The debtor company ordered furniture from the first creditor to sell; however, the debtor became past due to that creditor company. To help the debtor, the first creditor entered into an agreement that granted the first creditor a priority security interest in the debtor’s assets and account proceeds. The debtor company then entered into a separate loan agreement with a second creditor with a subordination agreement allowing the first creditor to retain their security interest in the debtor’s accounts receivable. For payments on both loans, the debtor would deposit proceeds into a lockbox controlled by the second creditor, who would then pay the first creditor. The loan agreement specifically indicated the debtor owned the proceeds in lockbox. Shortly after, the debtor filed for bankruptcy, and the trustee sought to avoid the transfers made by the second creditor to the first creditor.
To avoid a transfer, courts either employ the hypothetical Chapter 7 liquidation analysis or an abbreviated version of the test, which allows a transfer of funds to remain untouched by the trustee so long as funds could not otherwise be used to pay other creditors.* The court first determined that the lockbox where the debtor deposited proceeds belonged to the debtor, not the second creditor, despite the second creditor’s authority to take possession and pay debts with the proceeds. Moreover, the court determined the transfer was still from the debtor to first creditor even if the second creditor made payment to first creditor because of the specific requirements within the second creditor’s agreement. Since the second creditor never obtained ownership of the account proceeds and since the loan agreement with the first creditor had a first-priority lien on the proceeds, the abbreviated test was satisfied.
Using a similar analysis as the one within this case, courts do not need to go into a full hypothetical Chapter 7 analysis. Additionally, it is important to note that the lockbox account established by the debtor to benefit another creditor still survived the abbreviated avoidance test because the loan documents specifically indicated the debtor owned the lockbox. Practitioners should ensure loan agreements specify ownership of lockboxes in the future to ensure avoidance of a first-priority creditor’s security interest in similar situations.
* Id. at 791. The hypothetical Chapter 7 test is as follows: “the court (1) constructs a hypothetical Chapter 7 liquidation in which the creditor retains the disputed transfers . . . (2) constructs another in which the creditor returns those transfers . . .” Id. To meet the requirements of § 547(b)(5), the sum of the disputed transfer and the distribution of the creditor must yield more than the creditor’s distribution in the hypothetical. Id. The El Paso Refinery test allows courts to bypass the Chapter 7 test; specifically, the El Paso Refinery test requires that “if a creditor receives a transfer which, by its nature, would not have been available to any of the other secured or unsecured creditors, it could never receive ‘more’ under the hypothetical Chapter 7 liquidation analysis.” Id. at 792. If the transfer reduced the collateral of the creditor or was derived from the debtor’s collateral, then there is no method to prove that the creditor received more than his share under the hypothetical Chapter 7 analysis. Id.