In Schoenmann v. Bank of the West (In re Tenderloin Health), 849 F.3d 1231 (9th Cir. 2017), a divided panel of the U.S. Court of Appeals for the Ninth Circuit recently addressed as a matter of apparent first impression whether or not a bankruptcy court can consider hypothetical preference actions in analyzing whether a creditor-transferee in preference litigation received more than it would have received in a hypothetical chapter 7 liquidation, as required by section 547(b)(5) of the Bankruptcy Code. The majority ruled that a court may account for hypothetical preference actions against the creditor in applying this "greater amount test" when "factually warranted, supported by appropriate evidence, and so long as the hypothetical preference action would not result in a direct conflict with another section of the Bankruptcy Code."
Avoidance of Preferential Transfers: The Greater Amount Test
Under section 547(b) of the Bankruptcy Code, a trustee or chapter 11 debtor in possession may avoid a transfer made by a debtor to or for the benefit of a creditor for or on account of an antecedent debt within 90 days of a bankruptcy filing (or one year, if the transferee is an "insider") if the debtor was insolvent at the time of the transfer and if the transfer allows the creditor to receive more than it would have received in a hypothetical liquidation under chapter 7 of the Bankruptcy Code had the transfer not occurred. The hypothetical liquidation element of the preference analysis, which is contained in section 547(b)(5), is sometimes referred to as the "greater amount test."
Specifically, section 547(b)(5) provides that an otherwise qualifying transfer may be avoided if it enables the transferee creditor:
to receive more than such creditor would receive if— (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title (emphasis added).
As one court stated, this requirement is based upon:
the common-sense notion that a creditor need not return a sum received from the debtor prior to bankruptcy if the creditor is no better off vis-à-vis the other creditors of the bankruptcy estate than he or she would have been had the creditor waited for liquidation and distribution of the assets of the estate.
Hager v. Gibson (In re Hager), 109 F.3d 201, 210 (4th Cir. 1997).
To determine what a creditor-transferee would receive in a hypothetical chapter 7 liquidation, it is necessary to understand the Bankruptcy Code’s priority scheme. Secured claims enjoy the highest priority in bankruptcy. A claim is secured to the extent of the value of the underlying collateral. If the collateral’s value is less than the face amount of the indebtedness, the creditor will hold a secured claim in the amount of the collateral value, along with an unsecured claim for the deficiency. Applicable nonbankruptcy law and agreements between and among the debtor and its secured creditors generally determine the relative priority of secured claims. In addition, the Bankruptcy Code provides for the creation of "priming" liens under certain circumstances in connection with financing extended to a debtor during a bankruptcy case.
Unsecured claims follow secured claims in priority. Certain categories of unsecured claims enjoy higher priority than general unsecured claims under section 507(a) of the Bankruptcy Code. The categories of unsecured claims that receive priority treatment include, among others, certain domestic support obligations, administrative expenses, employee wages, and taxes.
In a chapter 7 case, the order of priority for the distribution of unencumbered assets is specified further by section 726 of the Bankruptcy Code. The order of priority ranges from payments on claims in the order specified in section 507(a), which have the highest priority, to payment of any residual assets to the debtor (after payment of all claims plus interest), which has the lowest priority. Distributions are to be made pro rata to claimants of equal priority within each of the six categories specified in section 726. If claimants in a higher category do not receive full payment of their claims, no payments can be made to lower category claimants.
Section 547(b)(5) is not the only provision in the Bankruptcy Code that mandates a comparison to distributions in a hypothetical chapter 7 liquidation. Pursuant to section 1129(a)(7), a chapter 11 plan can be confirmed only if the holder of a claim or interest in an impaired class of claims or interests accepts the plan or, failing acceptance, the holder:
will receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date.
A similar "best interests test" is required with respect to all allowed unsecured claims for confirmation of a chapter 13 plan pursuant to section 1325(a)(4).
Apart from the express language of sections 547(b)(5), 1129(a)(7), and 1325(a)(4), as well as the provisions governing distributions in a chapter 7 case, the Bankruptcy Code offers little guidance as to how the court is to perform a chapter 7 liquidation analysis. As noted by the court in In re Affiliated Foods, Inc., 249 B.R. 770, 788 (Bankr. W.D. Mo. 2000), "The valuation of a hypothetical Chapter 7 . . . is not an exact science." The exercise "entails a considerable degree of speculation about a situation that will not occur unless the case is actually converted to chapter 7." In re Sierra-Cal, 210 B.R. 168, 172 (Bankr. E.D. Cal. 1997).
