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Ninth Circuit – Courts May Entertain Hypothetical Preference Actions Within Section 547(b)(5)’s Hypothetical Chapter 7 Liquidation

March 7, 2017, California – Schoenmann v. Bank of the West (In re Tenderloin Health, FKA), 849 F.3d 1231 (9th Cir. 2017)

Defendant Bank of West extended loan to a Debtor Tenderloin Health, a walk-in clinic serving AIDS patients in San Francisco, three years prior to the Debtor’s Chapter 7 bankruptcy filing. The loans were secured by the Debtor’s personal property, including its deposit accounts with the Defendant. In late 2011, the Debtor winded up its affairs and sold its property. The Debtor used the proceeds of that sale to execute two transactions – it paid $190,595.50 to the Defendant to satisfy its outstanding loan obligations (debt) and transferred $526,402.05 in its deposit account with the Bank (deposit). Subsequently, the Debtor filed for bankruptcy. The Bank thus received two transfers simultaneously within 90 days of the Debtor’s bankruptcy — the $190,000 payment from a sale escrow and the $526,000 deposit.The Bank later voluntarily turned over the net balance (more than $500,000) in the its deposit account to the Trustee, never having set off anything. The Trustee sued the Defendant, alleging that the Debtor’s $190,000 payment to the Bank was preferential and subject to avoidance under §547(b)(5). The Bankruptcy Court determined that the Bank did not receive more than it would have in a hypothetical liquidation because it maintained a right of setoff that entitled it to full payment, and the Debtor’s deposit account held the requisite amount of funds on the petition date.

The Trustee appealed and argued that the Trustee would avoid the $526,402.05 deposit in a hypothetical liquidation, such that the deposit account would contain only $37,713.87 on the petition date, a sum far less than the $190,595.50 the Bank actually received, even allowing for its right of setoff. The District Court affirmed, and the Trustee timely appealed to the Ninth Circuit. The Bank alleged that it was impermissible to entertain a hypothetical preference action within a hypothetical liquidation and that the deposit made by the Debtor into its deposit account did not meet the definition of an avoidable preference.

The Ninth Circuit reversed the judgment and held that the courts may entertain hypothetical preference actions within a hypothetical Chapter 7 liquidation when such an inquiry is factually warranted, is supported by appropriate evidence, and the action would not contravene an independent statutory provision. The Court ruled that $526,402.05 deposit received by the bank would constitute an avoidable preference in the hypothetical liquidation at issue. The Court reasoned that the Bank gained a beneficial interest in the funds through the deposit and became indebted to the Debtor for $564,115.92, and correspondingly increased its right to exercise a setoff for the full amount of its loan. Thus, the Court held that the Trustee has sufficiently demonstrated that the Bank received more as a result of the debt payment that it would in hypothetical Chapter 7 liquidation. Reversing the District Court’s judgment for the bank, the Ninth Circuit remanded to the Bankruptcy Court for further proceedings.