In the recent case of Whittle Development, Inc. v. Branch Banking & Trust Co. (In re Whittle Development, Inc.), No. 10-37084, 2011 WL 3268398 (N.D. Tex. July 27, 2011), a bankruptcy court was asked whether a preference action could be sustained against a creditor who purchased real property in a properly conducted state law foreclosure sale. Recognizing a split of authority and some contrary principles enunciated by the Supreme Court in its prior decision, BFP v. Resolution Trust Corp., 511 U.S. 531 (1994), the bankruptcy court found that a preference claim could be asserted. The case demonstrated that in certain instances, even a properly conducted state foreclosure does not provide finality of all issues.

Factual Background

On December 31, 2007, Whittle Development Inc. entered into a development loan agreement with an entity that later became Branch Banking and Trust Company. The agreement provided Whittle with a $2,700,000 loan secured by real property.

In early 2010, Branch Banking declared the loan in default and accelerated payments owed by Whittle. On September 7, 2010, Branch Banking foreclosed on Whittle’s property securing the loan. The foreclosure sale complied with all relevant state law requirements. Ultimately, the foreclosed property was sold to a subsidiary of Branch Banking for approximately $1,200,000. On October 4, 2010, Whittle filed a chapter 11 petition in the bankruptcy court. Branch Banking subsequently filed a proof of claim in Whittle’s bankruptcy case for the difference between the sale amount and the outstanding loan amount, approximately $2,850,000.

Thereafter, Whittle brought an action to avoid, as a preferential transfer, the foreclosure sale. As the basis of its claim, Whittle argued that the approximate value of the property sold at foreclosure was $3,300,000, but that Branch Banking’s claim on the property at the time of foreclosure was only $2,200,000. Thus, Whittle alleged, Branch Banking had received approximately $1,100,000 more than it should have.

Preference Lawsuits

A “preference” is a pre-bankruptcy transfer of a debtor’s interest in property to a creditor that enables the creditor to receive more than she would have received had the transfer not taken place. Section 547 gives the trustee or a debtor in possession the power to “avoid” preferences. If a transfer is avoided, section 550 enables the trustee or debtor in possession to seek the return of the transferred property to the debtor’s estate. This furthers the basic bankruptcy policy of securing equal distribution of the debtor’s assets among similarly situated creditors. A successful preference action requires a trustee to prove six elements:

  1. a transfer of the debtor’s interest in property;
  2. to or for the benefit of a creditor;
  3. on account of antecedent debt;
  4. made while the debtor was insolvent;
  5. made within ninety days before the petition date (or one year for insiders); and
  6. such transfer enabled the creditor to receive more than such creditor would have received under a hypothetical chapter 7 liquidation.

There is a presumption that the debtor was insolvent during the ninety days immediately preceding the bankruptcy filing. In In re Whittle, the only dispute was to the final element— whether the proceeds from the foreclosure sale enabled Branch Banking to receive more than it would have in a chapter 7 liquidation.

BFP and the “Reasonably Equivalent Value” Defense

The key issue for the In re Whittle court was whether a creditor should be subject to attack for purchasing real estate at (so it was alleged) a discount in a validly performed state foreclosure sale. Branch Banking argued that such an action was proscribed by the Supreme Court’s decision in BFP v. Resolution Trust Corp., 511 U.S. 531 (1994). Accordingly, the In re Whittle court’s analysis turned first to a review of the of BFP case.

In BFP, a partnership formed for the purpose of buying a home in Newport Beach, California, defaulted on its mortgage payments, resulting in a foreclosure by the bank. A third-party purchased the home for $433,000 at a properly-noticed foreclosure sale shortly before the partnership filed for bankruptcy. Acting as a debtor in possession, the partnership sued to avoid the transfer as a fraudulent conveyance, alleging that the property had an actual value of $725,000.

