The Toolbox: Enhancing the Estate: Avoidance Powers

This month I will talk about the basics of avoidance powers under the Bankruptcy Code (the “Code”). ¹11 U.S.C. §§ 101 et seq. Avoidance powers are often central to a liquidation but typically play a smaller role in rehabilitation cases.

A trustee or debtor in possession has the power to recover transfers (including avoidance of liens). While these powers are largely concentrated in Subchapter III of Chapter 5 of the Code (in Sections 544-50), there are provisions scattered throughout the Code ²See, e.g., Code §§ 329, 506(d), 510(c). There are also provisions that give an individual debtor the ability to void liens and recover exempt property. See Code § 522. empowering a trustee or debtor ³Other entities may serve as estate representative in appropriate circumstances and bring avoidance actions in that capacity. See, e.g., Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics v. Chinery, 330 F.3d 548, 3d Cir.. to recover money or property or avoid liens that would not be recoverable or avoidable absent the bankruptcy case.

Section 544(a) gives the trustee (or debtor in possession) the same powers as a creditor holding a judicial lien, a creditor holding an unsatisfied writ of execution and (to a limited extent) a bona fide purchaser of real property. ⁴Sometimes referred to as the “Strong-Arm Clause.” For further reading, see Bloomberg Law: Bankruptcy Treatise, pt. II: Creditors, the Debtor and the Estate, ch. 72, at § 544.II and IV (D. Michael Lynn et al. eds., 2015). These provisions effectively avoid interests in estate property that have not been properly perfected under appropriate recording statutes. ⁵Recording requirements are usually established by state law (e.g., Uniform Commercial Code Article 9, respecting most personalty). Some security interests (e.g., in patents and aircraft) will be perfected under federal law.

Section 545 limits the effect of statutory liens. Most taxes (and some other obligations) are secured automatically through creation of a lien by statute. Most of these liens will not be affected by Section 545, which applies principally to liens for rent (Sections 545(3) and (4)), liens specifically triggered by the deterioration of the debtor’s financial condition, or statutory liens which require acts of perfection which have not been accomplished.

Section 549 of the Code deals with transfers occurring after the commencement of the case. Essentially, this Section effects the rule that, if a transfer of estate property is made after a bankruptcy petition is filed, it will not be valid and may be reversed, unless it (1) occurred in the ordinary course of the debtor’s postpetition business, ⁶Some transfers outside the ordinary course are authorized under the Code. Thus, a creditor may exercise reclamation rights (Section 546(c)) or perfect certain security interests (Section 362(b)(3)). Note that in a Chapter 7 case the “ordinary course” exception to Section 549 will not apply (unless the trustee is authorized to operate the business under Section 721). Section 549(b) also exempts transactions for value during the “gap” period in an involuntary case, but it does not permit payment of claims for goods or services provided prepetition (but see Section 503(b)(9), added in 2005 by the Bankruptcy Abuse Prevention and Consumer Protection Act (“the 2005 Act”)). or (2) was approved by the court.

Section 549 is an important provision. It allows recovery of payments improperly made and property inadvertently transferred in the hectic days after the commencement of the case. Its role in most cases, however, is likely to be more prophylactic than strategic (except perhaps in some involuntary cases). In most cases, if the debtor or trustee is properly advised, there should be few or no postpetition transfers.

Before turning to preferences and fraudulent transfers, there are several general provisions meriting study. Section 549(d) establishes an independent limitations period for attacks on postpetition transfers. Section 546(a) sets limitations on most voidable transfer suits. Note, also, that the limitation period of Code Section 546(a) controls actions and proceedings asserted under Section 544(b). Finally, do not confuse the reach-back period of a fraudulent transfer statute (increased in Section 548(a) from one year to two by the 2005 Act) with the limitations period. On the other hand, under state laws implicated by Section 544(b), the state law limitations period will be the reachback period.

Section 544(b) of the Code allows a bankruptcy trustee or debtor in possession to seek avoidance of a transfer if a creditor of the debtor’s estate could do so under applicable law (prior to bankruptcy only a creditor can pursue such a remedy, not the debtor—and then only up to the amount of the creditor’s claim—i.e., if the transfer was for $1,000 and the creditor invoking the avoidance statute was owed $500, the creditor could recover only $500). In the case of In re MortgageAmerica Corp., 714 F.2d 1266, 5th Cir., the Court of Appeals held that, following the filing of a bankruptcy case, only the trustee (or debtor in possession or other estate representative) could assert a claim under state fraudulent transfer law. Furthermore, as discussed infra, the trustee may avoid the entire transfer.

