Fraudulently Conveyed Assets Are Not Property of the Estate Until Recovered

By: Preston C. Demouchet

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

 

Although section 541 includes within the property of the estate both equitable interests and property that is recovered pursuant to section 550, in cases where the estate’s equitable interest is based on the fact that the debtor fraudulently transferred the subject property, the estate includes only the equitable claim for its recovery and not the property itself.[1] The actual transferred asset does not become property of the estate until after the trustee successfully recovers it.[2]

 

Recently, in Flanagan v. MJCC Realty Limited Partnership (In re Flanagan), the United States District Court of Connecticut interpreted section 541 property in a case involving a fraudulent conveyance of property.[3]  The debtor in this case, Michael Flanagan, started MJCC Realty Company (“MJCC”) prior to filing for bankruptcy. Flanagan functionally controlled the company but placed legal ownership with two associates, allegedly in order to fraudulently shield those assets from his creditors.[4]  MJCC purchased two properties.[5]  One of Flanagan’s major creditors, Cadle Bank, filed a RICO suit against the two associates for aiding Flanagan in fraudulently shielding his assets.[6] The two associates settled the RICO action by transferring their interests in MJCC to Cadle.[7] Cadle then sold one of the two properties held by MJCC.[8]  Flanagan’s bankruptcy trustee sought a declaratory judgment that the MJCC properties were properly part of the Flanagan estate and that Cadle’s sale violated the section 362 automatic stay provision.[9] The Bankruptcy Court rejected the trustee’s claims.[10]

 

On appeal, the district court stated that in order for the trustee to succeed on her automatic stay claim, she needed to show that the MJCC property was properly within the estate at the time the bankruptcy proceeding commenced.[11]  The court reasoned that section 541 property is limited to the rights that the debtor had as of the commencement of the cases, no more, no less.[12] Thus, since the debtor had transferred legal title, he held no legal interest in the assets as of the filing. Further, the debtor held an equitable interest in the underlying assets only if he had acted fraudulently. Thus, at the time of bankruptcy, the debtor “would not have been able to simply claim ownership … and expect the law to immediately recognize him as the legal owner.”[13] The debtor would have to first bring an equitable action to establish his rights in the property. Since the trustee stands in the debtor’s shoes, the equitable interest that becomes property of the estate is the right to maintain the action to recover the property, and not the fraudulently conveyed asset.[14] 

 

Although the Flanagan court reached the correct result, it failed to appreciate the difference between equitable interests in section 541(a)(1) and equitable claims in section 541(a)(3). Two statements by the court demonstrate this point. First, the court stated “[m]erely possessing an equitable interest in property is not enough to bring the property within the estate . . . .”[15] Second, the court noted that the trustee offered no case law to support the view that holding equitable interests in property, without “more action”, is sufficient to be considered within the estate.[16] If the words “equitable interests” were replaced with “equitable claims” the court’s two statements would conform with section 541’s language because “more action” is required for a trustee who has equitable claims under (a)(3) but not when the trustee has equitable interests under (a)(1). By failing to distinguish equitable interests from equitable claims, the court imposed “more action” on the trustee and read a recovery requirement usually found in section 541 (a)(3), into section 541(a)(1). Flanagan’s interpretation burdens a trustee with going to court and asserting claims on equitable interests in property. The correct way to analyze section 541 properties should be to assert that true equitable interests under (a)(1)are automatically considered property of the estate. However, equitable claims must be recovered by the trustee in a court proceeding to bring such property within the estate. Flanagan’s interpretation would cause needless litigation and illustrates the pitfall lawyers and courts may reach if they do not precisely analyze section 541.

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