Unlike a preference, a constructive fraudulent conveyance requires only two elements: (a) a transfer of a debtor’s property for less than reasonably equivalent value and (b) insolvency of the transferor. In BFP, the Supreme Court was ultimately asked whether the $433,000 received at the foreclosure sale was a transfer for “reasonably equivalent value.” The Supreme Court held that a “fair and proper price, or a ‘reasonably equivalent value,’ for foreclosed property, is the price in fact received at the foreclosure sale, so long as all the requirements of the state’s foreclosure law have been complied with.” To hold otherwise, the Supreme Court stated, would interfere with the essential state interest in ensuring the security of titles to real property.

This ruling effectively insulated regularly conducted foreclosure sales from avoidance under fraudulent conveyance law. In In re Whittle, Branch Banking requested that this result be extended to preference actions. In deciding this question, the bankruptcy court turned to an analysis of the competing interpretations of BFP.

Bankruptcy Court’s Analysis

Despite the differences in the applicable statutes, the In re Whittle court noted that some courts have simply held that the test for preferences—a transfer which enables a creditor to receive more than in a chapter 7 liquidation—is essentially the same as the Supreme Court’s test for “reasonably equivalent value” in the fraudulent conveyance context. That is, a court performing this analysis should simply look at the exchanged value and see if it was reasonable at that time and in that context. The courts that take this position (and apply BFP to a preference scenario) base their reasoning on the policy underlying the Supreme Court’s ruling in BFP; namely, they recognize that states’ have very important interest in enacting laws governing foreclosure of real property. See Chase Manhattan Bank v. Pulcini (In re Pulcini), 261 B.R. 836 (Bankr. W.D. Pa. 2001); Glaser v. Chelec, Inc. (In re Glaser), No. 01-10220-SSM, 2002 WL 32375007 (Bankr. E.D. Va. 2002). These courts conclude that, despite the language difference between the two statutes, a bankruptcy court’s ability to avoid state foreclosure sales under either section would undermine the states’ sovereign interest in the security and stability of title to land. While Article I, Section 8 of the Constitution gives Congress the authority to displace state law in the bankruptcy context, federal courts will not do so absent Congress’ “clear and manifest” intent. Looking to the preference statute, these courts have found no “clear and manifest” congressional intent to interfere with state foreclosure laws.

In contrast, other courts analyzing the preference test simply highlight the plain language of the statute and point out that the test for whether a transfer is a preference is fundamentally different than that used in the fraudulent conveyance statute. In addition, such courts note that preferences are much more likely to exist because the defendants are from a much smaller universe than fraudulent conveyance claims (preference defendants must be prepetition creditors of the debtor).

In summary, the debate between these two lines of authority is essentially whether a court should defer to federalism concerns and find that valid state foreclosure sales should be unassailable in the preference context, or whether the plain language of the statute should be followed and thus make foreclosure sales subject to attack as preferences.

The Bankruptcy Court’s Decision

The In re Whittle court sided with the second group of cases, holding that BFP was inapplicable in the preference context based on the clear language of the statute. “[L]ooking at the unambiguous language of the statute, it would seem that the only thing that must be shown is that the creditor did, in fact, receive more from the pre-petition transfer than it would have under a Chapter 7 liquidation . . . .” The court found BFP’s assessment of “reasonable equivalent value” wholly inapplicable to the preference context.

The court stated that it was not concerned about intruding on the states’ interest in the stability of title to real property because “[i]f an otherwise valid foreclosure sale is found to enable a creditor to obtain more than he would in a chapter 7 liquidation, then the additional amount of benefit conferred to the creditor is simply brought back into the estate.” Because a preference action may only be brought against a creditor of the estate, title to the real property would only be disturbed in those instances where the creditor was also the purchaser of the property. Additionally, the fact that preference reach back period is only ninety days from the bankruptcy filing (for noninsiders) versus the two-year reach back period for fraudulent conveyances, means that the “cloud on title” created by a potential preference claim is substantially more limited than that created by a potential fraudulent conveyance claim.

Based on this ruling and others like it, secured creditors and purchasers of foreclosed property who are also creditors of the estate should be cautious. These parties should view this case as a clear warning that, depending on the jurisdiction, the ability to resolve each and every case issue in a lawful foreclosure sale could potentially be threatened by a subsequent bankruptcy filing.