Creditors' Rights Issues For Title Insures
By Joseph C. Bonita
Chief Underwriting Counsel
Chicago Title and Trust Family of Companies
Originally Presented at the American Land Title Association Second Annual Legal Symposium
May 20, 1997, New Orleans, Louisiana
Copyright (c) 1997 Chicago Title Insurance Company
The purpose of this paper is twofold: To present a general overview of those provisions of the creditors' rights laws which most frequently affect title insurance transactions and to outline the transaction structures in which these problems usually appear. Therefore it should not be considered to be a complete treatment of the subject or to be legal advice for any purpose.
The two branches of creditors' rights laws which are most relevant to real estate transactions are fraudulent transfers and preferences. The word "transfer" is commonly used in creditors' rights law. For the purposes of this paper, it means the same thing as "conveyance," whether by deed, lease or mortgage.
I. Fraudulent transfers.
A. Intentional fraud.
American law has been concerned with fraudulent transfers of property since the country's inception. In England, the Statutes of Elizabeth forbade transfers intended to hinder, delay or defraud one's creditors. This concept has been carried over into American law in the form of Section 548(a)(1) of the federal Bankruptcy Code, various state fraudulent transfer laws and Section 4(a)(1) of the Uniform Fraudulent Transfer Act ("UFTA"). These provisions define intentional fraud. Title insurers usually see this in the form of deeds to spouses or other related parties just before judgment liens appear against the grantor. However, commercial transactions can involve intentional fraud too. The transaction leading to the case that started the concern over leveraged buyouts was held to be intentionally fraudulent.[1]
B. Constructive fraud.[2]
Transfers may be unintentionally fraudulent too. All it takes is the right combination of economic circumstances. With one exception, the Bankruptcy Code requires the simultaneous existence of impaired financial condition and insufficient consideration for a trustee in bankruptcy to seek a remedy.
The necessary financial impairment exists if the transferor is insolvent at the time it makes the transfer. It also exists if the transfer itself creates the insolvency or leaves the transferor with unreasonably small capital for its business operations.
Insufficient consideration exists when the transferor receives less than reasonably equivalent value for the transfer. The exception is the case of a transfer by a partnership to one of its general partners. In this case, whether the partnership gets reasonably equivalent value is irrelevant.[3]
The UFTA has been adopted in a large majority of the states. It uses similar tests for constructively fraudulent transfers although some of its nomenclature is different.[4] Its principal difference is in its treatment of partnership transfers, which is outside the scope of this paper.
As used in the Bankruptcy Code and the UFTA, insolvency exists when one's liabilities exceed the value of one's assets. [5] Neither law defines the concept of unreasonably small capital. Courts have come to the conclusion that it is a judgment based on multiple factors. One of the most important is the ability to get credit to continue operations.[6]
For most purposes, reasonably equivalent value approximates fair market value within some vague tolerance.[7] Consideration is not necessarily the same thing. Consideration is any act which a person is not legally obligated to perform, regardless of the value of that act to the person for whom it is performed. So while consideration may exist for a transfer, unless the value of the consideration approaches the fair market value of the property, there may be a problem.
When a transfer meets the tests of a fraudulent transfer, a trustee in bankruptcy has three remedies. The first is to have the transfer avoided.[8] When this happens, the bankruptcy estate of the debtor reacquires the property previously transferred.[9] The trustee can proceed directly under the provisions of Bankruptcy Code Sec. 548 or he or she can proceed under state fraudulent transfer law through Sec. 544. The trustee would use state law if it gave a more favorable result to the creditors or if the right to avoid under the Bankruptcy Code had expired for some reason.
The second remedy is to have the person who received the fraudulent transfer turn over the value of the property to the trustee for the estate's benefit.[10] This remedy is available only within the discretion of the bankruptcy court. In most cases, it's practical effect is to give the estate the difference in value between what was paid for the property and its market value. For example, if a deed in lieu of foreclosure to a piece of property worth $1 million were given for a mortgage debt of $800,000, the trustee could petition the court to have the lender pay the $200,000 difference to the estate rather than return the property.