Some courts have concluded that, in performing such an analysis, it is appropriate to consider other provisions of the Bankruptcy Code which would apply in a chapter 7 case, such as the avoidance, claims disallowance, and setoff provisions. See, e.g., Braniff Airways, Inc. v. Exxon Co., U.S.A., 814 F.2d 1030, 1040 (5th Cir. 1987) (in the hypothetical chapter 7 analysis under section 547(b)(5), the court should consider the creditor transferee’s setoff rights under section 553); Affiliated Foods, 249 B.R. at 788 (the section 1129(a)(7) best interests test requires an estimation of the value of all of the estate’s assets, including hard-to-determine asset values like disputed and contingent claims, the potential disallowance of claims, the probability of success and the value of causes of action held by the estate, and potential preference actions); In re Larson, 245 B.R. 609, 614 (Bankr. D. Minn. 2000) (in the hypothetical liquidation analysis under section 1129(a)(7), the court "must look not only at the Debtor’s assets as listed on his schedules, but must also consider the recovery of assets by the trustee through fraudulent transfer and preference actions"); Sierra-Cal, 210 B.R. at 174 (the hypothetical liquidation analysis should include potential avoidance recoveries under sections 544 and 549); Mason & Dixon Lines, Inc. v. St. Johnsbury Trucking Co. (In re Mason & Dixon Lines, Inc.), 65 B.R. 973, 976 (Bankr. M.D.N.C. 1986) (the section 547(b)(5) analysis should consider the creditor-transferee’s setoff rights); see also Collier on Bankruptcy ¶ 1129.02 [b][iv][C] (16th ed. 2017) (noting that "a trustee’s avoiding powers in a hypothetical chapter 7 case may also affect the analysis" under section 1129(a)(7)).
Support for this approach can be found in the language of section 547(b)(5) and its legislative history. As noted, section 547(b)(5) provides that "such creditor received payment of such debt to the extent provided by the provisions of this title," suggesting that the hypothetical liquidation analysis should consider provisions in the Bankruptcy Code apart from the section 726 distribution scheme and the provisions incorporated by it.
The legislative history of section 547(b)(5) also refers to the "distributive provisions" of the Bankruptcy Code. S. Rep. No. 95-989, at 87 (1978). It further notes that "[a] preference is a transfer that enables a creditor to receive payment of a greater percentage of his claim than he would have received if the transfer had not been made and he had participated in the distribution of the assets of the bankruptcy estate." H.R. Rep. No. 95-595, at 177 (1977). Moreover, the legislative history explains that the hypothetical chapter 7 liquidation analysis under section 547(b)(5) "requires the court to focus on the allowability of the claim for which the preference was made" and states that "[i]f the claim would have been entirely disallowed, for example, then the test of [section 547(b)(5)] will be met, because the creditor would have received nothing under the distributive provisions of the bankruptcy code." Id. at 372.
In Tenderloin Health, the Ninth Circuit considered whether, in applying the greater amount test, a court should consider hypothetical preference recoveries that could impact the amount a creditor would likely receive in a hypothetical chapter 7 liquidation.
In May 2009, Bank of the West ("BW") extended a $200,000 line of credit to Tenderloin Health ("Tenderloin"), a walk-in clinic serving AIDS patients in San Francisco. Two years later, BW loaned Tenderloin another $100,000. The loans were secured by Tenderloin’s personal property, including its deposit accounts with BW.
Tenderloin began winding up its affairs in late 2011 and sold its only real property for approximately $1.3 million. On June 13, 2012, Tenderloin used a portion of the proceeds to pay BW approximately $191,000 to satisfy fully its outstanding loan obligations and moved the remaining $526,000 from an escrow account to its BW deposit account.
Tenderloin filed a chapter 7 petition on July 20, 2012, in the Northern District of California. Ninety days before the petition date, Tenderloin’s BW account contained approximately $173,000, which had shrunk to $53,000 on June 13, 2012 (the date of the escrow transfers), and increased to $577,000 immediately after the bank deposit on that date. Approximately $564,000 remained in the BW deposit account on the petition date.
The chapter 7 trustee sued BW to avoid the $191,000 debt payment as a preferential transfer. In the complaint, the trustee argued, among other things, that the payment was a preference because, in a hypothetical liquidation of Tenderloin under chapter 7, the $526,000 deposit could be avoided as a preference. As a result of that avoidance, Tenderloin’s BW account would have contained only $38,000 on the petition date, meaning that BW received a greater amount in respect of its claim than it would have received in a chapter 7 liquidation if the $191,000 payment had not been made. The bankruptcy court granted BW’s motion for summary judgment, ruling that the trustee could not show that BW received more than it would have in a hypothetical liquidation. The district court affirmed on appeal.
The Ninth Circuit’s Ruling
A three-judge panel of the Ninth Circuit reversed and remanded the rulings below.
Initially, the court concluded that section 547(b)(5) does not "directly forbid" courts from considering hypothetical preference actions. The phrase "provisions of this title" in section 547(b)(5), the majority explained, "appears to refer to the totality of Title 11 of the Code, which includes the preference provisions appearing in section 547."
