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'No Harm, No Foul' Notion Has No Place in Bankruptcy Law

 By Myron A. Bloom

Just over two weeks ago, the 1st U.S. Court of Appeals issued an opinion that seems to put to bed once and for all, at least in one context, the notion that "no harm, no foul" has no place in bankruptcy law.

The fact pattern presented to the court in Collins v. Greater Atlantic Mortgage Corporation, et al. had little by way of twists and turns. In August 2001, Lazarus, the eventual debtor, together with her sister purchased a parcel of residential real property as joint tenants. To finance the transaction, Lazarus and her sister executed a note and mortgage in favor of Washington Mutual; the mortgage was duly recorded.

On June 22, 2004, Lazarus and her sister refinanced the property, using Greater Atlantic Mortgage Corporation (GAMC) as the mortgage lender, again signing a note and mortgage. While the papers were executed on June 22, nothing occurred until July. Then the following happened:

July 1:   GAMC paid Washington Mutual funds to pay off the Washington Mutual note.

July 15: GAMC recorded the new mortgage.

Aug. 3:   Washington Mutual satisfied its mortgage.

Then, on Sept. 29, 2004, within 90 days of the recording of GAMC mortgage, Lazarus filed for Chapter 7 protection.

In the Chapter 7 case, Lazarus's trustee filed an adversary proceeding against GAMC, claiming that the recordation of the GAMC mortgage - a transfer of Lazarus's property - constituted an avoidable preference. The bankruptcy court, ruling on cross-motions for summary judgment, found in favor of GAMC. In so ruling, the bankruptcy court found that because Washington Mutual's mortgage was still in place when GAMC filed its mortgage, no creditor was ever led to believe that the property was unencumbered. The district court affirmed.

On appeal, the circuit court was faced with two issues, both of which it concluded were matters of law subject to de novo review. The first issue was whether the transfer was preferential; the second was whether the transfer, if in fact preferential, was salvaged by the lack of prejudice to other creditors.

GAMC conceded the following:

That the alleged transfer (the recording of the new mortgage) was a transfer on account of an antecedent debt - the delay between execution and recording was more than 20 days;

That the transfer was for the benefit of a creditor (GAMC);

That the transfer was a transfer of an interest in property;

That the transfer was made within 90 days of the bankruptcy;

That the transfer was made while Lazarus was insolvent; and

That the transfer, unless avoided, would give GAMC more than it would receive as a general unsecured creditor.

What GAMC did contest was that the transferred property interest was that of Lazarus.

"This may seem odd," stated the 1st Circuit panel, given that Lazarus did grant a mortgage in favor of GMAC. However, noted the court, what GAMC was arguing was that the transfer was in reality a transfer of property from Washington Mutual to GAMC. In support, GAMC relied on the "earmarking doctrine."

The earmarking doctrine is often sought to be utilized in bankruptcy cases. The doctrine provides that where funds received by a debtor are "earmarked" for another, courts sometimes hold that the funds are not really the debtor's, and thus the transfer of those funds by the debtor to a third person is not really a transfer of the debtor's funds. The transfer of those funds, in such circumstances, is deemed to be a transfer of funds through the debtor, and not a transfer of funds by the debtor.

This doctrine is often applied in the case of guarantees. If a guarantor gives a debtor money to pay off a guaranteed debt, and the debtor pays on the guaranteed debt, the funds are held to have been transferred through, but not by, the debtor. The logic is that if the payment were held to be a preference, the funds transferred to the creditor would be recaptured and the guarantor would have to pay twice. Thus, the emergence of the earmarking doctrine.

Some courts have even extended this doctrine to situations where a new creditor, not a guarantor, advances funds, thus substituting the new creditor for other, older creditors, based on their view that the money passing through the debtor's hands are not his and that he is a kind of bailee.

The bankruptcy court, stated the panel, extended the earmarking doctrine by concluding that the "real" transfer was the transfer of a security interest in the realty from Washington Mutual to GAMC, at no disadvantage to the estate. The court disagreed. In a refinance, there is not a single transaction, stated the court. There are multiple transactions, namely a new loan, a mortgage back to the new lender, a pre-arranged use of proceeds and a release of the old mortgage. New proceeds are generated, nominally for the benefit of the debtor, and the debtor, by making a new loan, transfers a property interest to the new lender. The GAMC note and mortgage had, most likely, different, more favorable terms than did the Washington Mutual mortgage - otherwise, why refinance? And Washington Mutual did not transfer its mortgage to GAMC; it released its mortgage, the result being that GAMC was then first in line. In short, Lazarus did not act as a mere bailee, with the Washington Mutual mortgage passing through her hands to GAMC.

GAMC also argued, in several interlocking arguments, that the outcome of a reversal - leading to GAMC being an unsecured creditor having to share in the equity in the property - was manifestly unjust. In essence, GAMC claimed that though technically the transfer (the recording of the mortgage on July 15) was on account of an antecedent debt (either the loan document date of June 22 or the date of the advance of funds by GAMC of July 1), the pre-existing creditors were, in this case, not harmed, and no evidence exists that any new creditor arose during the "gap."

It also argued that this transaction, when viewed as a whole, should be held to be a contemporaneous exchange for new value. The court was not impressed by this argument. Turning to the text of Section 547 of the Bankruptcy Code, the court noted that there was indeed an exception to the preference provisions for a "contemporaneous exchange," but that Section 547(e)(2) specifically provides that with respect to a delay in recording mortgages, only those mortgages recorded within 10 days may be considered contemporaneous. Congress, stated the panel, had spoken to this issue, and saying, as GAMC tried, that a delay of either 23 days (if one used the date of the mortgage) or a delay of 14 days (if one used the date of the advance of funds to Washington Mutual) may be considered contemporaneous simply is not good enough. One must view the statute as written, noted the court, and not place a gloss on it when an arguably unjust result may occur in a specific case. Lack of prejudice, simply stated, is not a substitute for compliance with statutory mandate. GAMC's plight, stated the court, was of its own making, and despite the fact this case arguably calls for sympathy, the "contemporaneous exchange" exception to the general preference rules cannot be used to eviscerate the statute. After all, Section 547(e) speaks specifically to this situation. To ignore it would be to "undo Congress" chose."

The court thus reversed the lower court decisions and remanded.

Harsh? It would seem so. Avoidable? Absolutely. Once again, the courts have spoken. Read the law, and if it is precise, do not rely on "substantial" compliance, not to mention sympathy.

This article is reprinted with the permission from the January 26, 2007 issue of The Legal Intelligencer.  Copyright 2007 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.