) = [$20K undersecured] Bank s position at petition date: $150K (inventory) - $100K (debt) = $50K oversecured! Net improvement is $70K; trustee can avoid SI as to $70K of inventory on hand on petition date Amounts that otherwise would ve gone to pay unsecured creditors went to buy inventory that reduced/ eliminated the unsecured portion of First Bank s claim First Bank s claim: $80K secured, $20K unsecured 13

14 Fraudulent Transfers Under state law, an injured creditor can sue to invalidate a fraudulent transfer by the debtor E.g., Tortfeasor harms Victim Before Victim can get a judgment (and a lien vs. Tortfeasor s property), Tortfeasor gives his property to his children (who agree to let Tortfeasor use it) Victim can invalidate this transfer, which is intended to defraud Victim as a creditor [UFTA] Fraudulent Transfer Hypo October 1: X sells business equipment (FMV = $2,000,000) to his son for $1,000,000 November 1: X files for bankruptcy, with assets of $100,000 and liabilities of $1,000,000 Should X s bankruptcy trustee be able to recover the equipment from X s son? Bankruptcy Code 548 allows Trustee to set aside transfers of property made by Debtor during 2 years prior to bankruptcy, if they are Actually fraudulent, e.g., made w/intent to hinder, delay, or defraud creditors [ 548(a)(1)(A)], OR Constructively fraudulent [ 548(a)(2)(B)], meaning that: Debtor received less than reasonably equivalent value for the transfer, and The transfer was made while Debtor was insolvent or the transfer rendered Debtor insolvent Fraudulent Transfer Hypo X s sale to son was for less than reasonably equivalent value (50% of FMV) Sale to son rendered X insolvent Sale occurred within 2 years prior to bankruptcy Thus, trustee can recover the equipment from X s son, for benefit of X s creditors X s son would have a lien on the equipment to secure repayment of the $1,000,000 paid by X s son [ 548(c)] 14

15 Fraudulent Transfer Often, bankruptcy trustee may try to set aside a pre-bankruptcy foreclosure sale on the ground that the foreclosure sale price was less than reasonably equivalent value (and sale was thus constructively fraudulent as to debtor s unsecured creditors) We ll discuss Problem 6 more in Assignment 21, when we cover foreclosure sales 15