The Foreclosing Secured Creditor –Does It Have Any Exposure?

November 01, 1999

Consider this scenario:
Your bank client has lent money to an operating company secured by all of its assets. The borrower is in default on its payment obligations under various loan agreements with the bank. The bank is considering foreclosing on its secured interests in the assets of the borrower, by conducting a non-judicial public or private sale of those assets. The bank is substantially undersecured, i.e., the value of the assets securing the bank’s liens is less than the amount of outstanding debt owed to the bank. A newly formed company (“Newco”), owned in whole or in part by current owners and officers of the borrower, might submit a bid at the foreclosure sale. Would creditors of the borrower have any recourse against the bank, in the event that the borrower’s assets were sold to Newco at the foreclosure sale?

In a circuit-level opinion involving a foreclosure sale at which the purchaser was closely related to the debtor, the court held that: (1) a foreclosure sale of over-encumbered assets is not a “transfer” that can be attacked under the Uniform Fraudulent Transfer Act. (2) a foreclosure sale of over-encumbered assets is not a “bulk transfer” subject to the notice requirements of the Bulk Transfer Act. (3) regardless of allegations of a clandestine purpose for foreclosure, a secured creditor with uncontested right to foreclose could not be held liable for wrongful foreclosure where the value of collateral did not exceed the amount owed by debtor to the secured creditor. (4) The secured creditor’s uncontested right to conduct foreclosure precluded unsecured creditor’s claim that the secured creditor tortiously interfered with debtor’s business relationship with unsecured creditor. Peters Jewelry Co., Inc. v. C & J Jewelry Co., Inc., 124 F.3d 252 (1st Cir. 1997).

The rationale underlying each of these holdings is that, regardless of the secured creditor’s intent in conducting a foreclosure sale at which the debtor’s assets are sold to an entity related to the debtor, a creditor has not suffered any undue prejudice where, even if the aforementioned circumstances did not exist, there would be no surplus from which unsecured creditors could recover on their claims.

Fraudulent Transfer
Peters Jewelry was decided in a jurisdiction in which the Uniform Fraudulent Transfer Act (“UFTA”) is in effect. Under UFTA, the term “asset” is defined as “property to the extent that it is not encumbered by a valid lien.” The term transfer is defined in UFTA as the disposing or parting of an “asset.” Transactions involving encumbered property of the debtor are not subject to scrutiny under UFTA because encumbered property is not an “asset.” Peters Jewelry, 124 F.3d at 262; accord Kellstrom Brothers Painting v. Carriage Works, Inc., 844 P.2d 221, 222 (Or. App. 1992) (repossession and public sale of debtor’s collateral by secured creditor at public auction at which newly formed company headed by former president of debtor submitted highest bid held not to be a fraudulent transfer); see Ranser v. McFarland (In re McFarland), 170 B.R. 613, 622-24 (Bankr. S.D. Ohio 1994) (disposition of real property by quitclaim deed was “transfer” under Ohio Uniform Fraudulent Transfer Act only to the extent of debtor’s equity in the real property over and above the amount secured by mortgage lien).

UFCA, not UFTA
Some jurisdictions, such as New York have not enacted UFTA. Rather, the Uniform Fraudulent Conveyance Act (“UFCA”), the predecessor to UFTA, is still in effect in New York. Unlike UFTA, transfers of assets subject to a valid lien are “conveyances” technically subject to scrutiny under UFCA.

Nevertheless, the policy underlying the two statutes is precisely the same – prevention of diminution of the debtor’s assets available to unsecured creditors. Cases decided under UFCA indicate that a requirement for finding that a fraudulent conveyance has occurred is that creditors of the debtor have been prejudiced by the transaction in question. See, e.g., HBE Leasing Corporation v. Frank, 48 F.3d 623, 637 n.10 (2d Cir. 1995) (New York enactment of UFCA); Voest-Alpine Trading USA Corp. v. Vantage Steel Corp., 919 F.2d 206, 214 (3d Cir. 1990) (Pennsylvania enactment of UFCA); Citizens & Southern National Bank v. Auer, 640 F.2d 837, 838 (6th Cir. 1981) (Tennessee enactment of UFCA).

