Chapter 30 Secured Party Versus Trustee in Bankruptcy
A. Generally
Bankruptcy is often viewed as the "acid test" of whether an Article 9 practitioner has done his or her job properly in setting up a secured credit arrangement for a client. In general terms, bankruptcy aims at an equitable, ideally a pro rata, distribution of assets among creditors. However, valid and enforceable secured claims generally must be satisfied dollar-for-dollar and to this extent secured claims undermine the equitable distribution goal. Consequently, trustees are armed with several weapons that may be used to avoid security interests leaving the claims unsecured.
The ability of a trustee to avoid a security interest that is not properly perfected under either Bankruptcy Reform Act (BRA) § 544(a) or BRA § 547 poses a special threat to secured parties. This chapter explores the nature and scope of the threat. There also is a brief examination of the problem for non-possessory, non-purchase money security interests presented by BRA § 522(f)(1)(B).
In bankruptcy, perfection of interests in personal property and fixtures is defined in terms of the extent to which an interest is vulnerable as against a lien creditor under state law. For reasons that will appear in this and other chapters, the fact that bankruptcy employs a "lien creditor" test of perfection as to personal property and fixtures (rather than the bona fide purchaser test applicable to real estate interests) is especially important to Article 9 parties.
B. Avoidance of Security Interests under BRA § 544
Please review subpart D of Chapter 26 (Secured Party Versus Lien Creditor) now. You may test your recollection of BRA § 544 in the next three problems.
Problem 30.1 (interactive)
Lenny Lender and Donna Debtor enter into negotiations about a $10,000 loan to be secured by an interest in Donna's equipment, existing and after-acquired. Lenny then lends the $10,000 to Donna who signs a security agreement describing the collateral as all of Donna's equipment, existing and after-acquired. If Donna filed bankruptcy before Lenny filed a financing statement covering the equipment, could the trustee in bankruptcy avoid the security interest?
Suppose that Lenny and Donna had closed the loan and Lenny had filed a financing statement before Donna filed bankruptcy. Who would have first claim to the equipment now?
Suppose that as of the date of the bankruptcy Donna Debtor had signed a security agreement providing for a $10,000 secured loan and Lenny had filed a financing statement, but Lenny had not yet lent Donna the $10,000 as of the time that Donna filed bankruptcy. If Lenny lent the $10,000 after bankruptcy but without knowledge of the bankruptcy would the loan be secured?
Problem 30.2 (interactive)
Sid Seller sells a drill press to Donald Debtor for use in Donald's business. Sid takes a security interest in the drill press to secure its unpaid price. The next day Sid delivers the drill press to Debtor. Later that same day Donald files bankruptcy.
May Sid prevent Trustee in Bankruptcy from avoiding Sid's security interest under BRA § 544(a)?
Problem 30.3 (interactive)
Lisa Lender lends Delia Debtor $10,000. Delia signs a security agreement giving Lisa a security interest in Delia's equipment, existing and after-acquired, to secure the $10,000 loan and any future advances that Lisa chooses to make to Debtor. Lisa immediately properly files a financing statement covering Delia's equipment. Thirty days later, Delia files bankruptcy. The next day, Lisa learns of the bankruptcy. Forty days after the bankruptcy was filed, Lisa lends Delia $2,000. Ten days following the $2,000 loan, Lisa lends Delia another $3,000. Delia's equipment is worth $16,000. Interest in the amount of $500 has accrued on the loans ($200 on the $10,000 loan, $100 on the $2,000 loan and $200 on the $3,000 loan) and Lisa has incurred another $500 in attorney's fees and expenses.
To what extent may Trustee in Bankruptcy avoid Lisa's security interest?
C. Avoidable Preferences
1. The Concept of a Transfer on Account of an Antecedent Debt
BRA § 544 interacts with Article 9 to give a trustee in bankruptcy the right to avoid security interests when they are not timely perfected, usually meaning not perfected on the date of bankruptcy or within twenty days of possession of the collateral by the debtor. There is another bankruptcy law provision that can pose problems for a secured party even where the security interest has been timely perfected. BRA § 547 allows a trustee to avoid certain transfers, including security interests, as avoidable preferences.
BRA § 547(b) defines what constitutes an avoidable preference. It provides as follows:
(b) Except as provided in subsection (c) of this section, the trustee may avoid any transfer of an interest of the debtor in property -
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(4) made -
(A) on or within 90 days before the date of the filing of the petition;
or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such 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.
