Rochelle's Daily Wire

In this year’s Duberstein Moot Court Competition, being held in New York City March 2-4, one of the two questions being posed to the competitors is this:

Whether a chapter 7 trustee may sell, as property of the bankruptcy estate, the ability to avoid and recover [preferential] transfers pursuant to 11 U.S.C. §§ 547 and 550.

Joining the Eighth and Ninth Circuits, the Fifth Circuit answered the Duberstein question by holding “that preference actions may be sold pursuant to 11 U.S.C. § 363(b)(1) because they are property of the estate under 11 U.S.C. §§ 541(a)(1) and (7).”

Allowing debtors to sell avoidance actions isn’t entirely beneficial to an estate and its general creditors. If avoidance actions that arise after bankruptcy are estate property that is deemed to exist on the filing date under Section 541(a)(1), a prepetition secured lender might be able to obtain an enforceable lien on avoidance actions, taking valuable property away from the debtor and creditors. The lien could even sop up claims the debtor might wish to assert against the lender.

Assuming the three circuits have the correct answer on the right to sell avoidance actions, next year’s Duberstein question might ask whether a prepetition secured lender may validly obtain a lien on avoidance actions that’s enforceable after bankruptcy.

The Sale of the Preference Action

The January 22 opinion by Circuit Judge James L. Dennis sets out the facts in elaborate detail. Just a few are pivotal.

Before bankruptcy, a corporate officer made an $800,000 loan to the debtor and was paid $320,000 before filing. During the chapter 11 case, the debtor filed a preference suit against the former officer under Section 547.

The debtor proposed a chapter 11 plan that sold the preference suit to a prepetition, secured lender. Specifically, the plan and the confirmation order assigned and conveyed the preference claim to the lender.

In return for the preference claim, the lender waived its lien on $700,000 in collateral and also waived the right to pursue an administrative claim. The lender had no obligation to return anything to the debtor were it to recover more than its secured claim.

Over objection by the preference defendant, the bankruptcy court confirmed the plan.

The reference having been withdrawn, the preference suit slogged ahead for three years in district court. On the eve of trial, the preference defendant filed a motion to dismiss for lack of subject matter jurisdiction under Rule 12(b)(1).

There being no explicit authority from the Fifth Circuit, the district court dismissed the suit, reasoning that the preference claim was not estate property under Section 541(a) and that the lender was not a “representative of the estate” under Section 1123(b)(3)(B).

The lender appealed to the Fifth Circuit.

Estate Property Under Section 541(a)(1)

Judge Dennis agreed with the district court when he said, “This question of whether preference claims may be sold is indeed a novel issue for this circuit.” He also cited a Fifth Circuit opinion from 2010 where the appeals court said there was a split of authority on the ability to sell avoidance actions.

Judge Dennis first addressed the question of whether avoidance actions are estate property under Section 541(a)(1). The subsection says that estate property “is comprised of . . . all legal or equitable interests of the debtor in property as of the commencement of the case.” [Emphasis added.]

To answer the question, Judge Dennis first cited U.S. v. Whiting Pools Inc., 462 U.S. 198 (1983), where the Supreme Court held that estate property includes property that had been repossessed before bankruptcy in which the debtor had no possessory interest. He quoted the Supreme Court for saying that the section “is intended to include in the estate any property made available to the estate by other provisions of the Bankruptcy Code.” Id. at 205.

After Whiting Pools, Judge Dennis cited his appeals court for saying that the scope of Section 541(a)(1) is “very broad” to include “conditional, future [and] speculative” property along with causes of action.

“Preference actions,” Judge Dennis said, “are a mechanism in the Bankruptcy Code by which additional property is made available to the estate, fitting squarely within the Whiting Pools definition.” He held that “preference actions plainly fit the statutory definition of ‘property of the estate’ and may validly be sold under § 363(b).”

Estate Property Under Section 541(a)(7)

The lender also took the position that preference actions are estate property under Section 541(a)(7). It brings in “[a]ny interest in property that the estate acquires after the commencement of the case.”

With little ado, Judge Dennis held that “the preference actions qualify as property of the estate under § 541(a)(7).”

Other Supporting Authority

Beyond the “clear statutory language,” Judge Dennis said that his decision was “bolstered” by other courts, like the Eighth and Ninth Circuits, which have held that “the preference actions qualify as property of the estate under § 541(a)(7).” See, e.g., Pitman Farms v. ARKK Food Co. (In re Simply Essentials LLC), 78 F.4th 1006 (8th Cir. 2023). To read ABI’s report on Simply Essentials, click here.

Judge Dennis said that Simply Essentials dealt with the preference defendant’s “chief argument” that “avoidance powers are unique powers belonging to the trustee and that should not have been sold to someone who would not exercise those powers for the benefits of all creditors.” He described the Eighth Circuit as having said that “the trustee’s fiduciary duties require it to maximize the value of the estate, which may include and even require the sale of an avoidance action.”

Judge Dennis saw the sale of avoidance actions as “the most equitable option,” for instance, in cases where “the estate may not have sufficient funds to pursue preference actions.” He therefore decided that “the sale of preference actions does not undermine the purpose of avoidance actions. Rather, it is consistent with the trustee’s duty to maximize the estate.”

Section 1123(b)(3)(B) Doesn’t Matter

Even if avoidance actions are estate property, the preference defendant contended that the lender lacked standing because it was not an “estate representative” under Section 1123(b)(3)(B). The subsection provides that a chapter 11 plan may provide for “the retention and enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose, of any such claim or interest.” [Emphasis added.]

“On the other hand,” Judge Dennis said that Section 363(b)(3) allows a trustee or debtor in possession to “use” or “sell” estate property after notice and a hearing. Therefore, he said that reliance on Section 1123(b)(3)(B) is “inapposite,” because Section 363(b)(3) “provides different mechanisms by which a debtor-in-possession may liquidate its assets.” He found “no requirement in 11 U.S.C. § 363 that the purchaser of a piece of the estate’s property also be a representative of the estate.”

Judge Dennis held “that preference actions may be sold pursuant to 11 U.S.C. § 363(b)(1) because they are property of the estate under 11 U.S.C. §§ 541(a)(1) and (7).” Even if the lender “does not qualify as a representative of the estate,” he held that the lender “has standing to pursue the preference claim as it validly purchased the claim outright.”

For the Fifth Circuit, Judge Dennis reversed and remanded.

Observations

The opinion is not altogether good news for debtors and creditors, because the decision opens the door for prepetition lenders to perfect liens on avoidance actions arising after bankruptcy. Why’s that? The Fifth Circuit opinion and Simply Essentials could be read to mean that avoidance actions are property interests that exist before bankruptcy and could therefore be subject to lien.

Whether prepetition secured lenders can take liens on avoidance actions may not be a question answered entirely by the Bankruptcy Code, since a debtor must have an interest in collateral before a security interest can attach. Does an inchoate or contingent interest give rise to an interest in collateral sufficient to allow attachment before bankruptcy?

If a creditor claims to have a security interest in avoidance actions that had not attached before filing, the automatic stay would preclude attachment after filing, and Section 552(b) would not allow perfection after filing.

Debtors and creditors would have been better off if the opinion had been based entirely on Section 541(a)(7).