The third remedy is to have the claim of a creditor who became a creditor through a fraudulent transfer subordinated to the claims of other creditors of the debtor.[11] For example, at least one bankruptcy court has avoided an LBO mortgage and then subordinated that lender's now unsecured claim to the claims of all of the other unsecured creditors.[12]
C. Benefits of and limitations on avoidance power.
Who gets the benefits when a transfer is avoided? If the avoidance takes place under Sec. 548 of the Bankruptcy Code, the recovery is for the benefit of the estate as a whole. This means all creditors who are creditors of the debtor at the time it files bankruptcy may be benefitted, even if they were not creditors when the transfer being avoided was made. Under Sec. 548 of the Bankruptcy Code, the trustee may avoid only those fraudulent transfers made within one year prior to the filing of the bankruptcy. If the transfer is avoided under Sec. 544 of the Code, and the state law is the UFTA, then there may be a distinction between creditors that existed at the time the transfer was made and those who became creditors later.[13] Under the UFTA, fraudulent transfers may be avoided four years or more after the date they were made.[14]
II. Preferences.
A preference exists when, as a result of a transfer of property, one creditor is given an advantage in collecting its debt over the others at a time when the debtor is insolvent. This was not usually recognized as a problem at common law.[15] However, the Section 547 of the Bankruptcy Code makes some preferences voidable by a bankruptcy trustee. In order to be voidable, all of the following conditions must exist:
First, the transfer must be to a creditor of the person making the transfer or it must be for the benefit of that creditor. An example is a borrower giving its lender a mortgage to secure repayment of a debt.
Second, the transfer must be made for or on account of a pre-existing debt which the transferor owes the creditor. An example is when the debt for which the mortgage is given was created substantially before the giving of the mortgage.
Third, the transfer must enable the creditor to receive more than it would if the transferor were liquidated in a bankruptcy and the transfer had not been made. For example, this condition usually exists when the pre-existing debt for which the mortgage was given was unsecured at the time the mortgage is given. The mortgage will give the lender the status of a secured creditor in the borrower's bankruptcy which gives it an advantage over the borrower's unsecured creditors.
Fourth, the transferor must be insolvent at the time it makes the transfer. The test for insolvency is the same as that set forth above for fraudulent transfers, i.e., liabilities in excess of the value of assets.
Finally, the transfer must be made within 90 days prior to the time the transferor petitions for bankruptcy. If the creditor is an "insider," such transfers made within one year prior are voidable as well. Generally speaking, an "insider" is anyone that is a relative of or fiduciary to the transferor. Examples are relatives and corporate officers or general partners of the transferor.[16]
The transferor's trustee in bankruptcy has two remedies. He or she can avoid the preference.[17] In our examples above, this means cancelling the mortgage. The trustee can also have the mortgage or the debt subordinated to the claims of other creditors on equitable grounds, in a manner similar to the equitable subordination mentioned above with respect to fraudulent transfers.[18]
There are exemptions to the trustee's power to avoid transfers. For the most part, they do not often concern title insurers. However, one which does is the "new value" exclusion. Under it, generally speaking, the trustee cannot avoid transfers given at the same time the debtor was given new value by its creditor, to the extent of the new value.[19] Example: A mortgage is given to the lender to secure a pre-existing debt and new money loaned at the time the mortgage is given. The trustee cannot avoid the mortgage as it secures the new money.
CREDITORS' RIGHTS STRUCTURAL PROBLEMS
A creditor's rights structural problem exists when a transfer meets the tests of avoidability set forth above except for the economics of the transaction, the financial condition of the transferor or the expiration in the future of a statute of limitations. For example, if a borrower gives a mortgage to secure its previously unsecured debt to the same lender a creditors' rights structure exists. The only things that will save the mortgage from being avoided as a preference are (a) the fact (if true) that the borrower is not insolvent when it gives the mortgage or (b) the prediction that the 90 day or one year bar on avoidance will run before the borrower declares bankruptcy. In the fraudulent transfer context, an additional economic argument might be that the transferor receives reasonably equivalent value for its transfer. In either case, the transfer, whether it be a deed or a mortgage, is safe only if the right economic or financial conditions exist for a long enough time.