BRA § 547(b) can give you fits. The key to getting a handle on it is to understand that it is aimed at transfers on account of antecedent debts and that the dates of the actual transfer and the transfer for purposes of BRA § 547 may be different. Examine BRA § 547(b) carefully. Notice the salient elements:
A transfer;
On account of an antecedent debt;
Made within ninety days of bankruptcy (or one year if the transferee is an insider);
Made while the debtor is insolvent (something that is presumed under BRA § 547(f));
That has the effect of preferring the transferee (true except where all creditors would be paid in full).
Transfer is broadly defined in the BRA and includes the creation of a security interest. In BRA § 547 terms, the actual transfer is made when a security interest is created. However, as noted earlier, the transfer for purposes of BRA § 547 may be at a time that is different than the actual transfer. More particularly, the transfer for purposes of BRA § 547 may be at a time that causes the transfer to be on account of an antecedent debt even though the actual transfer was not.
The operation of the preference section is best understood through its application to fact situations presented in various problems. In working with the problems in this chapter you will find it useful to create a chronological sketch of the events. The next two problems involve situations that are at the opposite ends of the spectrum with regard to the vulnerability of a security interest under BRA § 547.
Problem 30.4 (interactive)
On May 1, Carl Creditor lends to Debbie Debtor on an unsecured basis. On June 1, Carl, feeling insecure about the debt, demands and receives a security interest in Debbie's equipment. Carl files immediately. On August 1 Debbie files bankruptcy.
Is Carl’s security interest in the equipment avoidable under BRA § 544? Is the security interest avoidable under BRA § 547?
Problem 30.5 (interactive)
Assume the facts of Problem 30.4. Assume further, however, that Carl Creditor lent originally on a secured basis, the security interest in the equipment, which was not purchase money, was created at the time of the loan and Carl filed immediately. (The loan, the creation of the security interest and the filing to perfect the security interest were all on May 1.)
Is Carl’s security interest avoidable under BRA § 544? Is the security interest avoidable under BRA § 547?
2. Delayed Perfection
Things can get messy when a secured party delays perfection. The reason is that delays in perfection can cause the transfer for the purposes of BRA § 547 to be different than the actual transfer. Under BRA § 547(e), the timing of perfection is critical to the determination of when a transfer for purposes of BRA § 547 takes place.
Under BRA § 547(e)(1)(b), for purposes of personal property and fixtures, perfection of a security interest occurs when the security interest cannot be subordinated by a lien creditor under Article 9. Under BRA § 547(e)(2)(A), if a security interest is perfected within thirty days (until 2005 ten days) of the creation of the security interest (the actual transfer), then the transfer for purposes of BRA § 547 takes place at the time the security interest is created. However, if perfection of a security interest is delayed beyond the thirty-day period then under BRA § 547(e)(2)(B), the transfer for purposes of BRA § 547 is when the security interest is perfected.
You may explore the scheme just described in the next problem.
Problem 30.6 (interactive)
On May 1, Carrie Creditor lends to Donald Debtor and takes a non-purchase money security interest in Donald's equipment. Carrie files a financing statement on June 15 (six weeks after the security interest in the equipment was created). On August 10 Donald files bankruptcy.
Is Carrie’s security interest in the equipment avoidable under BRA § 544?
Is the security interest avoidable under BRA § 547? Once again, creating a timeline of the events in this and the following questions will assist you in your analysis.
Would the result under BRA § 547 be different if Carrie had filed a financing statement on May 29?
If bankruptcy had been filed on May 28, would a May 29 filing by Carrie protect Carrie's security interest from avoidance under BRA § 547?
Suppose on the original facts (Carrie filed her financing statement on June 15) that Donald filed bankruptcy on November 1 (six months after the creation of the security interest). Would Carrie’s security interest be avoidable under BRA § 547?
Suppose Donald had not filed bankruptcy until November 1, but Carrie had not filed a financing statement until September 1 (four months after the creation of the security interest). Is Carrie’s security interest avoidable under BRA § 547?
3. Purchase Money Security Interests.
As has often been noted, purchase money security interests get special treatment in and out of bankruptcy. Transfers that are avoidable under BRA § 547(b) may not be avoidable because of certain exceptions in BRA § 547(c) for purchase money security interests. The exception applicable to purchase money security interests is in BRA § 547(c)(3).
