Payments made to creditors in the 90 days preceding a bankruptcy case may be avoided as preferential under Section 547 of the Bankruptcy Code if certain conditions are met. One of the conditions is that the transfer enables the creditor to receive more than the creditor would receive if:
- the case were a case under Chapter 7 of the Bankruptcy Code;
- the transfer had not been made; and
- the creditor received payment of the debt to the extent provided by the Bankruptcy Code.
The 9th Circuit Court of Appeals has recently considered the effect of a floating lien on a trustee's ability to recover preferential transfers.
Smith's Home Furnishings
In In re Smith's Home Furnishings, Inc., 2001 WL 1045600 (9th Cir., September 13, 2001), one of the debtor's primary secured lenders made loans that were secured by a first priority floating lien on inventory and its proceeds. Under the loan agreement, the secured creditor extended credit to the debtor by granting approval to purchases from various manufacturers. After receiving approval, the manufacturers shipped merchandise to the debtor. When the debtor sold a product financed by the secured creditor, it paid the secured creditor the wholesale price of the product.
In the year prior to the debtor's Chapter 11 petition, the debtor suffered substantial losses, and the secured creditor reduced the debtor's line of credit and required substantial pay downs on the indebtedness. The debtor paid the secured creditor most of its available cash in a series of 36 payments totaling more than $12 million between May 24, 1995, and August 22, 1995. The secured creditor declared a final default, accelerating the entire indebtedness due from the debtor on August 18, 1995, and sought a receiver for the company. For the first time, the secured creditor also sought to require the debtor to segregate the proceeds of its collateral.
In response to the secured creditor's actions and declarations of default, the debtor initiated a Chapter 11 bankruptcy proceeding on August 22, 1995. As of that date, the debtor owed $10.7 million to the secured creditor. The secured creditor took possession of its collateral and liquidated it for $10.8 million.
On October 11, 1995, the debtor's case was converted to a Chapter 7 liquidation and a trustee was appointed. The trustee discovered that the debtor made $12.8 million in payments to the secured creditor during the 90 days before the petition date. The trustee initiated an adversary proceeding seeking to avoid the payments to the secured creditor as preferential. It should be noted that in a Chapter 11 case, preference actions would be brought by the debtor in possession. 11 U.S.C. §1107.
In the litigation, the trustee was required to prove that the secured creditor received more than it would have received if the case had been converted to Chapter 7 of the Bankruptcy Code. The 9th Circuit Court of Appeals reiterated the general rule that prepetition transfers to a creditor that is fully secured on the petition date are generally not preferential because the secured creditor is entitled to 100 percent of its claim. However, payments that change the status of a creditor from partially unsecured to fully secured may be preferential. Moreover, a transfer may be avoided when the creditor is fully secured at the time of payment, but undersecured on the petition date.
In order for the trustee to succeed, based on the 9th Circuit's analysis, the trustee was required to prove that the secured creditor was undersecured at some time during the 90-day preference period. The evidence submitted by the trustee showed only that as of the petition date, the value of the collateral held by the debtor exceeded its indebtedness. Without a showing by the trustee that the secured creditor was undercollateralized at some point during the preference period, the secured creditor could not have received more by virtue of the payments it received than it would have received in hypothetical liquidation.
Floating Liens
A floating lien is a financing device where a creditor claims an interest in property acquired after the original extension of the loan and extends its security interest to cover further advances. The floating lien is unique in that it is secured by a constantly changing mass of collateral for a loan that will change as payments are received and future advances are made. In In re Smiths Home Furnishings, the court held that it was not enough for the trustee to show that the 36 payments plus the amount received upon dissolution exceeded the amount of the secured creditor's claim as of the petition date. Because the collateral and indebtedness changed throughout the preference period, such values did not prove that the secured creditor received more by virtue of the payments than it would have received without them. The court held that the trustee was required to show that the amount of indebtedness under the floating lien was greater than the amount of the collateral at some point during the 90-day preference period.
Based upon the decision in In re Smiths Home Furnishings, Inc., the burden of tracing funds used to make preferential payments and to prove collateral's value is on the trustee. Thus, any preference defense involving a creditor with a floating lien should include an inquiry regarding the collateral pool's value not only as of the petition date but as of any point within the preference period as well.