From the 9th Circuit last week, a decision providing creditors and their representatives with a potentially new source of preferential recoveries: pre-petition criminal restitution payments.

Jeffrey and Faye Silverman – electrical contractors – were indicted in 2005 for fraud and underpayment of workers’ compensation insurance premiums.  In March of that year, they paid the California State Compensation Insurance Fund $101,531 in restitution as part of a plea agreement and their court-ordered sentence.  Less than 60 days later, they sought relief under Chapter 7.

Their trustee sought recovery of the restitution payment from the State Fund under the theory that the payment was a preferential transfer under Section 547(b) of the Bankruptcy Code.

Both sides moved for summary judgment.  For its part, the State Fund argued that Section 547(b) doesn’t apply to criminal restitution payments, citing Kelly v. Robinson, 479 U.S. 36 (1986) and Becker v. County of Santa Clara (In re Nelson), 91 B.R. 904 (N.D. Cal. 1988).  Kelly held that criminal restitution payments are non-dischargeable under Section 523(a)(7).  Nelson extended Kelly to hold that payments on such non-dischargeable obligations are not recoverable as preferences.

The Bankruptcy Court for the Central District of California was not persuaded – nor was the District Court, which heard the matter on appeal following entry of summary judgment in the trustee’s favor.

The Ninth Circuit agreed.  Finding that criminal restitution payments are, in fact, subject to the preference statute, the Ninth Circuit held that State Fund enjoyed no “judicial exception” to Section 547(b)’s reach.  In the 3-judge panel’s view, an obligation’s non-dischargeability is separate and distinct from recovery of its pre-petition payment as a preference.  Further, the restitution payments to State Fund were “to or for the benefit of” State Fund within the contemplation of Section 547(b)(1) - State Fund’s arguments to the contrary notwithstanding.

The decision is an important one for creditors’ representatives and committees seeking possible additional sources of recovery where the debtor has been attempting to resolve criminal problems pre-petition.

“There’s a cement slab on Ridge Lane, topped with a few pipes, an electrical box and a porta-john.  Nearby, an empty house, a large sign in the driveway declaring ‘inventory home.’  Around the corner, a few muddy lots, rimmed with construction fences … ‘If [the developer] is gone,’ [Kathy] Koss [a resident in the neighborhood] said, ‘what is going to happen to these houses?’”

This quote from a story in March 15’s Charlotte Observer opens an extensive and intriguing study assembled by Sarah P. Woo, entitled “A Blighted Land: An Empirical Study of Residential Developer Bankruptcies in the United States – 2007-2008.”  Woo is an independent risk management consultant and doctoral scholar at Stanford University with prior experience as a research manager at Moody’s KMV London and a background in corporate finance at White & Case LLP.  She offers a simple premise as the basis for her 194-page work, which also serves as her dissertation:

Until the housing sector is stabilized, there will simply be no recovery in America.  And as financially distressed residential developers and home builders are forced into liquidation or foreclosure, the unfinished projects they leave behind affect not only the immediate community, but area housing prices as well.

Woo is not alone in her assessment of the persistent weakness of the US residential housing sector.  A Deutsche Bank study released in early August and briefly summarized in a CNN-Money article last Wednesday indicates that home prices may fall another 14% before hitting a bottom, leaving as many as 48% of mortgage holders “underwater” by 2011.

Ouch.

Among Woo’s findings on developers who have filed Chapter 11 cases over the last 2 years:

- Only 5.3% were able to successfully reorganize.  In fact, the majority of cases were actually dismissed or converted to Chapter 7 – leaving real estate to be foreclosed or liquidated in forced sales.

- 72% of the cases sampled involved at least one request by a secured lender to lift the stay for purposes of foreclosure.  In such instances, relief was granted approximately 90% of the time.  However, foreclosure may not always have been the best outcome for the bank.  According to Ms. Woo, “[i]n one case, the bank which repossessed the property not only had trouble with the remaining development process but also found itself in a position where it could not necessarily sell the property as a going concern . . . .  In [another] case, the bank which repossessed the property was seized by regulators 2 months later for being insufficiently capitalized, raising the issue of the extent to which a bank’s own financial problems might have contributed to its preference for liquidation during bankruptcy proceedings.”

- Where properties were disposed of through “363 sales,” Woo “uncovered a pattern of winning credit bids where secured lenders acquired the properties . . . at low prices.”

- Access to DIP financing appears to have been severely impaired for developers (as it has been for many Chapter 11 debtors this cycle, regardless of industry).  Even where DIP financing has been available, such financing often occurred in cases where the debtor was ultimately liquidated or packaged for sale (again, a common scenario this cycle regardless of the debtor’s industry).

Is the near-certain prospect of liquidation or sale facing struggling residential home developers a good one for the sector?

On the one hand, Woo’s study appears to suggest that the control available to lenders through mechanisms such as DIP financing and stay relief litigation, employed by highly regulated and troubled US banks desperate to raise capital by seizing and liquidating collateral, puts housing developers who might reorganize in Chapter 11 on a very slippery slope with little prospect of survival.  On the other, it suggests that the industry may be ridding itself of weak performers very quickly, leaving only the strongest to survive as the residential housing sector struggles back to prior levels.

Where real estate development and the residential housing sector are concerned, is the shortest way up . . . straight down?