Sections 550 and 551 are designed to allow recovery of the value of any transfer avoided. Note the separate, one-year limitations period on actions under Section 550 in subsection (f).

Section 547 of the Code is intended to foster, among other things, the goal of equal distribution among equally situated creditors of the bankrupt debtor. Thus, a creditor who is “preferred,” in that it received payments close to the filing of bankruptcy when most creditors were not being paid, may be forced to give back that extra advantage. In order for the trustee or debtor in possession to recover a preference, the following must be shown:

• (1) There must be a transfer of property of the estate;
• (2) The transfer must be to or for the benefit of a creditor;
• (3) The transfer must be in reduction of antecedent debt;
• (4) The transfer must have been made within the 90 days preceding the case’s commencement or, if the preferred creditor is an insider, within one year;
• (5) At the time of the transfer the debtor must have been insolvent; and
• (6) The creditor’s return on its claim must be higher than it would have been had the creditor received what it would have been entitled to receive in a Chapter 7. ⁷See generally Code Section 547, particularly 547(b), (f) and (i).

Section 547(c) provides affirmative defenses to a preference action. Sections 547(c)(6), (7) and (8) apply to special situations. Subsections (1), (3) and (4) cover situations where the preferential advantage to the creditor is offset by contemporaneous or subsequent new value to the debtor. The most contentious provision is Section 547(c)(2), which exempts from recovery transfers made in the ordinary course of business. In Union Bank v. Wolas, 502 U.S. 151, U.S., the Supreme Court held that Section 547(c)(2) protected payments made on an unsecured note in accordance with its terms. The 2005 Act’s amendment to Section 547(c)(2) (which, unlike most of the 2005 Act, was effective for cases filed before adoption of the 2005 Act) should serve to make the defense more widely available. Under the new Section 547(c)(2), a preferential transfer is not recoverable to the extent it is in payment of a debt (1) incurred in the ordinary course of business or financial affairs of the debtor and the transferee, and (2) the transfer was (a) made in the ordinary course of financial or business affairs of the debtor and the transferee; or (b) made according to ordinary business terms in the industry. ⁸See In re Gulf City Seafoods, Inc., 296 F.3d 363, 5th Cir. (in examining Section 547(c)(2)(C), the Fifth Circuit noted that the burden is on the defendant to the preference action to prove that the transaction was not so out of line with what others in the industry do that it satisfied the requirement of being “according to ordinary business terms”). Under prior law, a preference defendant had to establish both (a) and (b), with establishment of the ordinary business terms of the industry often necessitating expert testimony.

Most bankruptcy lawyers were surprised by the Wolas decision (Justice Scalia’s nasty concurrence notwithstanding). They, like the trustee in Wolas, saw the elimination of the old 45- day rule, limiting ordinary course transactions to those occurring within 45 days of the transfer, as serving the needs of parties to ordinary commercial transactions. The Supreme Court’s opinion shows the triumph of the “plain meaning rule” (though a meaning “plain” to some justices may not be so plain to others).

More often than not, the issue of whether there has been a preference turns on Section 547(b)(5) – in other words, whether the estate has been diminished to advantage one creditor at the expense of other creditors. Creative lawyers have sought recovery from insider guarantors (contingent creditors because of the guaranties) for a payment made more than 90 days before filing on the guaranteed debt (See, e.g., In re Mercon Indus., Inc., 37 B.R. 549, Bankr. E.D. Pa.) and from creditors whose debts were assumed by a purchaser in a prepetition transaction with the debtor (See, e.g., Palmer v. Radio Corp. of America, 453 F.2d 1133, 5th Cir.). In these cases, the transfer to creditor is held to benefit the guarantor.

In the case of fraudulent transfers, the principal question should be only whether the estate was diminished. That is, whether reasonably equivalent value for the transfer was received by the estate. This is not to say other issues will not be vigorously litigated — e.g., the debtor’s solvency at the time of the transfer. Moreover, if the transfer involved actual fraudulent intent — e.g., enhancing an undersecured creditor’s collateral to protect a guarantor-principal — a fraudulent transfer may be found notwithstanding value within the meaning of Code Section 548(d)(2)(A). Also conversion of non-exempt property into exempt property by an individual debtor can be fraudulent under state law.