While HBE Leasing did not involve the transfer of assets in satisfaction of a secured claim, in each of the latter two cases, the courts examined whether the subject transaction diminished the amount of the debtor’s assets available for satisfaction of claims of unsecured creditors. See also Melamed v. Lake County National Bank, 727 F.2d 1399 (6th Cir. 1984) (decided under the predecessor to section 548 of the Bankruptcy Code, holding that a debtor’s prepetition transfer of cash to its secured creditor did not constitute a fraudulent transfer, because the cash was the proceeds of the secured creditor’s perfected interest in the debtor’s accounts receivable).

In the event that the borrower commences a bankruptcy case subsequent to the foreclosure sale, the sale would be subject to scrutiny under section 548 of the Bankruptcy Code (entitled “Fraudulent Transfers and Obligations”) as well as UFCA, which is applicable in bankruptcy cases pursuant to section 544(b)(1). With respect to the “constructive fraud” provisions of section 548, allowing for the avoidance of transfers for less than reasonably equivalent value, the Supreme Court has held that “a `reasonably equivalent value for foreclosed property’ is the price in fact received at the foreclosure sale, so long as all the requirements of the State’s foreclosure law have been complied with.” BFP v. Resolution Trust Co., 511 U.S. 531, 545, 114 S. Ct. 1757, 1764 (1994). Thus, compliance with the procedures provided under state law (here section 9-504 of the New York Uniform Commercial Code) precludes avoidance under the constructive fraud provisions of section 548 of the Bankruptcy Code.

‘Intentional-Fraud’ Provision
On the other hand, collusive foreclosure sales are subject to attack under the “intentional fraud” provision of section 548, which authorizes the avoidance of transfers made with the actual intent to hinder, delay or defraud creditors. BFP, 511 U.S. at 545-46, 114 S. Ct. at 1765. In the auction context, the term “collusive” means “secret cooperation for a fraudulent or deceitful purpose.” Lone Star Industries Inc. v. Compania Naviera Perez Companc (In re New York Trap Rock Corp.), 42 F.3d 747, 752 (2d Cir. 1994).

Courts are in disagreement regarding whether actual harm to creditors is a required element for a cause of action under section 548(a)(1). In contrast to Melamed and the cases cited above which indicate that diminution in the amount of assets available for the satisfaction of claims is a required element for a cause of action under UFCA, a few courts have held that actual harm is not required to sustain a cause of action under section 548(a)(1). See Brown v. Third National Bank (In re Sherman), 67 F.3d 1348, 1355 n.6 (8th Cir. 1995); Trujillo v. Grimmett (In re Trujillo), 215 B.R. 200, 204-205 (9th Cir. B.A.P. 1997), aff’d, 1998 WL 894574 (9th Cir. December 22, 1998). In Sherman, a married couple owned several parcels of residential property subject to a bank’s deed of trust liens. A creditor sued the husband to collect an overdue account, and the bank prepared to foreclose on the properties because the couple had fallen behind in payments. The couple’s parents purchased the properties from the children with financing provided by the bank and secured by new deeds of trust for the properties. The bank released the deeds of trust executed by the children. The parents subsequently transferred the properties to a revocable trust for the benefit of the parents and their families. The appellate court affirmed the trial court’s determination that the transfers could be avoided under section 548(a)(1) because five of the badges of fraud were present. Finally, the appellate court rejected the argument that the transfers were not harmful because they merely amounted to realization of valid security interests:

The court indicated that, although there may have indeed been equity in the properties, over and above the bank’s liens, the court’s determination did not hinge on the existence of equity in the properties.

In Trujillo, the court also rejected the no-harm, no-foul approach and determined that a transfer of property that the debtor would have been entitled to declare exempt could be avoided as a fraudulent transfer made with actual intent to defraud. 215 B.R. at 204-05. Exempt property is property of the bankruptcy estate, and the transfer of such property is a “transfer of an interest of the debtor in property” for the purposes of section 548. While the court acknowledged that exempt property is not an “asset” for purposes of the Uniform Fraudulent Transfer Act, that definition was not controlling because the transfer of the property deprived the court of the opportunity to determine whether the debtor was actually entitled to the purported exemption.

Accordingly, although the policy underlying section 548 supports the view that a transfer to a secured creditor of property subject to that creditor’s lien is not fraudulent because the transferred property would not otherwise have been available for distribution to creditors, the presence of decisions rejecting the requirement of actual harm precludes any assurances that the contemplated sale of the debtor’s assets is insulated from attack as a fraudulent transfer in the event of bankruptcy. For this reason, the disposition of the debtor’s assets should be conducted in a strictly arms-length transaction in order to minimize the number of badges of fraud present and eliminate any appearance of impropriety.

