Restructuring

Contributed by Dana Hall
The United States Bankruptcy Court for the Northern District of Texas, in Whittle Dev., Inc. v. Branch Banking & Trust Co. (In re Whittle Dev., Inc.), recently held that a trustee or debtor in possession can avoid a prepetition foreclosure sale of a debtor’s property as a preferential transfer under section 547 of the Bankruptcy Code despite the fact that the sale was non-collusive and conducted in accordance with applicable state law.  Although the decision adds some meat to the rather skeletal framework of existing precedent on this issue, whether a non-collusive foreclosure sale is susceptible to being avoided as a preference remains a subject of discord among various courts.
It is common practice for mortgagees such as banks to foreclose on the collateral securing their loans and subsequently purchase such collateral by credit bidding their debt at the ensuing foreclosure sale.  Due to the circumstances of foreclosure sales, however, often,  such sales do not obtain as high a sale price as would a longer, properly marketed, sale process conducted by a debtor in possession or trustee.  As a result, debtors in possession and trustees may be tempted to seek to avoid such sales as preferences or fraudulent transfers under sections 547(b) and 548(a) of the Bankruptcy Code, respectively.  Section 547 provides for the avoidance of a prepetition transfer made to a creditor, on account of an antecedent debt, if the debtor was insolvent and the transfer enabled the creditor to receive more than it would have in a hypothetical chapter 7 liquidation.  Section 548 provides for the avoidance as a fraudulent conveyance of, among other things, certain prepetition transfers made by a debtor where the debtor was insolvent or was rendered insolvent by the transfer and the debtor received less than “reasonably equivalent value” for the exchange.
The United States Supreme Court, in BFP v. Resolution Trust Corp., curtailed a debtor’s ability to avoid as a fraudulent transfer a non-collusive foreclosure sale conducted in accordance with state law, holding that the value obtained at a foreclosure sale constitutes “reasonably equivalent value” as a matter of law.  The Court rejected commonly used valuation standards, such as “fair market value,” for determining reasonably equivalent value because it found that doing so would invariably cloud the title of almost any property purchased at a foreclosure sale and would, therefore, impede the important state interest of ensuring secure title to property.
Whether the BFP decision also prohibits a debtor’s avoidance of an otherwise valid prepetition foreclosure sale as a preferential transfer under section 547 of the Bankruptcy Code, however, has become a hotly contested issue.  Bankruptcy courts in Pennsylvania, Texas, and Alabama have come down on both sides of the issue and, with its decision in Whittle, the United States Bankruptcy Court for the Northern District of Texas has now stepped into the fray.  In Whittle, a creditor holding a $2.2 million claim secured by the debtor’s real property foreclosed on such property one month before the petition date and sold the property to its subsidiary for $1.2 million through a non-collusive foreclosure sale conducted in accordance with applicable state law.  The creditor then asserted a $1.2 million deficiency claim in the debtor’s chapter 11 case (the creditor believed that the value of its claim exceeded the $2.2 million figure asserted by the debtor).  The debtor sought to avoid the prepetition sale as a preferential transfer on the basis that the sale had enabled the creditor to obtain more than it would have in a hypothetical chapter 7 liquidation.  The debtor asserted that the property’s actual value was approximately $3.3 million and that, as a result of the sale, the creditor received claims and real property worth $4.5 million in satisfaction of its $2.2 million debt, which amount would have been the creditor’s maximum recovery in a chapter 7 liquidation.
The creditor sought to dismiss the preference action, relying primarily on the Court’s holding in BFP.  It argued that, although the BFP holding dealt with “reasonably equivalent value” under section 548, the same reasoning should apply in a section 547 avoidance action – the amount obtained at the foreclosure sale should, as a matter of law, be found to equal the amount that would be obtained in a hypothetical liquidation.
The Whittle court disagreed and sided with other courts that previously found the BFP holding inapplicable in a section 547 context.  It found that the BFP holding was not controlling because the Court’s decision in BFP was concerned solely with the issue of what “reasonably equivalent value” means as a matter of law and that, in the context of a section 547 avoidance action, the relevant metric is not “reasonably equivalent value,” but rather whether a creditor did, in fact, receive more than it would have had the transfer not occurred.  In distinguishing the facts before it from those of BFP, the Whittle court suggested that the determination of “reasonably equivalent value” is a legal question, but that the determination of value received in a hypothetical chapter 7 liquidation is a factual question.  The court did not elaborate further as to why the use of foreclosure price as a legal metric for determining reasonably equivalent value would be any different from the use of foreclosure price as a “factual” metric for determining hypothetical chapter 7 liquidation value, and its reasoning may, perhaps, be embedded in the policy considerations the court examined in reaching its decision.
The Whittle court found that the policy considerations underlying the Court’s decision in BFP are not readily applicable in a section 547 context.  In the section 548 context, absent the clarity wrought by the Court’s decision in BFP, almost every prepetition transfer of property through a foreclosure sale would be subject to the risk of later undoing and a purchaser could never take comfort in the finality of a sale because the purchase price would, for two years, be subject to challenge for failure to constitute “reasonably equivalent value.”  Unlike a section 548 fraudulent transfer, which can be used to avoid a transfer even to one who is not a creditor at the time of such transfer, a preference gives rise to wholly different concerns as it applies only to transfers “to or for the benefit of a creditor” and a purchaser without a claim is not subject to a preference action.  The Whittle court also noted that concerns about clouding title are more limited because the preference window is only 90 days, as opposed to the two-year window for fraudulent transfers.  In light of the foregoing, the Whittle court denied the creditor’s motion to dismiss and allowed the debtor’s preference action to proceed.
Although the Whittle decision does not stand for the proposition that all valid prepetition foreclosure sales are susceptible to avoidance as preferential transfers, it does carve out a narrow subset of such sales for whom the foreclosure sale may be anything but final.