Some Upside to Being Upside-Down: The Fifth Circuit Provides Undersecured Creditors an Additional Front on which to Contest Preference Claims
Undersecured creditors face unique challenges because they are neither fully secured nor fully unsecured. Beyond the obviously undesirable issue of being upside-down on their deal, undersecured creditors often are exposed to preference liability for those payments they received in the 90 days prior to the debtor filing bankruptcy. This is especially true where an aggressive trustee is looking to create value or where an opportunistic trustee sees a chance to make a quick buck.
Bankruptcy Code section 506 states that a creditor with a claim that is secured by property of the estate has a secured claim up to the value of their collateral and an unsecured claim for the remaining portion of their claim. Thus, an undersecured creditor’s claim is split, or bifurcated, into secured and undersecured portions. Fully secured creditors enjoy protection from preference claims by virtue of the fact that payments received in the preference period do not allow them to receive more than they would in a hypothetical chapter 7 liquidation because their fully secured status allows them to get paid in full.
Undersecured creditors face an additional challenge from the unsecured portion of their claim because payments they receive in the preference period may allow them to recover more than they would have in a hypothetical liquidation chapter 7 liquidation. While undersecured creditors have the same preference defenses available to them as an unsecured creditor, such as receiving payments in the ordinary course or that they provided new value, those defenses may not give quite the same level of comfort as a fully secured claim. In applying the language of the Bankruptcy Code, the Fifth Circuit in El Paso Refinery provided a two part test for undersecured creditors.
In Krafsur v. Scurlock Permian Corp. (In re El Paso Refinery), 171 F.3d 249 (5th Cir. 1999), the chapter 7 trustee sought to avoid payments made from the debtor to its supplier of crude oil. The supplier of crude oil shared a floating lien on accounts receivable, inventory, contract rights, and proceeds with the debtor’s prepetition lender pursuant to an intercreditor agreement. The bankruptcy court ruled that the intercreditor agreement worked as a partial assignment of approximately 55% of the prepetition lender’s interest in the collateral. The bankruptcy court went on to rule that the same portion of the payments received in the preference period were proceeds from the oil supplier’s own collateral, and, therefore, 55% of the alleged preferential preference payments were unrecoverable. The district court affirmed and both parties appealed.
The Fifth Circuit reversed and held that none of the payments the oil supplier received were preferential. In reaching this conclusion, the Fifth Circuit utilized the “improvement in position” or the “greater percentage” test interpreting section 547(b)(5) of the Bankruptcy Code. The goal of this test is to determine if, by virtue of the payments in the preference period, the creditor received a greater recovery on its debt than it would have otherwise received in a hypothetical chapter 7 liquidation. While this test is well established for unsecured creditors, the Fifth Circuit conformed its application of the test for undersecured creditors.
The Fifth Circuit stated that for undersecured creditors, two issues need to be resolved: “(1) to what claim the payment is applied and (2) from what source the payment comes.” The Fifth Circuit refers to these issues as the “Application Aspect” and the “Source Aspect,” respectively. In order to satisfy the Application Aspect of the test, the payments must be applied to the secured portion of the undersecured creditors claim, and the undersecured creditor must correspondingly reduce the secured portion of its claim. If the undersecured creditor does not correspondingly reduce the secured portion of its claim, the payment is considered a payment on the unsecured portion of the claim. To satisfy the Source Aspect of the test, the payments the undersecured creditor receives must come from its own collateral. The Fifth Circuit reasoned that a creditor which merely receives its own collateral cannot be receiving any more than it would have in a hypothetical liquidation, and creditors with an interest in accounts receivable or other cash equivalents are automatically receiving a payment from their own collateral.
As a result of the language referring to undersecured creditors generally, it was unclear whether this test was meant to replace or supplement the existing hypothetical liquidation analysis under section 547(b)(5) for undersecured creditors. The Fifth Circuit addressed this ambiguity in Garner v. Knoll, Inc. (In re Tusa-Expo Holdings Inc.), 811 F.3d 786 (5th Cir. 2016).
In Tusa-Expo, a chapter 7 trustee brought an action to avoid payments made to an office furniture supplier by an office furniture dealer. The office furniture supplier had first-priority lien on certain of the debtor’s accounts receivable and a second-priority lien on all other and after acquired property. The bankruptcy court, in a belt and suspenders approach, punted on determining whether to conduct the analysis in El Paso Refinery or a section 547(b)(5) hypothetical chapter 7 liquidation analysis and conducted both. The bankruptcy court subsequently found that under both analyses the payments received by the office furniture supplier in the preference period were not preferences. The district court affirmed, albeit for different reasons.
The Fifth Circuit resolved the issue regarding the proper standard to apply by stating that a court could alleviate the need to conduct a typical hypothetical liquidation analysis by conducting the analysis under El Paso Refinery first. If under the El Paso Refinery analysis the payments are not found to be preferential, that analysis is dispositive of the preference issues. In the event that the El Paso Refinery standard is not met, the trustee is still required to establish that the undersecured creditor received more than would have received in a hypothetical chapter 7 liquidation. As a result, the Fifth Circuit made clear that the El Paso Refinery analysis is a threshold which is intended to aid a section 547(b)(5) analysis rather than replace it. In so concluding, the Fifth Circuit affirmed the holdings of the bankruptcy and district courts.
Tusa-Expo addresses the issues left open by El Paso Refinery and makes clear that the analysis in El Paso Refinery is merely a shortcut to potentially avoid a hypothetical chapter 7 liquidation analysis. While the test in El Paso Refinery and the clarifying holding in Tusa-Expo do not change the outcome for a hypothetical liquidation analysis under section 547(b)(5), they do provide an additional and valuable front on which to challenge a trustee’s preference claims. For those undersecured creditors that do not have an interest in the debtor’s accounts receivable or other cash equivalents, Tusa-Expo makes clear that that they still have the same tools available as any other creditor accused of receiving preferential payments. While this holding is not a boon for undersecured creditors without an interest in accounts receivable or the like, it does clear up any unnecessary confusion about the scope and applicability of the standard in El Paso Refinery.
As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.