05 Aug Can a Foreclosure Sale be Set Aside as a Preference in Bankruptcy?
It is commonly understood that bankruptcy law affords no basis to set aside a prepetition foreclosure sale, even if the sale generated far less than the fair market value of the property, as long as the sale was conducted in a procedurally proper manner under state law. That understanding may be an oversimplification, according to a Texas Bankruptcy Court opinion that recently held that while such a sale may not be a fraudulent transfer, it may be avoidable as a preference.
The Supreme Court held in BFP v. Resolution Trust Corp. that such foreclosure sales are not fraudulent transfers because a procedurally proper sale by definition generates a “reasonably equivalent” value. While we know that’s not factually true — foreclosures typically sell for far less than a listing and sale by an agent, which is why lenders often agree to allow short sales — it is legally true because the Supreme Court said so.
But a preference does not depend on whether the sale is for “reasonably equivalent” value. For a transfer of an interest in property to be a preference, it must (a) be to or for the benefit of a creditor; (b) be on account of an antecedent (i.e., already existing) debt; and (c) enable the creditor to receive more than it would receive in a chapter 7 liquidation. The debtor must also have been insolvent at the time of the transfer (which is presumed for 90 days pre-petition), and the transfer must have been made within 90 days before the petition date.
A foreclosure sale is certainly a transfer of an interest in property, and it is to or for the benefit of the creditor and on account of an antecedent debt. But if the creditor purchases the property for less than fair market value, does the creditor receive more than it would in the event of a chapter 7 liquidation? Judge Hale of the Northern District of Texas, in the case of In re Whittle Development, Inc., held that it does. The creditor receives the property, worth more than the foreclosure price, and typically receives an unsecured deficiency claim for the balance of its debt. At a minimum, a below-market sale increases the unsecured deficiency claim, but the creditor also receives the benefit of the difference between the foreclosure price and the market value of the property. As a result, the court found that all elements of a preference claim were met.
While the Whittle Development case was a Chapter 11 case, this analysis would apply in Chapter 7 as well, provided there was equity that could have been exempted absent the foreclosure, and in Chapter 13 where there was exempt equity or, even if not, in those jurisdictions that allow debtors to pursue avoidance claims on behalf of the estate.
While other courts have rejected this analysis, where it is available it may give debtors the ability, by filing bankruptcy, to undo foreclosure sales that have already taken place. While you should never wait until after the foreclosure to file bankruptcy, this may afford some relief to those who do.
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