A chapter 7 trustee sought to avoid as a preference a mortgage that was recorded within 90 days before a bankruptcy filing. The mortgagee defended on the basis that it was protected by the “earmarking” doctrine and because it would have been entitled to receive all of the proceeds of the property anyway based on its junior mortgage.
The mortgagee held both first and second priority mortgages on property of the debtors. In connection with refinancing the first priority mortgage, the debtors executed a new mortgage and the lender executed a subordination confirming that the second mortgage remained a junior mortgage. The new loan was used to pay off the old loan on January 25; a discharge of the old mortgage was recorded on February 12; and the new mortgage was recorded on April 18.
Unfortunately for the lender, the debtors filed bankruptcy on June 28, so that the new mortgage was recorded within 90 days of the bankruptcy filing. The debtors filed bankruptcy schedules valuing the property at $145,300. On the petition date, the balance of the new refinanced first mortgage loan was ~$75,000, and the balance of the second mortgage loan was ~$162,000.
Two key elements of a preference action are (1) a transfer of an interest of the debtor in property is made on account of an antecedent debt that (2) allows the transferee to receive more than it would have received in a chapter 7 liquidation.
Usually when a new loan is made that is secured by a mortgage, the loan and the grant of the mortgage lien will be contemporaneous, so that the grant of the mortgage is not on account of an antecedent debt. However, under Section 547(e)(1) of the Bankruptcy Code a transfer of property will be considered made at the time the transfer takes place between the two parties if it is perfected within 30 days.
In this case, since the mortgage was recorded more than 30 days after the loan was made, the grant of the lien was considered made at the time the mortgage was recorded – with the result that the grant of the mortgage lien was on account of an antecedent debt.
In defense, the lender argued that the “earmarking” doctrine applied. As described in the opinion: “The earmarking doctrine applies ‘where a third party lends money to the debtor for the specific purpose of paying a selected creditor’… in such situations, the loan funds are said to be ‘earmarked’ and the payment is held not to constitute a voidable preference.” The theory is that the money passes through the debtor’s hands, who is just acting as a kind of bailee, so the loan payment does not involve a transfer of property of the debtor. However, the 1st Circuit has rejected application of earmarking in the context of refinancing a mortgage.
The lender made the additional argument that in a chapter 7 proceeding it would not receive any more on account of the first mortgage because based on its second mortgage nothing would have been available for other creditors in any event. The court rejected this argument because (1) the lack of prejudice to other creditors is not relevant to determining whether there was a preference, and (2) the lender’s second mortgage position is not relevant to determining whether its first mortgage position was improved.
Accordingly, the court found that the new first mortgage constituted a preference.
Recognize that the consequence of this decision was that the court ordered a judgment against the lender in the amount of ~$75,000 (since under Section 550 the trustee may recover either the transferred property or the value of the property). Also note that even if the court had not entered a money judgment against the lender, Section 551 would automatically preserve the first mortgage lien for the benefit of the estate. Thus, the first ~$75,000 of proceeds from disposition of the property would have been recovered for the benefit of the estate before the lender was entitled to receive proceeds on account of its second mortgage.
Also, a lesson worth remembering is that it is very important that a secured lender record any mortgages and file any UCC financing statements within 30 days after closing in order to avoid preference exposure.