First, some arts and crafts:
Lenders lend money to land owners. The land owner will grant a mortgage to the lender as security for such loan. The lender will usually seek 'title insurance' for the purpose of protecting its lien status on the subject property. Title insurance is extremely important to a lender that, among other things, may ultimately be forced to foreclose on the mortgagor. Sadly, bankruptcy is becoming more and more of an issue these days. The bank wants protection. The ALTA Loan Policy (6-17-06) affords a number of 'covered risks' to a lender. In keeping with the title of this article, I will be focusing on covered risk 13 (b). The relevant section reads:
13. The invalidity, unenforceability, lack of priority, or avoidance of the lien of the insured Mortgage upon the Title . . . (b) because the insured Mortgage constitutes a preferential transfer under federal bankruptcy, state insolvency, or similar creditors' rights laws by reason of the failure of its recording in the Public Records (i) to be timely, or (ii) to impart notice of its existence to a purchaser for value or to a judgment or lien creditor.
Objective: This article will enable a title examiner to understand what a bankruptcy trustee is attempting when she moves to avoid a mortgage lien under Section 547 of the bankruptcy code. I will accomplish this by helping the reader digest the preferential transfer statute, discussed below, as it relates to covered risk 13(b). EXAMINERS: If you haven't already done so, attain a copy of the current ALTA Loan Policy jacket and become familiar with its coverages and exclusions. When mortgagors find themselves in financial trouble, the crap will begin to hit-the-fan. At that moment, all parties scramble to protect their positions. The parties include the debtor, the mortgagee (lender), and the title company.
The elements of a preferential transfer are set forth in Section 547 of the bankruptcy code. In particular, Section 547 (b). The bankruptcy trustee will invoke the use of this section, as it is only the bankruptcy trustee or debtor-in-possession that can bring the action.Section 547(b) reads:
. . . 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.
Now, let me use Mr. Routine to help us untangle the mess.
Section 547(b): The trustee may avoid any transfer of an interest of the debtor in property. Explanation: When Mr. Routine grants a mortgage of his land as security for the bank loan, he has effectively transferred an interest in his land.
Section 547(b)(1): To or for the benefit of a creditor. Explanation: Mr. Routine's granting of a mortgage is for the benefit of the bank. The bank is the creditor.
Section 547(b)(2): For or on account of an antecedent debt owed by the debtor before such transfer was made. Explanation: An antecedent debt is a debt in existence prior to the transfer of the debtor's interest in property. Example: Let's say that Mr. Routine takes a loan from the bank on February 1, 2008. He subsequently grants a mortgage to the bank, in regards to such loan, on April 1, 2008. We would technically say that Mr. Routine had transferred an interest in his land, the granting of the mortgage, on account of the loan received on February 1, the antecedent debt. The loan existed before the actual transfer of Mr. Routine's interest in land. Now, most loans are given in concurrence with the granting of the mortgage. Both are accomplished simultaneously at the same closing. But for preference policy, the transfer of the debtor's interest in property, the granting of the mortgage, is not deemed to be effective until the mortgage is perfected (recorded) in the public records. This is usually some days subsequent to the date of closing. Sensible or not, a loan/mortgage swap may be considered a transfer on account of an antecedent debt. More on this shortly.
Section 547(b)(3): Made while the debtor was insolvent. Explanation: A debtor is insolvent if the debtor cannot pay its debts as they mature. Very simple. The trustee has the benefit of assuming insolvency of the debtor at the time of the transfer in question. It is then up to the debtor to show rebuttable evidence to the contrary; the so-called burden of proof. The reasoning behind this section is prudent: if the debtor, at the moment the questionable transfer is made, is solvent, the debtor would theoretically have had enough money to pay all creditors on time. With solvency there is no preference; it only becomes an issue when it appears that one creditor is being favored over another.
Section 547(b)(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, is such creditor at the time of such transfer was an insider. Explanation: Subsection (A) is self-explanatory: was the transfer of an interest of the debtor in property executed within 90 days prior to the filing of the petition. If the answer is yes, then the trustee can proceed with her analysis. However, if the answer is no, the trustee must move to subsection (B) in an attempt to establish transfer to an insider. Briefly, an insider includes a person or entity that has a special advantage or influence over other creditors or the debtor. A family member or business partner can be used as examples. If the trustee is successful in establishing insider preference, then she may lean on subsection (B) to satisfy this element.