In particular, the bank should not provide the financing for Newco’s bid at the anticipated foreclosure sale. In both Peters Jewelry and Voest-Alpine, the secured creditor extended loans to the purchaser that were used to pay the purchase price for the debtor’s assets at foreclosure sales. The presence of these loans reinforced the impression that the foreclosure sales were undertaken merely to permit the secured creditor to continue its relationship with the debtor and its successor, free from the demands of all other creditors. In Voest-Alpine, the foreclosure sale was avoided as a fraudulent transfer and the purchaser was held liable for the value of the assets transferred from the debtor, where, if the purchaser had paid reasonably equivalent value for the assets, there would have been sufficient proceeds to satisfy the claim of the secured creditor and allow for a distribution to unsecured creditors. 919 F.2d 214-15.

Successor Liability
As noted above, the Peters Jewelry court dismissed the fraudulent transfer claim because, under UFTA, there is no “transfer” where the subject assets are fully encumbered. However, the court declined to dismiss the claim that the purchaser at the foreclosure sale should be held liable to creditors of the debtor as a successor to the debtor. 124 F.3d at 266-74. Under Rhode Island law, successor liability claims are not precluded by the fact that assets were transferred via a foreclosure sale or that the value of collateral did not exceed amount owed by debtor to secured creditor. Notably, the successor liability claim was asserted only against the purchaser of the debtor’s assets, and nothing in the opinion implies that the foreclosing creditor could be held liable under the successor liability theory.

Bulk Transfer Act
As noted in Peters Jewelry, foreclosure sales are not subject to the notice requirements of the Bulk Transfer Act because they constitute “[t]ransfers in settlement of a lien or other security interest.” 124 F.3d at 264-66. The provision of the Rhode Island Bulk Transfer Act relied in Peters Jewelry is identical to its counterpart under New York law. See N.Y. U.C.C. § 6-103(3). Accordingly, the bank can carry out a foreclosure of the debtor’s assets without notice to the debtor’s unsecured creditors.

Tortious Interference
In Peters Jewelry, the unsecured creditor alleged that the secured creditor and the principals of the debtor tortiously interfered with the unsecured creditors’s contractual relations with the debtor by improperly causing the extinguishment, via the foreclosure, of the debt owed to the creditor by the debtor. Noting that intent to do harm without justification is a required element for a cause of action for tortious interference under Rhode Island law, the court dismissed the tortious-interference claim against the secured creditor because the secured creditor, had a valid legal right to foreclose on the debtor’s assets. 124 F.3d at 275-76.

New York law is similar in this respect to Rhode Island law. In order to sustain a cause of action for tortious interference with contractual relations under New York law, the plaintiff must demonstrate that the asserted interference was intentional and not merely negligent or incidental to a legitimate business purpose of the defendant. Alvord and Swift v. Stewart M. Muller Construction Co., 46 N.Y.2d 276, 281, 413 N.Y.S.2d 309, 312 (N.Y. 1978). Since the bank unquestionably has a legitimate business purpose for foreclosing on the borrower’s assets, the bank should be able to conduct the proposed foreclosure sale without incurring liability for tortious interference with the borrower’s contractual relations with its unsecured creditors.

Wrongful Foreclosure
As noted in Peters Jewelry, the few jurisdictions recognizing a cause of action against a foreclosing creditor for wrongful or collusive foreclosure have indicated that liability on such claims is reserved for situations where the security interest is invalid or fraudulently obtained or the foreclosure sale was conducted in such a manner so as to dispose of a greater portion of the debtor’s property than is necessary to satisfy the secured creditor’s claim. 124 F.3d at 262-63 & n.8.

In addition, the court flatly rejected the plaintiff’s argument that “a secured creditor, with an uncontested right to foreclose under the terns of a valid security agreement, nonetheless may be liable on a claim for wrongful foreclosure should a jury find that the secured creditor exercised its right based in part on a clandestine purpose unrelated to the default.” Id. at 262.

Failure to Conduct Foreclosure in a Commercially Reasonable Manner
Section 9-504(3) of the New York Uniform Commercial Code provides that, upon the debtor’s default under the security agreement, the secured creditor may sell the collateral in whatever manner is commercially reasonable and apply the proceeds against the outstanding debt. The method, manner, time, place and terms of the sale must all be commercially reasonable.

