Courts Permit Creditors to Reach Disclaimed Assets

By: Yaakov Seff

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Despite California’s provision in its Probate Code explicitly shielding disclaimed assets (inheritance funds that the debtor refused to accept) from being reached by a creditor, the Ninth Circuit in United States Small Business Association v. Bensal[1] held that creditors can recover disclaimed assets.[2] Bensal had borrowed $175,000 to fund his new restaurant and the loan was guaranteed by the Small Business Administration (“SBA”), a federal agency.[3] Ultimately, Bensal defaulted on the loan and the SBA paid the bank $50,027.39 to satisfy its obligations as a guarantor.[4] The bank assigned the right to collect the remainder of the debt to the SBA.[5] Several years later, Bensal’s father died, leaving him a 40% share of a trust that was worth approximately $400,000.[6] Bensal disclaimed his share of the inheritance, and it passed to his children under California Probate Code.[7] The SBA sued Bensal, alleging that the disclaimer was a fraudulent transfer under the Fair Debt Collection Practices Act (“FDCPA”)[8] and his share was thus available to the SBA. The district court granted summary judgment in favor of the SBA[9] and the Ninth Circuit affirmed.[10] The court held that the Supremacy Clause of the Constitution mandated that the FDCPA’s broad definition of “fraudulent transfer” – which includes a disclaimer of a right in a trust – preempts California’s narrow definition that would shield the assets.[11] The court rejected Bensal’s analogy to In re Costas,[12] where the Ninth Circuit upheld a woman’s invoking of an Arizona statute to protect assets she disclaimed several weeks before she filed for bankruptcy, despite a federal law that made those assets available to creditors.[13] The court explained that the disclaimer in Costas happened before the liability, not after as in Bensal’s case.[14] Furthermore, the court distinguished between the Bankruptcy Code and other federal statutes.[15] The Bankruptcy Code “largely respects state substantive rights,”[16] whereas other federal statutes, such as the FDCPA, is “primarily concerned with the collection of federal debt”[17] and is not deferential to state laws.

The Bankruptcy Code provides that "[t]he trustee may avoid any transfer . . . of an interest of the debtor in property . . . that was made . . . within two years before the date of the filing of the petition . . ." where the transfer involved actual or constructive fraud. [18] The Supreme Court has held that “Congress has generally left the determination of property rights in the assets of a bankrupt's estate to state law,"[19] meaning that "[i]n the absence of any controlling federal law, 'property' and 'interests in property' are creatures of state law."[20] Consequently, several appellate courts have held that when state law provided for full disownership of property through a disclaimer, a disclaimer is not a "transfer of an interest in property" subject to avoidance under § 548(a).[21]  However, in Drye v. United States, a tax case, the Supreme Court explained that “[w]e look initially to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer's state-delineated rights qualify as 'property' or 'rights to property' within the compass of the federal tax lien legislation."[22] The Supreme Court held that the right to disclaim afforded by the state statute constituted property under federal law and was thus avoidable. Some courts, such as Costas and Bensal, limit this two-step analysis to the non-bankruptcy context only, reasoning that in sharp contrast to the federal tax lien statute, the Bankruptcy Code “largely respects substantive state law rights, neither granting a creditor new rights in the debtor's property nor taking any away.”[23] Further, the Costas court declared an intentional policy to achieving uniformity between state and federal treatment of property interests, which would be undermined by an application of Drye to the bankruptcy cases.[24]

The distinction drawn in Costas and Bensal is a nebulous one. If the right to disclaim under state law is a property interest itself under federal law, it stands to reason that it should be so universally. The Bensal decision, in following Costas’ refusal to apply Drye to the bankruptcy setting, further defines the clear line of demarcation that is emerging between the levels of deference shown to state law in bankruptcy debt versus other debt. The open question, however, is, will the courts find another area of debt besides for bankruptcy where federal law will defer to the state law and conversely, will the courts find a provision in the Bankruptcy Code that will override a state provision to the contrary?