In In re Falcon Products, Inc., 381 B.R. 543 (8th Cir. BAP, 2008), the bankruptcy appellate panel (BAP) for the Eighth Circuit reversed a decision by the bankruptcy court for the District of Missouri, and held that when applying the hypothetical liquidation test to determine whether a secured creditor received potentially preferential payments, the collateral must be valued as of the petition date and not as of the payment transfer date.

Falcon Products, Inc. (the Debtor) and First Insurance Funding entered into a commercial premium financing agreement in which First Insurance financed several of the Debtor’s insurance policies in exchange for the Debtor’s agreement to remit monthly installment payments. To secure the Debtor’s obligations, the Debtor granted First Insurance a security interest in the unearned premiums under the policies. The agreement also provided that in the event the Debtor failed to make an installment payment, First Insurance had the right to cancel the policies and to apply any unearned premiums to unpaid balances owed. The Debtor made the first two payments and thereafter filed for bankruptcy protection.

Pursuant to the Debtor’s plan, the Falcon Creditor Trust was formed to prosecute avoidance actions. The Trust filed a complaint against First Insurance seeking the avoidance and turnover of the Debtor’s two payments pursuant to 11 U.S.C. §§ 547 and 550. First Insurance moved for summary judgment claiming that because it was a secured creditor and that on each of the transfer dates the value of its collateral (unearned insurance premiums) exceeded the amount of debt owed to it, it did not receive anything more than it would have received had the case been one under chapter 7 of the United States Bankruptcy Code and the transfers had not been made. This is referred to as the hypothetical liquidation test.  Agreeing with this analysis, the Bankruptcy Court granted summary judgment in favor of First Insurance. The Trust appealed.

After briefly setting forth the elements of a successful preference suit, the BAP focused on the relevant issue: when applying the hypothetical liquidation test to a secured creditor, should the creditor’s collateral be valued as of the date of the transfer(s) or as of the petition date?

The old adage “timing is everything” has special meaning for preference demands aimed at secured creditors. Using the facts in Falcon will allow us to better illustrate this point.

If we value the collateral (unearned insurance premiums) as of the transfer dates (the dates the payments were made to First Insurance), the debt owed to First Insurance (remaining installment payments plus interest) would be less than the value of that collateral. Using this timing method, First Insurance would be over-secured. Therefore, neither of the transfers would enable First Insurance to receive anything more than it would have received had the Debtor been liquidated under chapter 7 of the Bankruptcy Code. Accordingly, the Debtor cannot establish all of the preference elements. Indeed, this is exactly the result reached by the Bankruptcy Court.

If, on the other hand, the collateral was valued on the petition date, it would have been worth less than the amount of the debt, making First Insurance under-secured. Thus, to the extent First Insurance was under-secured, it would have received more from the Debtor in those two payments than it would have received had the case been one under chapter 7 of the Bankruptcy Code. Using this timing method, the Debtor satisfies the hypothetical liquidation test set forth in 11 U.S.C. § 547(b)(5). Assuming that all of the other § 547(b) elements are met, the Debtor has established a prima facie case for an avoidable preference.

According to the BAP, the hypothetical liquidation test timing issue was already decided by the Supreme Court in Palmer Clay Products Co. v. Brown, 297 U.S. 227 (1936). In Palmer, the Supreme Court concerned itself with the actual effect of the alleged preferential payment as determined when bankruptcy results, not when the payments were made. Although Palmer involves payments only on unsecured claims, the BAP felt that this distinction was irrelevant and that the same concerns, i.e., the impracticality of conducting the hypothetical liquidation test on the date of each transfer, remained whether the claims were secured or unsecured.

Although the BAP noted that it may be illogical to find that a payment on a claim fully secured at the time of the transfer might be preferential under § 547(b), it cautioned that the answer was not to refashion § 547(b) to include the § 547 defenses, but to raise those defenses at the appropriate time. Finally, the BAP was aware, and indeed, the lower court relied, on the fact that First Insurance had the right to terminate the contract and to obtain the unearned premiums upon the Debtor’s failure to make an installment payment. The BAP found, however, that nothing in the record indicated that First Insurance would have terminated the contract upon non-payment. Accordingly, the BAP reversed the Bankruptcy Court’s decision on summary judgment and remanded the case so that the Bankruptcy Court could hear evidence on First Insurance’s § 547 defenses and to determine the actual effect of the transfers at issue.

The Eighth Circuit BAP, while finding that the hypothetical liquidation test required valuation of the collateral on the petition date, noted that courts are generally divided on the timing. Therefore, it makes sense to understand how the courts in a particular jurisdiction will come out on the issue. In addition, the BAP noted that the contract itself provided that in the event the Debtor failed to make an installment payment, First Insurance had the right to cancel the policies and to apply any unearned premiums to any unpaid balance owed to them. However, in this case, nothing in the record established First Insurance’s desire to do so. Of course, canceling insurance policies rests on individual business realities. Clearly, a secured insurer that validly cancels its policies and takes its collateral prior to an insured’s bankruptcy is less likely to deal with this issue. Also, to the extent that the financing agreement is executory and the debtor assumes the agreement post-petition, the debtor is required to make the non-breaching party whole by paying all outstanding pre-petition amounts. Finally, the BAP indicates that nothing in its opinion serves to preclude any preference defenses to which a party may be entitled under 11 U.S.C. § 547(c). Accordingly, a secured party whose collateral is valued in excess of the debt owed to it has little to worry about. It is only when the value of the collateral dips below the outstanding debt that preference issues may arise.