I. Fraudulent transfer structures.
A. Upstream transactions.
These are transactions in which at least some of the money loaned by the mortgagee goes "upstream" to the owners of the mortgagor. The mortgagor, however, either owes the debt for this money or has incumbered its property as security for the owner's repayment or both. The following are common examples:
1. The leveraged buyout (LBO).
This is the ne plus ultra of all upstream transactions because, in its pure form, the mortgagee gets to keep none of the money. Though there are many variations, the basics of the transaction have a corporation which is being purchased mortgage its property as security for a the repayment of money which will be used by the new owners to pay the new owners for the stock of the Company. These transactions leave the company with secured mortgage debt but none of the money for it. It could leave the purchased company insolvent, or with insufficient capital to continue in operation depending on how large the debt is compared to its assets.
The LBO is not limited to corporations. Partnerships have often borrowed money for the purpose of financing the sale of a partnership interest from an existing partner to a new one. Essentially the same consequences that attend the corporate leverage buyout exist here.
2. Guarantees of parent's debt repayment.
It is common today to have subsidiaries or corporations execute guarantees to lenders to their parents. For example, if a company's principal assets are its shares of stock in its subsidiaries, it has only two ways of securing borrowing. The first is to pledge those shares of stock. This usually does not concern title insurers because they don't insure those transactions. It is less desirable to the lender because the value of that stock varies with the net worth of the subsidiary. If the parent cannot repay the loan it is probably because the subsidiary has economic problems and its stock isn't worth much. The other way is to have the subsidiary mortgage its real estate. The value of the real is usually more stable because it isn't reduced by the subsidiary's creditors.
However, if the subsidiary gets none of the funds of the loan, the potential for a fraudulent transfer exists, depending on its financial situation.
3. Mortgage loans to pay dividends or partnership distributions.
The only difference between this and the LBO is that no change in ownership of stock or partnership interests are involved. The same problem exists: the mortgagor doesn't get the benefit of the money it has agreed to repay or for which repayment it has mortgaged its property as security.
4. Mortgage loans to repurchase corporate stock.
Corporations sometimes purchase their stock as a means of raising the market price of the remaining shares. Stock repurchases also were made on occasion in the 1980s to thwart the attempts of dissident shareholders to replace company management. In either case, if there is no market for the stock or if it is repurchased at substantially above market price, there may be a problem. If the corporation cannot sell the stock at roughly the price for which it purchased it, what good does it do it in economic terms to have obtained it?
B. Sidestream transactions.
These are transactions in which the benefit of the mortgage or other transfer goes to an affiliate of the mortgagor, e.g., a sister corporation or partnership. In the nomenclature of streams, they may get their name because that's all that's left after you exhaust up and down. These are the most commonly seen of transactions with structural problems today. Some examples follow:
1. Cross-collateralized mortgage loans of sister companies.[20]
These occur in virtually all securitized lending transactions in which different single purpose, single asset corporations, partnerships or limited liability companies own the mortgaged properties. They are also common in other kinds of lending transactions in which the borrowers are related to each other by a common owner.
In its most usual form, each of the owners executes a note for its own loan. It also executes a guarantee which allows the lender to foreclose on its land as security for each of the other mortgaging owners debts. If they don't pay, the promise goes, you can foreclose on my property to collect their debt to you. Performance of this guarantee is secured either by the mortgage given for its own debt or by a second mortgage on the property. This creates a structural problem because of the possibility that the liability of the guarantee will render the guarantor insolvent.