Section 547(b)(5): That enables such creditor to receive more than such creditor would have received if - (A) the case were a case under chapter 7 of this title. Explanation: In a chapter 7 proceeding, the trustee will marshall as many non-exempt assets as possible for payment to unsecured creditors. Note, however, that a real estate mortgage, once perfected, secures the loan to its collateral: the homeowner's land. A secured creditor will receive 100 cents on the dollar. As a result, the lender holding a mortgage will not receive more than it would have received if the debtor subsequently files under chapter 7.
IMPORTANT INTERJECTION:
Section 547(e)(2) allows for immunity from a preferential transfer attack. This section allows for a 30 day grace period (or safe-harbor) in which a mortgage must be perfected. If the mortgage is successfully recorded within this time frame, a preferential transfer cannot be established. Section 547(e)(2) permits title companies, functioning efficiently, to avoid preferential transfer claims. If a title operation is negligent in its recording department, a preferential transfer attack is likely to pay a visit to such operation.
Now that 547(e)(2) has been disclosed and the main dimension discussed, I can now make the connection between covered risk 13(b) of the loan policy and 547(e)(2). Section 13(b) insures the insured against a preferential attack only if the mortgage is not recorded timely. What this means is this: a valid claim will exist against the loan policy if the title company does not get the mortgage perfected within the 30 day safe-harbor period (547 (e)(2)). In essence, 30 days subsequent to the closing of the loan. Remember, if the mortgage is timely perfected, a preference cannot be established.
Additionally, the ALTA Loan Policy contains exclusions from coverage. I want to draw your attention to Exclusions From Coverage Section 6(b). In short, Section 6(b) excludes from coverage a preferential transfer for any reason not stated in Covered Risk 13(b) of this policy. Explanation: Understanding coverages and exclusions of any policy is essential for completing the full circle and understanding just what risks are being insured. I believe that exclusion Section 6(b) is saying this: "We, as your title insurer, will only assume liability if we are in violation of the safe-harbor rule set forth in Section 547(e)(2) of the bankruptcy code. We assume no liability regarding any provisions of Section 547(b)." In other words, the title company will not be a party to any arguments regarding the debtor's solvency or preference periods concerning the date of the filing of the bankruptcy petition. These are all arguments to be had between the trustee, the debtor, and the lender. Without this reasoning, title companies could not function in any logical manner; they would be defending a tremendous amount of their loan closings.
The elements of a preferential transfer are not very difficult to understand. The trustee has some homework to do before such an avoidance action can be brought. If all the elements of Section 547(b) are established, the trustee must then turn to 547(e)(2) to establish untimely recording. If all this is successfully accomplished, the trustee will be empowered to avoid the transfer of an interest of the debtor in such property. By avoid I mean "wiping out" the transfer of such interest. This makes good business sense, as the trustee is attempting to pay as many creditors as possible through equal distribution of the debtor's non-exempt assets. The trustee in a successful preferential transfer attack wins in two ways. She avoids the lien of the mortgage, and she can also recover pre-petition payments to such lender, as these payments would be considered preferential.
Author Note: I think it is imperative that the reader understand that a preferential transfer, although avoidable, is not illegal. The debtor is attempting to satisfy an obligation to an existing creditor. That's a good thing! Establishment of a preferential transfer simply allows the trustee to pay all creditors on an equal basis: the so-called equal distribution principle.Title insurance, like any other form of insurance, involves risk. Every property transaction contains risk. Title insurance companies have no part in the contract between a land owner and a bank. For example, as it relates to Section 547, a title company does not have a duty to confirm debtor solvency on the day a loan was given to such debtor. Indeed, an underwriter has one simple demand of its title agent: RECORD THE MORTGAGE, PROPERLY, WITHIN 30 DAYS OF THE CLOSING. In so doing, although the elements of a preferential transfer exist, Section 547(e)(2) will act as an affirmative defense.
dave
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