The decisions illustrate the harsh consequences imposed by the Bankruptcy Code on lenders who fail to promptly perfect their liens after funding their loans. Further, the Court of Appeals ruled unequivocally that these harsh consequences could not be ameliorated by appealing to the Court’s role as a court of equity in the face of the clear mandate of the bankruptcy statutes.

The two decisions are In re Millivision, Inc. (Ostrander v. Gardner) 2007 U.S. App. LEXIS 873 (1st Cir. January 16, 2007) and In re Lazarus (Collins v. Greater Atlantic Mortgage Corporation) 2007 U.S. App. LEXIS 388 (1st Cir. January 9, 2007). The legal and factual context of each case is distinct. One case involved a mortgage on real property, which the trustee sought to avoid as a preference under 11 U.S.C. §547, and one a commercial loan secured by personal property in which the trustee used his “strong arm” avoiding powers of §544 to avoid the lien. Nevertheless, the result was the same for each of the lenders, with their liens being avoided and their claims rendered unsecured because the lenders failed to immediately perfect their liens at the time their loans were extended.

In the Millivision case, the lender extended a $500,000 loan to a debtor, which the lender knew was not able to pay its current expenses. The purpose of the loan was in fact to allow the debtor to pay essential business expenses to keep operating. The lender did not file a financing statement to perfect the loan until five days after extending the loan. This short delay was too long under the circumstances. Unsecured creditors of the debtor had filed an involuntary Chapter 11 bankruptcy petition against the debtor the day after the lender extended its loan. A Chapter 11 trustee was appointed, and the trustee filed suit against the lender to avoid the lien under the trustee’s “strong arm” avoiding powers of 11 U.S.C. §544(a).

The “strong arm” avoiding powers statute provides the lender with the status of a hypothetical lienholder who has perfected his lien as of the petition date. Because the trustee’s hypothetical lien was perfected before the lender’s lien was perfected several days later, the trustee claimed the lien should be avoided in favor of the estate. The lender defended the claim by arguing the perfection date of its lien should “relate back” to the date it extended its loan based on the provisions of the Bankruptcy Code’s preference statute (11 U.S.C. §547), which provide that a lien perfected by the filing of a financing statement within ten days of the date of the transfer of the security interest “relates back” to the date of the transfer.

The First Circuit rejected the argument. The Court held that as a matter of statutory construction, under 11 U.S.C. §546, a trustee’s strong arm avoiding powers are only subject to or diminished by the rights of creditors under “generally applicable law” that would render the trustee’s hypothetical lien subject to or junior to the other creditor’s lien. A number of courts have held that the Bankruptcy Code preference provisions do not constitute “generally applicable law” for the purposes of §546. Rather, that term refers to “generally applicable non-bankruptcy law” such as the Uniform Commercial Code (UCC) or state lien or recording statutes, none of which applied in this case to make the delayed filing of the financing statement relate back to the date the loan was extended.

Further, the lender asserted that equity under the circumstances warranted denial of relief to the trustee to avoid a windfall to the bankruptcy estate. The Court rejected the lender’s equitable arguments, noting the lender could have avoided its loss simply by filing its financing statement prior to funding, a common practice among commercial lenders to avoid precisely the problem encountered by the lender in that case. The Court found the lender under the circumstances had not acted diligently, and as a result, was not entitled to relief in equity.

In the Lazarus decision, the lender made a loan to the debtor to refinance a mortgage but failed to record the mortgage until 14 days after the loan proceeds were paid to the original lender to satisfy its loan. The debtor filed a voluntary Chapter 7 petition in bankruptcy within 90 days thereafter, and the Chapter 7 trustee filed suit to avoid the lender’s mortgage as a preference under 11 U.S.C. §547.

The lender in Lazarus prevailed in the Bankruptcy Court and District Court, with those courts concluding that the earmarking doctrine should be applied so the transfer would “be viewed in substance as a transfer of the mortgage from” the original lender to the new lender, which provided the refinancing. The First Circuit, however, rejected this argument. The Court analyzed the cases in which the earmarking doctrine had been applied as involving either a payoff of a loan by a guarantor or satisfaction of an existing debt by a new lender where the new lender is substituted for the existing lender. In those cases, the Court asserted it could “plausibly” be argued that the transfer of property occurred only between the third-party lenders without affecting property of the debtor.

The First Circuit distinguished the Lazarus case from the other earmarking cases because the original mortgage was not transferred or assigned to the new lender but was instead paid off and the lien discharged, with a new lien in favor of the lender providing the refinancing being recorded thereafter. While the Court conceded that the debtor’s creditors remained in essentially the same position before and after the refinance, and other creditors were probably not prejudiced in this case by the refinancing lender’s delay in recording the mortgage, the Court held it was bound to apply the clear terms of the preference statute. That statute only provides for a relation back of the perfection of a security interest if perfection occurs within ten days of the date of the transfer. Because the lender did not record its mortgage until 14 days after the loan closed and the funds were paid to the original lender, the ten-day relation back rule did not apply. The mortgage — and therefore the transfer of the debtor’s interest in property — to the new lender was made on account of an antecedent debt and subject to avoidance as a preference by the terms of the statute.

The First Circuit also rejected the lender’s argument that the transaction should be held to fall within the “contemporaneous exchange of value” exception to preference recovery or that the Court sitting in equity should otherwise except the transaction from the application of the preference statute under the circumstances. The Court held it would be inappropriate to create such an exception or apply the contemporaneous exchange exception when the clear terms of the relation back provisions of the preference statute would not protect the transaction from avoidance.

The results in these decisions are consistent with the application of the express provisions of the Bankruptcy Code governing the issues presented. The decisions are also consistent with U.S. Supreme Court precedent in Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206-207 (1988), which two decades ago reconfirmed that the Bankruptcy Court’s general equitable powers are not unbounded and cannot be used to override a result compelled by application of governing statutory law. These cases send a clear message to creditors that they should not expect a sympathetic reception from the courts when they fail to diligently protect their security interests through prompt perfection of their liens.

Lesley Anne Hawes is a partner with McKenna Long & Aldridge, LLP, a full-service law firm of 400 lawyers and public policy advisors with offices in Atlanta, Brussels, Denver, Los Angeles, Philadelphia, San Diego, San Francisco and Washington, DC. The firm provides business solutions in the areas of corporate law, government contracts, intellectual property and technology, complex litigation, public policy and regulatory affairs, international law, real estate, environmental, energy and finance as well as bankruptcy and creditor’s rights. To learn more about the firm and its services, visit www.mckennalong.com.