Rochelle's Daily Wire

The Eighth Circuit has held definitively that avoidance actions are property of the estate under Section 541(a) that a trustee may sell “free and clear.”

The tightly written opinion on August 21 by Circuit Judge Michael J. Melloy confirms the virtue of having a former bankruptcy judge on an Article III bench.

The chapter 7 trustee of a corporate debtor had what he believed to be meritorious avoidance claims against the owner. However, the trustee lacked the funds to prosecute the claims.

A creditor offered to buy the avoidance actions for $600,000 cash, reduce its claim by $20 million and share a portion of the proceeds with the trustee. The owner, who was the target of the avoidance actions, made a counteroffer to buy the avoidance claims for $1 million and thereby extinguish the claims.

The trustee decided that the creditor was making a better offer and filed a motion to sell the claims to the creditor free and clear of liens and claims under Section 363(f). The owner objected, but Chief Bankruptcy Judge Thad T. Collins of Cedar Rapids, Iowa, approved the sale to the creditor, holding that chapter 5 avoidance actions are property of the estate that a trustee may sell. Simply Essentials LLC, 640 B.R. 922 (Bankr. N.D. Iowa April 6, 2022). To read ABI’s report, click here.

The owner appealed, and Judge Collins authorized a direct appeal to the Eighth Circuit. The appeals court accepted the direct appeal and heard argument in April.

The facts being beyond dispute, Judge Melloy reviewed legal conclusions de novo and said that the “only issue on appeal is the legal question of whether avoidance actions can be sold as property of the estate.”

Property Under Sections 541(a)(1) and (a)(7)

The appeal entailed construction of Section 541(a)(1), which says that “all legal or equitable interests of the debtor in property as of the commencement of the case” are property of the estate, and Section 541(a)(7), which says, “Any interest in property that the estate acquires after the commencement of the case” is estate property.

Judge Melloy found the answer in opinions from the Supreme Court and the Eighth Circuit. He began with U.S. v. Whiting Pools Inc., 462 U.S. 198 (1983), where the Court held that estate property includes property that had been repossessed before bankruptcy in which the debtor had no possessory interest. Next, he cited Segal v. Rochelle, 382 U.S. 375 (1966), for the proposition that “property of the estate includes inchoate or contingent interests held by the debtor prior to the filing of bankruptcy.”

From the Eighth Circuit, Judge Melloy drew on In re Racing Services Inc., 540 F.3d 892, 898 (8th Cir. 2008), to say that “creditors may seek permission to obtain derivative standing to bring the avoidance actions on behalf of the estate when a trustee is ‘unable or unwilling’ to do so.”

From binding authority, Judge Melloy held that “avoidance actions are property of the estate under § 541(a)(1)” because “the debtor has an inchoate interest in the avoidance actions prior to the commencement of the bankruptcy proceedings.”

“Even if” the debtor didn’t have an interest in avoidance actions before bankruptcy, Judge Melloy held that “avoidance actions clearly qualify as property of the estate under subsection (7), which includes ‘[a]ny interest in property that the estate acquires after the commencement of the case.’”

Contrary Arguments Refuted

Judge Melloy refuted the owner’s argument based on statutory construction.

The owner contended that Judge Melloy’s interpretation of Sections 541(a)(1) and (a)(7) would create surplusage because Sections 541(a)(3) and (a)(4) specifically bring some after-acquired property into the estate.

Recognizing the realities of the legislative process, Judge Melloy said it was “not unreasonable that Congress would repeat itself in order to ensure the results it intended were followed . . . . Such redundancies are particularly likely when, like in this case, the statute was edited over time to add specificity.”

Given amendments to the statute and “the complex nature of the Bankruptcy Code,” Judge Melloy said that “the possibility of our interpretation creating surplusage does not alter our conclusion that avoidance actions are part of the estate under the plain language of § 541(a).”

Judge Melloy also rejected the owner’s argument that selling avoidance claims would violate the trustee’s fiduciary duties. Quite to the contrary, he said that the trustee has a duty to maximize the value of the estate.

Even if there were ambiguity in the statute, Judge Melloy took comfort in “the consensus of courts across the country: avoidance actions are property of the estate.” He cited the First, Fifth and Seventh Circuits for holding that avoidance actions are estate property or can be sold by a trustee.

Judge Melloy affirmed the bankruptcy court’s order approving sale of the avoidance actions.

Observation

Consider Judge Melloy’s holding that “the debtor has an inchoate interest in the avoidance actions prior to the commencement of the bankruptcy proceedings.”

Does the statement mean that a debtor has a sufficient interest in avoidance actions before bankruptcy, such that a creditor could obtain a perfected security interest in avoidance actions to persist after bankruptcy?

Generally speaking, a debtor must have an interest in collateral before a security interest can attach. Courts might (or should) hold that the “inchoate” interest mentioned by Judge Melloy is inadequate to confer attachment before bankruptcy.

If a creditor claimed 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.

Further Observation

Following private practice, Judge Melloy served as a bankruptcy judge in Ohio from 1986 to 1992. After appointment to the district court, he was chair of the bankruptcy committee of the U.S. Judicial Conference.

This writer ventures to say that Judge Melloy readily arrived at the (correct) answer in less than seven pages by virtue of his intimate familiarity with the Bankruptcy Code. Would that every circuit court had a former bankruptcy judge in its midst.