Can A Payment To A Fully Secured Mortgagee Be A Preference?

Surprisingly, the answer may be "yes."

If you follow the reasoning of a recent bankruptcy case, a payment to a fully secured first mortgagee may be recovered from the first mortgagee, or possibly even a second mortgagee. In Gladstone v. Bank of America (In re Vassau), 499 B.R. 864 (Bankr. S.D. Cal. 2013), the Bankruptcy Court for the Southern District of California held that a payment made on a fully secured first mortgage was a preference recoverable from an undersecured junior mortgagee whose equity in the property was increased, or potentially from the first mortgagee as the "initial transferee" under section 550 of the Bankruptcy Code.

The purpose of the preference statute is to ensure that the debtor does not engage in favoritism among its creditors prior to the bankruptcy. If a payment is found to be a preference, then the creditor must repay the money to the trustee so that it can be distributed evenly among the creditors.

Pursuant to section 547(b) of the Bankruptcy Code, a preference occurs when, within ninety days prior to the bankruptcy (or one year if the creditor is an insider), an insolvent debtor makes a transfer "to or for the benefit of a creditor," and "for or on account of an antecedent debt owed by the debtor before such transfer was made," provided that the transfer enables the creditor to receive more than it would have received had the debtor's assets been liquidated and the proceeds distributed under Chapter 7 of the Bankruptcy Code. Usually, if the debt is unsecured, the creditor will have received more than it would under a Chapter 7 distribution.

A line of cases states that if the creditor is fully secured, then it is entitled to be paid in full under Chapter 7 in any event, and consequently, a payment cannot be a preference. See e.g., In re Prescott, 805 F.2d 719 (7th Cir. Wis. 1986). However, if a payment is found to be a preference, then the money transferred may be recovered under section 550 of the Bankruptcy Code from the "initial transferee" or the "entity for whose benefit such transfer was made."

In Vassau, the debtor made payments to a fully secured first mortgagee within ninety days prior to the bankruptcy. There was also a junior mortgage on the debtor's property, and the property was valued high enough that there was some equity available to partially (but not fully) secure the obligation owed to the junior mortgagee. The Bankruptcy Court held that because the payments to the first mortgagee...