United States: Recent Developments In Bankruptcy Law, July 2022

Covered Activities

Order granting counterclaim declaring validity of mortgage on the debtor's property does not violate the stay. The debtor acquired property subject to a disputed mortgage. The debtor brought a quiet title action against the mortgagee. The mortgagee counterclaimed to declare the mortgage valid. While summary judgment motions were pending, the debtor filed a chapter 11 case. The nonbankruptcy court granted summary judgment to the mortgagee after the debtor's petition date. The automatic stay prohibits continuation of any action against the debtor that was or could have been commenced before the petition date, any act to obtain possession or exercise control of property of the estate, and any act to create, perfect, or enforce a lien against property of the debtor. Because the mortgagee's counterclaim was simply the mirror image of the debtor's complaint, did not seek additional relief, and was only a defense to the complaint, the mortgagee's counterclaim was not an action against the debtor. The counterclaim also sought only to maintain the status quo and as such, did not constitute an act to obtain possession or control of property of the debtor or the estate. It simply affirmed the validity of an existing lien. Finally, the judgment on the counterclaim did not create, perfect, or enforce a lien on the debtor's property. It only declared existing rights. Therefore, the nonbankruptcy court's summary judgment order did not violate the stay. Censo, LLC v. Newrez, LLC (In re Censo, LLC), 638 B.R. 416 (9th Cir. B.A.P. 2022).

Effect of Stay

Remedies

Fraudulent Transfers

A bank's customer is a financial institution for purposes of section 546(e)'s safe harbor. The debtor's special purpose entity, which issued notes under note purchase agreements to facilitate the debtor's Ponzi scheme, transferred payments on the notes, as provided in the agreement, to the note holder at the holder's custodial account at a bank. Section 546(e) prohibits a trustee from avoiding a transfer that is a settlement payment or made in connection with a securities contract and that is by or to (or for the benefit of) a financial institution. The Code defines "financial Institution" to include a customer of a bank when the bank is acting as agent or custodian for the customer. The bank was an agent or custodian for the note holder, because it received the note payments into a custodial account for the note holder. Therefore, the note holder was a financial institution. The note is a security. But the court below did not adequately examine whether the transfer was made in connection with a securities contract. Therefore, the court remands for that determination. Kelley v. Safe Harbor Managed Account 101, Ltd., 31 F.4th 1058 (8th Cir. 2022).

Preferences

Pleading the due diligence prerequisite for a preference complaint. The debtor in possession analyzed transfers to a creditor, including days-to-pay information for each transfer and for pre-avoidance period transfers and any unusual collection activity, and included that information in a preference avoidance and recovery demand letter to the creditor. When the creditor did not respond, the DIP sued to avoid and recover the preferences. In the complaint, the DIP recited that it had conducted an analysis of the transfers and whether they were protected from avoidance by any applicable defense. The complaint also referred to, but did not attach, the demand letter. Section 547(b) permits a trustee or DIP to avoid a preference, "based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses." On a motion to dismiss, the court may consider a document the complaint references. Combined with the complaint's allegation that the DIP conducted an analysis, the letter satisfied the statutory prerequisite for bringing the complaint, whether or not the prerequisite is an element of the preference claim. Center City Healthcare, LLC v. McKesson Plasma & Biologics LLC (In re Center City Healthcare, LLC), 2022 Bankr. LEXIS 1638 (Bankr. D. Del. June 13, 2022).

Ear-marking doctrine requires satisfaction of the dominion/control and diminution of the estate tests. The closely held debtor owed money to an insider on a note that was to receive no payments until a separate series of notes was paid in full. The debtor's principal loaned money to the debtor specifically to make payments on the insider note and the other notes. Upon the debtor's bankruptcy, the trustee sued to avoid and recover the payments on the insider notes as preferences. A preference is a transfer of property of the debtor that meets certain additional conditions. If a new creditor loans money to a debtor to pay an old creditor, the payment might be protected by the ear-marking doctrine, which deems the money not to have been property of the debtor. To satisfy the ear-marking doctrine, the new money must not be subject to the dominion or control of the debtor—that is, the debtor must be under a binding agreement to use the new money to pay the old creditor and not for any other purpose—and the transaction must not result in the diminution of the estate—that is, the reduction in the amount of assets available to pay creditors. The doctrine's application is clearer when the new creditor pays the money directly to the old creditor and the money does not pass through the debtor's account, but that is not required. Here, the new lender (the principal) required the debtor (controlled by the principal) to use the new loan to pay the insider note, so the debtor did not have dominion and control over the funds. However, the insider note payments resulted in the diminution of the estate, because it replaced subordinated debt with general unsecured debt. Therefore, the court concludes, the transfer was of property of the debtor and avoidable. Montoya v. Goldstein (In re Chuza Oil Co.), 639 B.R. 586 (10th Cir. B.A.P. 2022).

PPP loan rescission and return is not a preference. The debtor applied for a Payroll Protection Program loan on April 24, 2020. It signed the note on May 5 and received the funds on May 8. It held the funds aside, pending a decision whether to revoke the loan and return the funds, which it did on May 13, under a "safe harbor," no-questions-asked provision in the PPP program policy, which permitted return of the funds and cancellation of the loan by May 14. The debtor filed a bankruptcy case on May 27. The trustee sued the lender to avoid the funds' return as a preference. A preference is a transfer of an interest of the debtor in property for or on account of an antecedent debt. Upon rescission of a contract, the contract become void ab initio, and the rescinding party must restore anything of value received. The court may impose a resulting trust to effectuate that result. Therefore, under the circumstances, the funds the debtor had held aside were subject to a resulting trust and were not property of the debtor. Moreover, because of the rescission, the transaction was cancelled, and there was no antecedent debt. Therefore, there was no avoidable preference. Brady v. United States, SBA (In re Specialty's Café & Bakery, Inc.), 639 B.R. 548 (Bankr. N.D. Cal. 2022).

Postpetition Transfers

Setoff

Statutory Liens

Strong-arm Power

Recovery