2. Mortgages to fund sister company cash needs.
In these transactions, a company borrows money which goes to its sister company to be used for the sister company's business. This usually occurs in cases where neither the parent nor the sister company have sufficient collateral to satisfy the lender.
C. Miscellaneous transactions.
1. Deeds in lieu of foreclosure.
Generally, the only issue involved is the comparison between the amount of the debt owed the lender and the value of the land taken in lieu of foreclosure. In most cases, the borrower can be assumed to be in great financial difficulty. Otherwise, the transaction would not be likely to occur.
2. Mortgage modifications which increase the economic burden on the land without additional loans.
This is seen often in loan workouts. The borrower is having difficulty paying the loan and the lender doesn't want to foreclose. The loan is restructured to provide for some kind of current interest rate relief for the borrower. Sometimes this takes the form of a reduced interest rate but with greater interest payable at maturity or refinancing as a result of shared equity. Other times the rate relief is merely an agreement to make monthly loan payments as if the interest rate were lower for some period of time but then to charge interest on the interest which wasn't paid according to the original terms thereafter.
3. Partnership "roll-ups."
It is often desirable to combine the properties of several related partnerships into a single "master" partnership. Sometimes this is to create a single borrower for the purposes of a loan. It is a common practice in creating the "umbrella partnership" for use in an UPREIT real estate investment trust stock offering.[21] It is usually done by each partnership conveying its real estate to the newly created master partnership for the consideration of a partnership interest in that new partnership. The creditors' rights problem arises if the partnership interests are not distributed to each contributing partnership in proportion to the equity in the property which each contributes. Partnerships which are nearly insolvent could be made insolvent if they receive an interest in the new partnership which is less than the equity they previously had in the property.
4. Irregularly conducted foreclosures.
In a recent controversial decision, a sharply divided U.S. Supreme Court held that in regularly conducted, non collusive foreclosures, the borrower gets reasonably equivalent value for the property sold in the foreclosure sale as a matter of law.[22] So, if the foreclosure sale meets all legal requirements and there is no skullduggery, an insolvent borrower can lose its title to property worth more than the debt it owes the lender. However, if it doesn't meet legal requirements, the issue may still be alive and create a problem for the foreclosing lender.
5. Sales at prices "too good to be true."
If an insolvent seller sells its land at a bargain price, its bankruptcy trustee may be able to have the deed set aside and give the purchaser a lien for the purchase price.[23] This creates a problem for the purchaser; if this happens, it loses the benefit of its bargain.
6. Mortgages refinancing "tainted" mortgages.
A "tainted" mortgage is one emanating from a transaction with a creditors' rights structural problem. For example, a common practice in LBOs is to refinance the LBO mortgage with a new mortgage sometime after the transaction. If the LBO mortgage was a fraudulent transfer and if the refinancing lender was either connected with the LBO transaction or knows enough about it, the refinancing mortgage might be avoided as a fraudulent transfer too.[24]
7. Sales of property to pay off LBO debt.
This is similar to the "tainted mortgage" problem, above. If the purchaser is connected with the LBO transaction, the courts might consider its purchase to be a part of the same transaction. If so, the trustee may be allowed to recover the property sold, turn the purchaser into a creditor of the bankruptcy estate and, perhaps, subordinate its claim to those of the other creditors.
II. Preference structures.
A preference structure exists when a lender holding a previously unsecured or undersecured debt obtains security for it from the borrower. This happens in the following kinds of transactions:
A. Mortgages to delay debt enforcement.
1. The borrower defaults on its unsecured loan and the lender agrees to forbear collection if the borrower will give it security. The borrower does so because it believes it can recover from its financial problems if it can delay the lender from taking action.
2. A borrower in a secured loan transaction is required to provide more security because of a covenant in the loan agreement relating to declining liquidity, etc. The additional security is the mortgage of its land. At the time it makes the mortgage, the existing security held by the lender is insufficient to cover the debt.
