Two unexpected decisions by the First Circuit Court of Appeals in what seemed to be routine cases offer object lessons for banks: Pay attention to deadlines and take nothing for granted, or you may be deprived of basic legal protections when the borrowers default.
Banks have often relied on the earmarking doctrine to protect their loans to debtors in financial difficulty.
In the classic earmarking case a person who has guaranteed a debtor's obligation gives the debtor the funds to pay off the creditor; the debtor makes the payment and then files for relief under the bankruptcy code. The courts treat the earmarked funds not as the debtor's property, but as the property of the person making the payment. Consequently the bankruptcy trustee cannot claim the funds as part of the bankruptcy estate.
In one recent case the First Circuit Court of Appeals raised some eyebrows by deciding that this doctrine did not apply. The debtor and her sister purchased real property with funds borrowed from Lender 1. They gave Lender 1 a promissory note and a mortgage on the property.
Three years later they refinanced the first loan with Lender 2. In the refinancing, the debtor and her sister executed another promissory note and mortgage in favor of Lender 2. Six days after the promissory note was signed, Lender 2 paid Lender 1 funds to pay off the loan to Lender 1 and to terminate Lender 1's mortgage on the property. Lender 2 recorded its mortgage two weeks later. Lender 1 recorded its satisfaction of the first mortgage two weeks after that.
Unfortunately for Lender 2, it recorded the new mortgage and the satisfaction of the first mortgage within 90 days of the day that the debtor filed for bankruptcy relief under Chapter 7. The bankruptcy trustee commenced an adversary proceeding against Lender 2 seeking to avoid the mortgage to Lender 2.
The bankruptcy court denied the trustee's request, taking the position that the earmarking doctrine applied and that the mortgage to Lender 2 was a mere substitution of the mortgage to Lender 1. The District Court affirmed, but the First Circuit Court of Appeals reversed.
The appeals court reached this decision because it found that the mortgage was recorded outside the safe haven provided under the bankruptcy code and was not contemporaneous with the new loan. Lender 2 did not dispute this reading of the statue, but argued that the transaction was nothing more that a transfer of the mortgage from Lender 1 to Lender 2.
The Court of Appeals found, however, that this was not merely an arrangement between third parties with no transfer of property by the debtor. Instead, it found multiple transactions including a new loan to the debtor, a mortgage from the debtor to the new lender, the prearranged use of the proceeds of the new loan to pay off the old loan, and the release of the old mortgage.
The new loan did in fact generate proceeds for the benefit of the debtor, and the debtor, by making a new mortgage, transferred a property interest to the new lender.
The trustee was not seeking to recover for the estate loan proceeds paid on the debtor's behalf by the new lender to the original lender, but only to address the granting of the new mortgage in favor of Lender 2. There was no transfer of Lender 1's mortgage to Lender 2 when Lender 1's mortgage was paid.
Since the court found that it was not the case that one mortgage passed through the debtor's hand from Lender 1 to Lender 2, it did not apply the earmarking doctrine. Rather, it found that Lender 2's mortgage represented a transfer of an interest in the debtor's property.
The Court of Appeals remanded this decision for further proceedings on other issues.
Though the final outcome of this case is still unclear, it is clear that when a creditor gets involved with a troubled borrower, it had better act swiftly to protect its rights and make sure that it meets all deadlines.
Another recent case from the First Circuit presents a situation in which a creditor failed to assess all the facts and suffered for it.
Five days before the debtor filed for relief under Chapter 11 of the bankruptcy code, while the parties were negotiating the purchase of the debtor's assets, the lender that is the defendant in this case made a loan to the debtor for $500,000.
The day after the money was advanced, an involuntary Chapter 11 petition was initiated against the debtor. The defendant, unaware of the bankruptcy filing, did not record its financing statement on the loan until five days after the money was advanced and four days after the involuntary petition was filed.
The order for relief was entered 40 days after the involuntary petition was filed.
The trustee brought an action to avoid the untimely recorded security interest. The bankruptcy court granted judgment in favor of the trustee, which was subsequently affirmed by the bankruptcy appellate panel and then by the First Circuit.
The First Circuit rejected the defendant's argument dealing with the timing of the commencement of the bankruptcy case. The judges held that the involuntary action against the debtor commenced when the case was filed, not when the order for relief was entered. Consequently, the defendant was found to have perfected its security interest after the commencement of the case.
The court also found that the defendant's problems could have been avoided if it had filed its financing statement before it advanced the loan proceeds. According to the court, the defendant should have known the risk, and its lack of due diligence precluded the granting of equitable relief.
These recent cases have caused quite a stir. The results, though arguably correct if one reads the applicable statutes literally, were certainly not the results intended by the parties involved in either transaction. Both deals appeared to be relatively simple, routine matters.
The lesson to be learned from these cases is that you cannot take anything for granted. Protect your rights diligently, because if you don't, you might not get what you bargained for.