After you have cut through the verbiage of BRA § 547(c)(3), you will discover that the section gives purchase money parties a thirty-day grace period (on or before 30 days after the debtor receives possession) within which to perfect and prevent the security interest from being avoided under BRA § 547(b). To this extent the scheme is not unlike that provided for in new Article 9, section 9-317(e), examined in Chapter 26 (Secured Party Versus Lien Creditor). However, the grace period in new section 9-317(e) is twenty days and not thirty days (actually, the period provided for in BRA § 547(c)(3) was twenty days until October of 2005), unless and until the period in new section 9-317(e) is changed to correspond to that in BRA § 547(c)(3) there could be some curious outcomes. You may explore the application of BRA § 547(c)(3) in the next problem.
Problem 30.7 (interactive)
On May 30 Sid Seller sells a drill press to Donna Debtor on credit for use in Donna’s business. Sid takes a security interest in the drill press to secure its price. The drill press is delivered to Donna on June 5. Sid files a financing statement covering the drill press on July 1. Donna files bankruptcy on July 2. Is Sid's security interest avoidable under BRA § 544?
If the security interest were not purchase money, would it be avoidable under BRA § 547(b)?
Is the security interest nonetheless safe from being avoided under BRA § 547(b)?
Suppose that Donna filed bankruptcy on June 30. Would new section 9-317(e) and BRA § 546(b) prevent the trustee from avoiding the security interest under BRA § 544?
If Donna filed bankruptcy on June 30 would Sid's security interest as to which Sid filed a financing statement on July 1 be avoidable under BRA § 547? Be sure to read carefully not only BRA § 547(c)(3), but also BRA § 362(b)(3).
4. After-Acquired Property Cases.
So far we have looked only at situations where the collateral in which a security interest was taken was in existence at the time the security interest was created. After-acquired property cases present special problems in bankruptcy. Recall that under BRA § 552 a security interest is not enforceable in property acquired after a bankruptcy has been filed unless the property is proceeds. However, a security interest can be avoided under BRA § 547 even where the property was acquired before bankruptcy was filed.
The crux of the difficulty is BRA § 547(e)(3). BRA § 547(e)(3) mandates that no matter what else may be true under BRA § 547, there can be no transfer for purposes of BRA § 547 until the debtor has rights in the collateral, i.e., until the debtor has acquired the collateral.
You may consider the operation of BRA § 547(e)(3) in the next problem.
Problem 30.8 (interactive)
On May 1 Central Bank lends to Donald Debtor and takes a security interest in Donald's equipment, existing and after-acquired. Central files immediately. On May 1, Donald's equipment includes an Apex drill press. On June 1 Donald acquires a Superior drill press. On July 1 Donald files bankruptcy. Is Central Bank's security interest in the Apex drill press avoidable under BRA § 544? Is Central's security interest in the Superior drill press avoidable under BRA § 547?
5. BRA § 547(e)(3) and Inventory and Accounts.
BRA § 547(e)(3) presents special problems for inventory and accounts collateral as such collateral is likely to consist extensively of after-acquired inventory and accounts. Congress created a special exception that offers some protection against the effect of BRA § 547(e)(3). That exception is found in BRA § 547(c)(5). You should read the provision but you likely will not understand it without some explanation. Oversimplifying somewhat, the exception protects security interests in after-acquired inventory and accounts (and the proceeds thereof) to the extent that inventory and accounts acquired during the preference period (the ninety-day period) do not improve the position of the secured party at the expense of the estate (other creditors). Here we can do no more than lay out the basic operation of the scheme in a case that is free of the many complexities that actually may arise.
The next problem allows you to explore the basics of BRA § 547(c)(5) as applied to a simple inventory situation free of many of the complexities that actually may arise.
Problem 30.9 (interactive)
On May 1 Southern Bank lends to Donna Debtor and takes a security interest in Donna's inventory of widgets, existing and after-acquired. Southern files immediately. On June 1 Donna owes Southern $50,000 and the inventory of widgets is worth $40,000. During the next ninety days Donna acquires $10,000 worth of widgets. On September 1 Donna files bankruptcy. On that date the debt owed Southern is still $50,000 but the inventory of widgets is worth $50,000.
To what extent is Southern Bank's security interest avoidable under BRA § 547? Hint: Compare Southern Bank's position on June 1 with its position on September 1.
D. Avoidance of Security Interests under BRA § 522(f)
Most states have exemption laws that protect certain property against legal process. There also are some exemptions in federal law and in the bankruptcy statute. The exemption laws prevent a creditor from levying on the exempt property to enforce a judgment. They do not affect the enforcement of a security interest. Thus, a security interest is enforceable under both state law and bankruptcy law against an item of property despite the fact that the property is exempt from legal process.
