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A Hypothetical Question Deserves a Hypothetical Answer: The Ninth Circuit’s Approach to Preference Transfers in In re Tenderloin Health

As a creditor, the news of a debtor who owes you a substantial sum of money filing bankruptcy is often the most alarming news you can learn—that is, until you seek advice of counsel and learn that payments the debtor made to you within 90-days prior to the bankruptcy will be the subject of a lawsuit and likely recoverable by the bankruptcy estate as a “preference.”  This is usually the point I offer soothing chamomile tea to the client.

Recovery of “preference” transfers in bankruptcy cases, though seemingly unfair to the individual creditor, serve an important role and offer a degree of protection to the creditors as a whole.  The primary elements of a preference transfer are relatively straightforward: a debtor who is insolvent, makes a payment or payments to a creditor, within 90 days[1] prior to the bankruptcy filing, to satisfy at least a portion of a pre-existing debt[2], and the creditor receives more than it would have had the debtor filed a chapter 7 (liquidation) bankruptcy case.  Though the “don’t rob Peter to pay Paul” concept appears clear enough, the Ninth Circuit has recently illustrated how complicated the matter can become in In re Tenderloin Health[3] where the court addressed the often overlooked final element to a preference—the “greater amount” test.

As the Ninth Circuit noted, the “greater amount test … ‘requires the court to construct a hypothetical chapter 7 case and determine what the creditor would have received if the case had proceeded under chapter 7’ without the alleged preferential transfer.” Id. at *7.  This task of creating a hypothetical chapter 7 liquidation grows ever more daunting as a case grows more complex, leading to uncertainty for a creditor client, especially when unresolved legal issues come up within the hypothetical bankruptcy.

In Tenderloin Health, the debtor sold property and paid off a debt of $190,595.50 to Bank of the West (“BOTW”) and concurrently deposited the net proceeds of $526,402.05 into debtor’s deposit account with BOTW; all within ninety days prior to filing bankruptcy.  It is important to note that the paid off loan had been secured by the deposit account—therefore, even if BOTW was not paid in full, BOTW could have setoff its debt against the funds in the account.  The bankruptcy court granted defendant’s summary judgment and ruled, in short, that the $190,595.50 debt payoff could not be a preference payment because, whether or not the payoff was made, there were enough funds to cover the debt in the bank account and BOTW would have held a right to setoff against those funds in a hypothetical chapter 7.

Now, fasten your safety belt because the Ninth Circuit took this concept on a wild ride.

The Ninth Circuit reversed the ruling of the bankruptcy court, essentially finding that the court did not take the hypothetical analysis far enough.  The Ninth Circuit reasoned that, in a hypothetical chapter 7 where the payoff of BOTW’s debt never happened, a hypothetical chapter 7 trustee would hypothetically avoid the $526,402.05 deposited in the account as a preference leaving insufficient funds to satisfy BOTW’s debt when BOTW hypothetically seeks a setoff to satisfy their debt against the amounts in the account. This dizzying analysis illustrates the potential for a deepening trench of hypotheticals when faced with a preference action.

The lengthy Tenderloin Health opinion supports its conclusion that a hypothetical preference action can be considered through a detailed analysis of the statute text, legislative history, and recent case law, finding that as long as the hypothetical analysis is based on “actual facts of the case” it is permissible.  The court then walked the reader through the hypothetical chapter 7 with a thorough analysis of two hypotheticals within the hypothetical bankruptcy—including the hypothetical interplay between those two hypotheticals.  At this point, it is important to remember that an actual preference action requires a separate lawsuit, complete with proper service of a complaint, discovery and evidence presented at trial, if necessary.  Similarly, a setoff in bankruptcy would require BOTW to file, and sufficiently prove a separate action.[4]

The litigating of hypothetical claims seems to hit a tipping point when one considers the reasoned concurrence of Judge Edward R. Korman. Though Judge Korman concurs in the judgment, he disagrees with the majority’s conclusion as to the hypotheticals.  Judge Korman’s analysis of a hypothetical preference action and a hypothetical setoff leads him to the conclusion that the entire $526,402.05 deposited would not be avoided as a preference because the funds would first be subject to the setoff rights of BOTW.  This disagreement encapsulates the danger in the incomplete litigation of hypothetical actions—which naturally should include all applicable hypothetical defenses.  As Judge Korman seems to put it best:

[I]n a hypothetical liquidation, there is no such gatekeeper to protect other claimants. There is of course no actual bankruptcy judge available to exercise discretion in such a case, and it would push the already somewhat strained boundaries of our hypothetical analysis too far to exercise our own discretion, sitting as a three-headed hypothetical bankruptcy judge, weighing the imaginary equities of a fantasy liquidation. The majority asserts that this adds a new variable to what is supposed to be a controlled experiment, but so would exercising our own discretion—by substituting our judgment for that of the real bankruptcy judge.

Id. at *36 (emphasis original; citations omitted).

In the end, a creditor client’s rights when facing a preference action, though seemingly straightforward at the outset, may include a labyrinth of complex considerations, including the layers of hypotheticals addressed by the Ninth Circuit in Tenderloin Health.  Counsel and the client, alike must be sufficiently prepared to litigate not only the facts of the case, but the facts as applicable to a number of potential proceedings that could arise in a hypothetical chapter 7 liquidation.

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[1] Or one year for “insiders” of the Debtor, including officers, managers, or relatives of the debtor.

[2] See 11 U.S.C. § 547(b).

[3] __ F.3d  __, No. 14-17090, 2017 WL 894461 (9th Cir. 2017); http://cdn.ca9.uscourts.gov/datastore/opinions/2017/03/07/14-17090.pdf.

[4] Setoff is permitted under section 553 of the Bankruptcy Code to the extent permitted under state law. This would require BOTW to seek relief from the automatic stay to pursue the setoff action or otherwise seek relief under California law in the bankruptcy court.