There are two types of fraudulent transfers: (1) those made by a debtor intending to defraud its creditors (Section 548(a)(1)(A)); and (2) those deemed constructively fraudulent because the debtor did not receive reasonably equivalent value in exchange for the transfer (Section 548(a)(1)(B)). Because they are easier to prove (and because it is rare that a transfer is voidable under (a)(1)(A) but not under (a)(1)(B)), the constructive fraudulent transfer is seen more often. Note that it is the debtor’s intent under Section 548(a)(1)(A). This is generally shown by so-called badges of fraud including:

• (1) actual or threatened litigation against the debtor;
• (2) transfer of all or substantially all of the debtor’s property;
• (3) insolvency on the part of the debtor;
• (4) a special relationship between the debtor and the transferee; and
• (5) retention or use of the property by the debtor after the transfer.

See Max Sugarman Funeral Home, Inc. v. ADB Investors, 926 F.2d 1248, 1st Cir. (citations omitted); Kelly v. Armstrong, 141 F.3d 799, 8th Cir.; see also Acequia. Inc. v. Clinton (In re Acequia, Inc.), 34 F.3d 800, 9th Cir. (citing Max Sugarman); and Helwig v. Vencor, 251 F.3d 540, 6th Cir. (listing nine badges of fraud more specifically applicable to securities fraud).

In addition to Section 548, the trustee (or debtor in possession) can pursue transfers (usually fraudulent) voidable under state law pursuant to Section 544(b) if a creditor exists who could have asserted a claim under the applicable state law; some states have laws to avoid any preferences and many states allow avoidance of insider preferences. State fraudulent transfer statutes are, for the most part, substantially similar to Section 548. ⁹Most states have adopted either the Uniform Fraudulent Conveyance Act or the Uniform Fraudulent Transfer Act (which are almost identical).

Recall that prior to bankruptcy, state fraudulent transfer actions may be pursued only by creditors with standing to sue under the applicable state law. Once a bankruptcy is filed, however, only the trustee (or debtor in possession or other estate representative) may pursue recovery under state fraudulent transfer laws. In re MortgageAmerica Corp., 714 F.2d 1266, 5th Cir.. In addition, while a creditor suing under a state law may recover a transfer only to the extent of its debt, using Section 544(b), the trustee may avoid the entire transfer. ¹⁰See Moore v. Bay, 284 U.S. 4, U.S.. The trustee, however, must be able to prove the existence of a creditor that could invoke the state statute (though the amount owed that creditor will not affect the trustee’s recovery).

Usually the reason for using state law is a longer reach-back period. While Section 548 reaches back two years (one year for cases filed before the 2005 Act became effective), Texas law, for example, can go back four years. ¹¹This is the limitations period. Some courts have held limitations run from discovery of the fraudulent transfer, which would extend the period even further, especially as some transfers are voidable under state law by future creditors (i.e., a creditor whose claim arose after the transfer). It is not clear what happens to a state law fraudulent transfer action that becomes time-barred under Section 546(a) but as to which state law limitations have not run. Presumably it reverts to eligible creditors, ¹²See, e.g., Bloomberg Law: Bankruptcy Treatise, pt. II: Creditors, the Debtor and the Estate, ch. 74, at §546.III.D n.8 (citing In re Geraldo Leasing, Inc., 173 B.R. 379, Bankr. N.D. Ill. for the proposition that once a bankruptcy trustee was time-barred by §546(a), §544(b) could not revive the claim). though arguably it could still be used by the trustee under Section 502(d).

A controversial use of fraudulent transfer statutes has involved leveraged buyouts. In a leveraged buyout, the purchaser of a company finances the purchase by causing the acquired company to pledge its assets to secure the loan of the purchase price to the purchaser. Since it is the new owners, not the company (debtor) pledging the assets, who receive the loan and its benefit, courts have concluded that the pledge of the assets to the lender is fraudulent (if the other tests for a fraudulent transfer are met). ¹³The seminal case in this area is United States v. Tabor Court Realty Corp., 803 F.2d 1288, 3d Cir.. Courts have sometimes found “value” to the acquired company in the “benefits” of new management.

In sum, voidable transfers often add value to an estate. They may also be valuable tools in settlement or plan negotiations. Outside of a liquidation context, they are rarely central to a Chapter 9, ¹⁴In Chapter 9, a trustee may be appointed for the sole purpose of pursuing voidable transfers. See Code § 926(a). 11, 12, or 13.