Non-Collusive Mortgage Foreclosure Held Preferential

 By: Adam S. Cohen

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re Whittle Development, Inc.,[1] the Bankruptcy Court for the Northern District of Texas held that a pre-petition foreclosure action against real property may be avoidable as a preferential transfer where the foreclosing creditor receives more than it would have in a liquidation under chapter 7 of the Bankruptcy Code, even though the action was non-collusive and complied with state law.[2] Whittle Development, Inc. (the “Debtor”) and Colonial Bank, N.A. (the “Creditor”) entered into a Development Loan Agreement on December 31, 2007 pursuant to which the Creditor loaned the Debtor $2,700,000 (the “Loan”).[3] The Creditor declared a default on the Loan, accelerated the balance due, and on September 7, 2010, foreclosed on the property that secured the loan.[4] At the pre-petition foreclosure sale, a subsidiary of the Creditor bought the property for $1,220,000.[5]  The Debtor filed for bankruptcy on October 4, 2010 under chapter 11 of the Bankruptcy Code.[6]  The Creditor filed a proof of claim for $2,855,243.29, alleging that $1,181,513.27 of the claim represents the deficiency from the foreclosure sale.[7]  The Debtor disputed the Creditor’s deficiency claim and argued that the Creditor was over secured by $1,100,000 because the property was worth $3,300,000.[8]

In this case, the court focused on the statutory language of 11 U.S.C. § 547[9] where the operative question is “simply whether the creditor did in fact receive more than it would have had the transfer not occurred.”[10] The court found that the Debtor made a prima facie showing that the Creditor received more than it would under a hypothetical chapter 7 liquidation and therefore that the foreclosure could constitute an avoidable preference.[11]

The court’s rationale stands in contrast to several other courts[12] that have relied on BFP v. Resolution Trust Corp.[13] to decide similar issues even though BFP interpreted section 548 and not section 547.[14]  In BFP, the Supreme Court relied upon their interpretation of the Code and public policy concerns in holding that regularly conducted non-collusive judicial foreclosure sales could not be avoided as constructively fraudulent transfers under section 548.[15]  Under section 548(a)(1)(B)(i), transfers are avoidable if they were for less than a “reasonably equivalent value,” whereas under section 547(b)(5)(A), transfers are avoidable if the creditor receives more than it would have under a hypothetical liquidation in chapter 7.[16]  Courts that have relied on BFP have contended that sections 547 and 548 involve “similar federalism concerns,” and in both instances “allowing a debtor to avoid a foreclosure sale would subvert state interests since the foreclosure sale complies with state law.”[17]  The Whittle court declined to follow this line of cases because it found that both the operative language and policy rationales in section 547 differ from those in section 548.[18]  Section 548 allows for avoidance only where a party fails to pay “reasonably equivalent value” based on the price paid at a foreclosure sale, and not based on some hypothetical fair foreclosure value.[19] The Whittle court also suggested that the federalism concerns influencing the decision in BFP do not apply in section 547 foreclosure cases, as transfers similar to the one that occurred in Whittle “may be examined on an individualized basis and not, as a matter of law, be avoidable as preferential transfers.”[20]

Whittle is an important case because it provides an alternative analysis for cases which have sometimes led to anomalous results when applying the BFP rule. “The apparent lesson of BFP is that if a creditor is oversecured, the Debtor must file a bankruptcy petition (or creditors must file an involuntary petition) before foreclosure to prevent the secured creditor from reaping a windfall at the expense of other creditors.”[21] Following Whittle, there will also be less incentive to accelerate a debt and foreclose when a creditor knows the debtor may file for bankruptcy within 90 days, as the court will look to the actual value of the foreclosed property as opposed to the potentially discounted foreclosure sale price, therefore potentially giving creditors less value than they would normally have.[22]  If adopted nationwide, we may see creditors act more leniently with their mortgagors before foreclosing on their properties.