Disposition may be by public or private sale. There is no presumption that a private sale is less commercially reasonable than a public sale. Peters Jewelry, 124 F.3d at 264; In re Zsa Zsa Limited, 352 F. Supp. 665, 670 (S.D.N.Y. 1972) (expressly rejecting argument that model for a commercially reasonable sale is a public sale with free and open bidding by the greatest number of interested purchasers), aff’d, 475 F.2d 1393 (2d Cir. 1973). The official comment to section 9-504(3) acknowledges that there are situations where “a private sale through commercial channels will result in higher realization on collateral for the benefit of all parties.”

Did the Sale Comport With Prevailing Trade Practices?
The most important factor in assessing the reasonableness of a sale is whether the sale comported with prevailing trade practices among those engaged in the same or a comparable business. Peters Jewelry; see Henry-Luqueer Properties, Inc. v. Mayo (In re Henry-Luqueer Properties, Inc.), 145 B.R. 771, 776 (Bankr. E.D.N.Y. 1992) (foreclosure sale of distressed real estate was commercially reasonable where sale was advertised for several weeks in publication directed at parties interested in purchasing real property at foreclosure sales; advertisement of sale in publication of more general circulation would have served only to attract unsophisticated onlookers who would have been in no position to bid).

In Peters Jewelry, the court accepted as plausible the secured creditor’s justification for conducting a private sale, namely, that the publicity attending a public sale of the debtor’s assets would cause the debtor’s customers, retailers with sterling reputations, to avoid conducting business with the purchaser at the sale, thereby depressing the sales price.

The Zsa Zsa court gleaned the following guidelines for a commercially reasonable sale from section 2-706 of the Uniform Commercial Code: (1) goods should be available for inspection prior to the sale; (2) reasonable notice and location should be provided; and (3) sales should be limited to identified goods, unless trading in futures is appropriate for the goods involved. 352 F. Supp. 670-71.

A disposition which has been approved in any judicial proceeding or by any bona fide creditors’ committee or representative is conclusively deemed to be commercially reasonable. N.Y. U.C.C. § 9-507(2).

The only parties entitled to notice of the foreclosure sale are the debtor and parties with liens in the goods to be sold that have notified the foreclosing creditor of their interests. Unsecured creditors are not entitled to notice. N.Y. U.C.C. § 9-504(3).

In the event that the sale is not conducted in a commercially reasonable manner, the foreclosing creditor can be held liable for any loss caused by the failure to conduct the sale in a reasonable manner. N.Y. U.C.C. § 9-507(2). Since the bank’s claims exceed the value of the borrower’s assets, the only party that would be harmed by a failure to conduct the sale in a commercially reasonable manner would be (1) the bank, since its realization on the collateral was less than optimal, (2) the borrower, since the bank’s deficiency claim against the borrower would be smaller if there was a greater realization on the collateral and (3) any guarantors of the borrower’s obligations to the bank, since the amount outstanding on the guarantee would be reduced if there was a greater realization on the collateral. However, the amount of the deficiency would only be relevant if the bank attempted to collect the deficiency from the borrower or any guarantors. In such instance, the failure to conduct the sale in a commercially reasonable manner would be asserted merely as a defense against the bank’s collection efforts and not as a means to obtain damages from the bank.

The only parties with standing under section 9-507 to sue the secured creditor for damages caused by a failure to foreclose in a commercially reasonable manner are those parties entitled to notice of the foreclosure sale. Unsecured creditors have no standing to sue for damages under section 9-507.

Ted A. Berkowitz is a partner at Farrell Fritz, concentrating in Bankruptcy and Creditors’ Rights. He represents secured and unsecured creditors, landlords, purchasers of assets and other parties in interest in bankruptcy court proceedings. He defends preference and fraudulent conveyance actions as well as claims arising out of failed business transactions. Mr. Berkowitz also counsels clients in out-of-court workouts and debt restructurings. An often-published author on bankruptcy and secured lending topics, Mr. Berkowitz served as editor of the Bankruptcy Strategist, a publication of the New York Law Journal, and is currently a member of its board as well as a frequent contributor.

Patrick Collins is an associate in the Commercial Litigation department of Farrell Fritz, concentrating in bankruptcy and creditors’ rights.

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