However, BRA § 522(f)(1)(B) allows a debtor to avoid a non-possessory, non-purchase money security interest to the extent that the security interest impairs an exemption in property that is listed in BRA § 522(f)(1)(B).
There are certain prerequisites to the avoidance of a security interest under BRA § 522(f)(1)(B). The first is that the security interest must be non-possessory and non-purchase money.
The second, there must be an exemption to be impaired by the security interest. Most states, including Arizona, have "opted out" of the federal bankruptcy provisions. Therefore, the exemptions available to a debtor who files bankruptcy in Arizona (and most other states) are those that are provided in state law and in non-bankruptcy federal law. The latter includes some special protection for such things as social security benefits and do not have a role with regard to BRA § 522(f)(1)(B). The relevant Arizona exemptions, those for personal property, are found in A.R.S. § 1121 et seq. These exemptions are considered at length in B & S (cited in Chapter 3), Ch. 22. There are limited exemptions for household goods and certain personal property and also for tools of trade.
The third prerequisite for BRA § 522(f)(1)(B) to apply is that the property involved must be listed in BRA § 522(f)(1)(B). The list includes:
"(i) household furnishings, household goods, wearing apparel, appliances, books, animals, crops, musical instruments, or jewelry that are held primarily for the personal, family, or household use of the debtor or a dependent of the debtor;
(ii) implements, professional books, or tools, of the trade of the debtor or the trade of a dependent of the debtor; or
(iii) professionally prescribed health aids for the debtor or a dependent of the debtor."
Lastly, the non-possessory, non-purchase money security interest must "impair" an exemption. BRA § 522(f)(2)(A) specifies what constitutes impairment. The gist of the provision is that an exemption is impaired when its dollar value is reduced by the enforcement of the security interest. Thus, if a television is exempt in the amount of $500 and there is a security interest in the television to secure a debt of $300 and the television is worth $500, then the security interest impairs the exemption in the amount of $300 and may be avoided to that extent. If the television is worth enough to satisfy both the exemption and the security interest then the security interest does not impair the exemption.
You may consider the operation of BRA § 522(f)(1)(B) in the next problem.
Problem 30.10 (interactive)
Friendly Finance Company lends $1,000 to Donald Debtor to enable Donald to purchase a used Honda automobile for personal and family purposes. Friendly takes a security interest in the Honda and Donald uses the $1,000 to purchase the Honda. Debtor files bankruptcy in Arizona owing $1,000 to Finance Company. The Honda is worth $1,500. Arizona law, A.R.S. § 33-1125(8) provides a $1,500 exemption for a vehicle used primarily for personal purposes.
Is Friendly's security interest avoidable under BRA § 544?
Assume that Friendly timely perfected the security interest in the Honda? Is the security interest avoidable under BRA § 522(f)(1)(B)?
Suppose that Donald did not use the $1,000 to purchase the Honda. May Donald avoid Friendly's security interest under BRA § 522(f)(1)(B)?
Arizona law, A.R.S. § 33-1130(1), contains a $2,500 exemption for a vehicle used primarily in business. Suppose the facts of Problem 30.10 are that Friendly Finance Company's security interest is not purchase money and Donald Debtor uses the Honda primarily in Donald's business. Does BRA § 522(f)(1)(B) apply now? If so, to what extent is Friendly's security interest avoidable?
Recall from Chapter 11 (Enforceability and Attachment of Security Interests in Consumer Transactions) that taking a non-possessory, non-purchase money security interests in household goods (other than certain electronic goods) is an unfair trade practice under the FTC Fair Credit Practices Rule. To this extent, the importance of BRA § 522(f)(1)(B) is diminished.
CASE COMMENTARY
In re Yates, 332 B.R. 1 (10th Cir. BAP 2005)
In re James Baker, __ F.Supp.2d __, 2006 WL 1778203 (D. Colo. 2006)
In re Watson, 286 B.R. 594 (Bkcy D. N.J. 2002)
In re Jeans, 326 B.R. 722 (Bkcy W.D. Tenn. June 28, 2006)
In re Millivision, Inc., 474 F.3d 4 (1st Cir. 2007)
In re Commercial Money Center, Inc., 350 B.R. 465 (B.A.P. 9th Cir. 2006)
2009-02-01 update