B. Substitution of collateral.
A borrower wants to sell land it has mortgaged but doesn't want to pay off the loan. It makes a deal with its lender to transfer the mortgage to another parcel of land it owns. At the time it makes the new mortgage the land encumbered by the existing mortgage was worth less than the debt and the newly mortgaged land is worth more than the land released.
C. Single borrower cross-collateralization of previously independent mortgages.
This usually happens in workouts of mortgage loans in default. In the usual case, a borrower has two or more loans with the same lender. Each is secured by a mortgage on a different property. In order to work out a default in one of the loans, the lender requires that all be cross collateralized. At the time of the cross-collateralization, one or more of the mortgaged properties was worth less than the debt it secured.
D. Delayed mortgage recording.
Under the preference section of the Bankruptcy Code, a debt exists when the closing of the loan transaction takes place. However, the mortgage which is security for a debt is deemed to be given when it is perfected against a bona fide purchaser.[25] Usually, this is at the time the mortgage is recorded. Because this means that the debt exists before the mortgage is recognized, a savings clause was created: If the mortgage is recorded within ten days after the debt is created, the mortgage is deemed to have been given at the same time the debt is created.[26] Thus, the debt is not pre-existing with respect to the transfer, i.e., the mortgage.
However, as stated above, if the mortgage is not recorded within this ten day period it is deemed to come into existence when it actually is recorded. This means that if the borrower becomes insolvent on the day the mortgage is recorded and files bankruptcy within 90 days after the recording, the basis exists for avoiding the mortgage as a preference.
NOTES
[ 1] US v. Tabor Court Realty Corp., 803 F.2d 1288 (3rd Cir. 1986) and preceding lower court opinions. This case was decided under the Uniform Fraudulent Conveyance Act (predecessor to the UFTA) and not the federal Bankruptcy Code but the relevant provisions are parallel.
[ 2] 11 USC 548(a)(2).
[ 3] 11 USC 548(b).
[ 4] UFTA Sec. 4 & 5.
[ 5] 11 USC 101(32); UFTA Sec. 2(a)
[ 6] Moody v. Security Pacific Business Credit, Inc. (In re Jeannette Corp.), 971 F.2d 1056 (3rd Cir. 1992).
[ 7] Opinions diverge on whether liquidation value or going concern value should be the measure. See, Gilman v. Scientific Research Products Inc. of Del. (In re Mama D'Angelo, Inc.), 55 F.3d 552 (10th Cir. 1995). The author presently believes that market value is a reasonable middle ground in this dispute.
[ 8] 11 USC 548(a).
[ 9] 11 USC 550(a).
[10] Ibid.
[11] 11 USC 510(c).
[12] Murphy v. Meritor Savings Bank (In re O'Day Corp.), 126 BR 370 (Bankr. D.Mass. 1991).
[13] Compare UFTA Secs. 4 and 5. Sec. 4 speaks of transfers fraudulent as to present and future creditors while Sec. 5 deals with present creditors only. Future creditors appear to get the benefit if the transfer left the transferor undercapitalized rather than simply insolvent.
[14] UFTA Sec. 9.
[15] 37 CJS Fraudulent Transfers 235, 237.
[16] 11 USC 101(30).
[17] 11 USC 547(b).
[18] 11 USC 510(c).
[19] 11 USC 547(c)(3)(A).
[20] See, Bonita, Real Estate Title Problems Created by Cross Collateralization, enclosed herewith.
[21] See, Bonita, Real Estate Investment Trusts: Title Issues in the UPREIT Structure, enclosed herewith.
[22] BFP v. Resolution Trust Corporation, 511 US 531, 114 S.Ct. 1757, 128 L.Ed. 556 (1994).
[23] 11 USC 548(c).
[24] 11 USC 550(a)(2); Wieboldt Stores, Inc. v. Schottenstein, et al., 94 BR 488 (ND Ill.1988).
[25] 11 USC 547(e)(1)(A).
[26] 11 USC 547(e)(3)(A).
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