If FanDuel took bets on how the Supreme Court will decide cases, this writer would wager that the justices will hold that Section 106(a) does not permit a bankruptcy trustee to sue the federal government for receipt of a fraudulent transfer under Section 544(b)(1), when no actual creditor could sue the government outside of bankruptcy.

The comments and questions from the justices are not an infallible indication of how the Court will rule, but a majority (if not all) of the justices seem to be aligned with the idea that the “actual creditor” requirement in Section 544(b)(1) brings sovereign immunity back into play as a defense for the Internal Revenue Service, even though Section 106(a) waives sovereign immunity.

In mid-2023, the Tenth Circuit, in U.S. v. Miller, 71 F.4th 1247 (10th Cir. June 27, 2023), sided with the Ninth and Fourth Circuits. All three held that the waiver of immunity in Section 106(a) allows claims against the government under state law for recovery of fraudulent transfers. See In re DBSI, Inc., 869 F.3d 1004 (9th Cir. 2017); and Cook v. U.S. (In re Yahweh Center Inc.), 27 F.4th 960 (4th Cir. 2022). To read ABI’s reports, click here and here. To read ABI’s report on Miller in the Tenth Circuit, click here.

There is a circuit split because the Seventh Circuit had held to the contrary in 2014 in In re Equip. Acquisition Res. Inc., 742 F.3d 743 (7th Cir. 2014). The Seventh Circuit reasoned that Section 106(a) did not modify the actual creditor requirement in Section 544(b).

Based on the circuit split, the government filed a petition for certiorari in Miller. The Court granted the petition on June 24, near the end of the last term. Oral argument took place on December 2.

The Admittedly Fraudulent Transfers to the IRS

The Internal Revenue Service receives constructively fraudulent transfers when a corporation pays federal income taxes owing by an owner. That’s what happened in the case before the Tenth Circuit. The IRS conceded that it had received fraudulent transfers.

The corporation’s chapter 7 trustee sued the IRS in bankruptcy court under Section 544(b)(1) for receipt of a constructively fraudulent transfer under Utah law. The section allows a trustee to “avoid any transfer of an interest of the debtor in property . . . that is voidable under applicable law by a creditor holding an [allowable] unsecured claim.” [Emphasis added.]

The trustee could not sue under Section 548, because the bankruptcy occurred more than two years after the transfer.

Although no actual creditor could have sued the IRS because there is no waiver of sovereign immunity outside of bankruptcy for cases of the sort, the waiver of sovereign immunity in Section 106(a) allowed the trustee to sue.

Section 106(a)(1) “abrogates” sovereign immunity as to dozens of provisions in the Bankruptcy Code, including Sections 544, 547 and 548. But the question remains: Did the Section 106(a)(1) waiver eliminate the “actual creditor” requirement in Section 544(b)(1)? In substance, the Tenth Circuit believed that the sovereign immunity waiver in Section 106(a)(1) effectively ended any sovereign immunity argument under Section 544(b)(1).

Section 106(a)(5) also plays a role. It provides:

Nothing in this section shall create any substantive claim for relief or cause of action not otherwise existing under this title, the Federal Rules of Bankruptcy Procedure, or nonbankruptcy law.

In the Supreme Court, the Solicitor General took the position that Section 106(a) has “no bearing” on the outcome because the waiver of sovereign immunity does not alter the substantive requirement in Section 544(b) that there must be an “actual creditor” entitled to sue. Furthermore, the government argued that Section 106(a)(5) does not allow alteration of the “actual creditor” requirement under state law.

The Government’s Argument

As custom, the justices made life miserable for both sides. However, comments from the bench seemed to favor a ruling for the government.

In what may have been the question most favorable to the trustee, Justice Neil M. Gorsuch observed that the sovereign immunity waiver in Section 106 does not “single out” Section 544(a), which would have allowed the trustee to sue successfully had the bankruptcy occurred within two years of the transfer.

The government responded to Justice Gorsuch by saying that Section 106 does not create “any substantive claim for relief that doesn’t otherwise exist.” Justice Gorsuch responded, “No, it doesn’t create a new cause of action. I grant you that.”

Justice Gorsuch may still be the trustee’s best hope, because he went on to talk about Moore v. Bay, 284 U.S. 4 (1931), written by Justice Oliver Wendell Holmes, Jr. He described Moore v. Bay as meaning that “sometimes a trustee’s powers to avoid property transfers can transcend the rights of the creditor in whose shoes he might otherwise step.”

The government distinguished Moore v. Bay, pointing out how the case held that a trustee could recover the full amount of the transfer, not just the smaller amount that the creditor could have recovered on its own outside of bankruptcy.

Justice Ketanji Brown Jackson seemed to be in the government’s camp when she said,

[W]hat’s happening there is the trustee gets the avoidance power but only to the extent that an actual creditor could have [e]ffected the same kind of disruption in the market by bringing this kind of action on his own.

The trustee had a glint of hope from questions asked by Justice Elena Kagan. She asked,

[W]hy would Congress have gone to this trouble of waiving sovereign immunity if the trustee was always going to lose anyway as a result of the substantive question in the suit?

The trustee had lodged an argument based on policy: If a trustee cannot sue the IRS, it opens the door for corporate owners to have their companies pay their personal taxes. With the IRS having been paid, the owners would gain by having no nondischargeable debt owing to the IRS.

The government turned the argument around, saying that a successful suit against the IRS would allow the owners “to go free” because the bankruptcy trustee is only entitled to single recovery.

The Trustee’s Argument

When it came time for the trustee to argue, the trustee’s counsel was met immediately with a question by Justice Clarence Thomas. He implied that the trustee’s theory would modify the “actual creditor” requirement, in contravention of Section 106(a)(5).

The trustee contended that the government’s theory meant that there needed to be two waivers of sovereign immunity: the general waiver in Section 106(a), and a second for Section 544(b)(1). Justice Jackson responded, “[I]sn’t that a function of Congress’s policy choice to incorporate state law as the requirement of 544(b)?”

Justice Jackson was not through. She said,

I thought the waiver of sovereign immunity was a threshold issue that didn’t tell us anything about the merits of whether or not you win the action underlying it.

Justice Jackson saw two different questions: (1) Does the waiver of sovereign immunity allow a trustee to sue; and (2) if the trustee can sue, can the trustee win on the merits?

Justice Sonia Sotomayor seemed of the same mind when she prevailed on the trustee’s counsel to admit that Section 544(b) incorporates state law defenses. She said, “I’m not sure why we’re going to have to incorporate 106(b) in the state law defenses.” Similarly, Justice Amy Coney Barrett won a concession from the trustee to say that state law defenses are available even if there is a waiver of immunity.

Similarly, Justice Kagan said, “[T]his waiver of sovereign immunity is not supposed to affect the substance.”

Along the same lines, Justice Jackson said it was “strange” that a trustee could recover “under circumstances in which no actual creditor could.” She elaborated,

If we think about what 544 is really about, then it seems to me to undermine your view that we should be reading 106 to allow for the trustee to recover money that an actual creditor would not have been able to recover.