According to the court, this conclusion is supported by the legislative history. Reference in the legislative history to "participate[s] in the distribution," the majority wrote, "leaves room to assume the hypothetical chapter 7 trustee might initiate preference actions in conjunction with the ‘distribution’ of the assets of the estate." The court also explained that "by invoking ‘allowability,’ which refers generally to whether payment of a claim would violate some independent provision of the Bankruptcy Code, the [legislative history] suggests it is appropriate to consider whether a hypothetical claim would be affected by the preference provisions."
Further support for this approach, the Ninth Circuit majority noted, can be found in rulings by other courts (as noted above) that have considered "hypothetical preference actions within hypothetical chapter 7 liquidations" in construing the best interests test under sections 1129(a)(7) and 1325(a)(4), as well as decisions applying "hypothetical setoff analyses under section 553 within hypothetical chapter 7 liquidations."
The Ninth Circuit distinguished its prior holding in Alvarado v. Walsh (In re LCO Enters.), 12 F.3d 938 (9th Cir. 1993). In LCO, the debtor assumed a commercial real property lease by curing all defaults, as required by section 365(b) of the Bankruptcy Code, and later obtained confirmation of a chapter 11 plan. A trustee appointed to pursue avoidance actions sued the landlord to avoid and recover pre-bankruptcy rent payments as preferential transfers. The trustee argued that in a hypothetical chapter 7 liquidation, the trustee might have rejected the lease, giving the landlord an unsecured claim for unpaid rent, rather than payment in full, as actually occurred in accordance with section 365(b).
The Ninth Circuit rejected this argument, ruling that "the phrase ‘hypothetical chapter 7’ [in section 547(b)(5)] . . . does not mean that the bankruptcy court can construct its own hypothetical from whole cloth or from only some of the facts." According to the court, because the lease had been assumed, "the [bankruptcy] court could neither speculate that there was no lease nor assume that the lease was rejected." Holding otherwise, the Ninth Circuit noted, would permit section 547(b) "to circumvent the requirements of § 365(b)."
The Ninth Circuit ruled that the facts in Tenderloin Health were different. "Unlike in LCO," the court wrote, "permitting such an action would not violate any other statutory provision, and it is consistent with the text and legislative history . . . ." Therefore, the court ruled that LCO did not prevent it from assuming in a hypothetical liquidation that a chapter 7 trustee would sue to avoid and recover the $526,000 deposit from BW as a preference.
The Ninth Circuit thus explained that in a hypothetical liquidation: (i) BW would have a right under section 553 to set off amounts in Tenderloin’s deposit account against Tenderloin’s debt; (ii) because section 502(d) requires disallowance of any claim unless and until a transferee returns a challenged transfer to the estate, the bankruptcy court would likely adjudicate the trustee’s hypothetical preference claim before allowing BW’s claim and adjudicating BW’s setoff rights; (iii) Tenderloin’s $526,000 deposit into its BW deposit account was a "transfer" of Tenderloin’s property which is avoidable under section 547(b); and (iv) the $526,000 deposit would be avoided as a preference because, in addition to the other preference elements, the transfer diminished the funds available to Tenderloin’s creditors by increasing the size of BW’s secured claim against the bankruptcy estate. As a consequence, the Ninth Circuit concluded, "Tenderloin’s account functionally would contain [$38,000] on the petition date, a sum far less than the [$190,000] BW received," meaning that "[u]nder the hypothetical facts," the trustee could satisfy the greater amount test set forth in section 547(b)(5).
District judge Edward R. Korman (sitting by designation) concurred in part. Although he concurred in the judgment, Judge Korman disagreed with the hypothetical analysis undertaken by the majority, particularly with respect to BW’s setoff rights and the requirement for bankruptcy court approval under section 553(b):
[I]n a hypothetical liquidation, there is no such gatekeeper to protect other claimants. There is of course no actual bankruptcy judge available to exercise discretion in such a case, and it would push the already somewhat strained boundaries of our hypothetical analysis too far to exercise our own discretion, sitting as a three-headed hypothetical bankruptcy judge, weighing the imaginary equities of a fantasy liquidation. The majority asserts that this adds a new variable to what is supposed to be a controlled experiment . . . but so would exercising our own discretion—by substituting our judgment for that of the real bankruptcy judge.
Tenderloin Health indicates that when applying the greater amount test, bankruptcy courts in the Ninth Circuit may consider the potential impact of various provisions in the Bankruptcy Code other than the chapter 7 distribution scheme. According to the court, that discretion must be informed and constrained by the evidentiary record, and it cannot be exercised in a manner which would violate other provisions of the statute. The decision also highlights potential pitfalls in applying a hypothetical analysis that obligates the court to engage in speculation and a complex analysis of what might have happened, as distinguished from the actual facts of a bankruptcy case.