Preference Recovery: You May Be More Exposed Than You Think

Author: Vicki R. Harding, Pepper Hamilton LLP

Imagine a $2 million property that secures a $1.75 million senior loan and a $500,000 junior loan.  The owner files bankruptcy, and during the 90 days prior to bankruptcy the senior lender received payments totaling $250,000.  Does the senior lender have preference exposure?

A typical assessment is that because the senior lender is over-secured, it did not receive a preference because it did not receive more than it would have in a chapter 7.  However, it can be argued that the payments constitute a preference to the junior lender since it will receive more than in a chapter 7 as a result:  Without the payments, only $250,000 would be left after payment of the senior lender, but with the payments, $500,000 is left.  And the senior lender could be liable in a recovery action as the transferee of the preference under Section 550.

But wait, isn’t that a Deprizio argument, and didn’t Congress fix the Code to preclude this result? The answer is no: Deprizio and Section 550(c) address transfers benefitting insiders made between 90 days and a year prior to bankruptcy.  It does not protect a lender for claims based on transfers made during the 90 days prior to bankruptcy.  Unfortunately for senior lenders, this is not a fanciful hypothetical, but rather the approach taken in Gladstone v. Bank of America, N.A. (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal. 2013), discussed more in Preferences:  Surprise – Being Fully Secured May Not Be A Complete Defense.