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Protect Liens From Preference Avoidance The Easy Way: Watch Your Timing

Commercial Bankruptcy, Restructuring & Creditors' Rights Update Susan G. Boswell, Faye B. Feinstein, John A. Harris, Roy L. Prange Jr., Christopher Combest

While recent economic news focuses on the complex risks created by derivatives and other financial instruments, we continue to see lenders lose money the old-fashioned way: by failing to timely perfect liens against their borrowers' collateral. In one recent bankruptcy case, a lender's mortgage lien was invalidated as a preferential transfer. As shown by Chase Manhattan Mortgage Corp. v. Shapiro (In re Lee), 530 F.3d 458 (6th Cir. 2008), the mortgage could easily have been protected; it's all a matter of timing.

The Ground Rules

  1. "Attachment" of a Lien: Liens are interests in a borrower's property, granted to a creditor to secure its borrower's obligations to it. Generally, liens become effective, as between the creditor and the debtor, when they attach, that is, at the time the creditor advances value (e.g., loaned funds) in exchange for the lien.

  2. "Perfection" of an Attached Lien: For an attached lien to be enforceable as well, against other creditors with competing claims to the debtor's assets (including a bankruptcy trustee), the creditor must take the steps required under state law to ensure that no other party may obtain an interest in the collateral superior to the creditor's lien. Those steps are generically referred to as perfection. A properly perfected lien gives its holder the right to satisfy its claim out of the value of its collateral, ahead of junior lien creditors or unsecured creditors.
  3. Preference Risk to a Lender's Lien: Section 547 of the Bankruptcy Code authorizes a trustee to "avoid" - that is, invalidate - certain transfers of property made by a debtor before the filing of its bankruptcy petition. For our purposes, the key characteristics of such a transfer are that it (a) be a transfer of the debtor's property, (b) be made within 90 days before the filing of the bankruptcy petition and (c) be made on account of a pre-existing ("antecedent") debt owed to the creditor by the debtor. A lien granted under these circumstances is vulnerable to avoidance, which would leave the once-secured creditor with an ordinary, lower-priority unsecured claim for repayment of its loans.

The Preference Trap for Lenders

As in many preference cases, the key facts in Chase Manhattan involve the dates of the various transactions. On October 6, 2003, Chase advanced funds to its borrower to refinance an existing mortgage loan; to secure that debt, Chase simultaneously obtained a new mortgage from the borrower. The debt for the funds was created on October 6, and the mortgage lien under the new mortgage became effective - as between Chase and the borrower - on October 6 as well. However, Chase did not perfect the mortgage lien until it recorded it on December 17, 2003 - 72 days after the creation of the debt on October 6, and within the 90 days before the borrower filed his bankruptcy case, on March 4, 2004.

From Chase's perspective, timing may not have appeared to be an issue at all. Because Chase was refinancing its own loan, it argued that there was no transfer of property of the debtor; it viewed the transaction as Chase simply paying itself with its own money. It also viewed the entire refinance as a single, indivisible transaction, in which Chase essentially continued the same lien it had always had (the mortgage) in the same collateral (the borrower's real estate) to secure a debt that, while it may have changed in principal amount or other terms, was not in any significant sense a new debt.

While Chase's position may make sense from a business standpoint, the court took what it deemed the majority view of refinancing transactions and held that, even if the same lender is on both sides, a refinancing constitutes at least two separate transfers: first, money from the lender to the borrower to pay off the old loan and, second and separately, a transfer of a new mortgage lien to the refinancing lender. Although Chase's payment to itself was not vulnerable to attack as a preference, that second, separate transfer of the mortgage lien from the borrower was.

The question then became one of timing: For the purposes of bankruptcy preference law, when was the debtor deemed to have effected the transfer of the mortgage lien to Chase? If on October 6, the lien would have been given in exchange for a simultaneously incurred, not pre-existing (antecedent), debt and could not have been avoided. If on December 17, however, the lien would have been transferred on account of a 72-day-old debt and would have been vulnerable to avoidance.

How to Escape the Preference Trap

Fortunately for creditors, the Bankruptcy Code provides a direct answer and offers a lender in Chase's position a safe harbor. Section 547(e) (as it then read) provides that, for preference purposes, transfers take place at the time they are perfected (in this case, the day the mortgage was recorded), as long as such perfection occurs within 10 days (since amended to 30 days) after that date.

If Chase had recorded the new mortgage on or before October 16 - ten days after the October 6 funding of the loan and execution of the mortgage - the mortgage lien would have been deemed granted on the same date that the funds were advanced, and Chase's lien would have been safe. However, because perfection occurred after that 10-day safe harbor to record, the lien was deemed transferred on the perfection (recording) date, i.e., December 17, which fell within the debtor's 90-day preference look-back period. The bankruptcy court, and then the Sixth Circuit, allowed the trustee to invalidate the mortgage lien, leaving Chase with only a general unsecured claim for the amount of its refinanced mortgage.

Practice Tips

  1. Perfect liens or security interests as soon as possible. Generally, creditors may take the steps required for perfection before a credit transaction closes so that, upon closing, the creditor's liens are immediately perfected, with no gap period.

  2. If recordation does wait until after the closing, take advantage of the Bankruptcy Code. As noted above, the former 10-day safe-harbor period has since been tripled, to 30 days, making the harbor wider and safer than ever.

For more information, please contact the author, Christopher Combest, at 312-715-5091 /, your Quarles & Brady LLP attorney or one of the following Commercial Bankruptcy, Restructuring and Creditors' Rights practitioners:

Phoenix: John Harris
National Group Chair
Chicago: Faye B. Feinstein 
Chicago/Midwest Office Chair 
Madison: Roy Prange   608-283-2485
Tucson: Susan Boswell 520-770-8713