The Fifth and Eighth Circuits ostensibly did debtors and trustees a favor by holding that Sections 541(a)(1) and (a)(7) mean that avoidance actions are estate property that may be sold. Respectfully, the circuits should have limited their holdings to Section 541(a)(7), which says that estate property includes property acquired after filing.

Invoking Section 541(a)(1), the circuits held that avoidance actions are “inchoate” property interests of the debtor “as of the commencement of the case.” In reporting the Fifth Circuit opinion, we issued the following warning:

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.

That’s exactly what happened in a case before Chief Bankruptcy Judge Thad J. Collins of Cedar Rapids, Iowa. The secured lender had a security interest in general intangibles and proceeds. Citing the two circuits, the lender filed a motion to recognize the validity of the security interest in the estate’s avoidance actions and any proceeds from them.

The chapter 7 trustee won when Judge Collins issued an opinion on September 9 denying the lender’s motion for summary judgment.

The two circuit decisions are Pitman Farms v. ARKK Food Co. (In re Simply Essentials), 78 F.4th 1006 (8th Cir. 2023); and Briar Cap. Working Fund Cap. v. Remmert (Matter of S. Coast Supply Co.), 91 F.4th 376, 382 (5th Cir. 2024), cert. denied sub nom. Remmert v. Briar Cap. Working Fund Cap., LLC., 144 S. Ct. 2631 (2024). To read ABI’s reports, click here and here.

Given that Iowa is in the Eighth Circuit, Judge Collins was tasked with explaining why Simply Essentials was not controlling and why inchoate property interests do not include avoidance actions. That is what he did in his 22-page opinion.

Inchoate Property Interest

In one of the Eighth Circuit’s two holdings, Judge Collins recited how the Court of Appeals said “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.’” Simply Essentials, supra, 71 F4th. at 1009. He embarked on an analysis of whether Simply Essentials changed the law because he cited six cases and the Collier treatise to say that the “weight of the case law that existed before the Simply Essentials decision flatly rejected the arguments [that the lender] makes here.”

Judge Collins saw “nothing” in Simply Essentials that “changes this well-established law” because the opinion “never addressed this issue at all.”

Judge Collins said that the lender read “too much” into “an inchoate interest.” The lender, he said, had no independent right of recovery before filing because the right of action arose after bankruptcy and “only for the trustee or debtor in possession (‘DIP’) to pursue, and only for the benefit of the estate — not a single creditor.” He pointed out how Simply Essentials said that the right of action belonged to the debtor in possession or to a trustee.

Indeed, Judge Collins went on to say that the right of action to file avoidance actions “did not and could not exist pre-petition, or ever” and “do not exist outside of bankruptcy.” In fact, avoidance actions were not the debtor’s property before filing. They came into being by statute and “not as a continuation of rights already held by Debtor pre-petition.” Moreover, the post-petition right of action exists for the benefit of all creditors, not just one.

Judge Collins saw the lender’s argument as challenging three “bedrock” principles: (1) Avoidance actions arise by statute after filing; (2) the trustee or the debtor in possession has the exclusive right to pursue avoidance actions, and (3) avoidance actions can be pursued only for the benefit of all creditors.

Recognizing the lender’s argument, Judge Collins said, “would undercut or effectively gut” the principle that avoidance actions are for the benefit of the estate generally. If there were a valid lien, avoidance actions could be locked up for the benefit of one creditor.

Judge Collins said that the lender overlooked the second holding in Simply Essentials, where the circuit court said that avoidance actions were after-acquired property that became estate property under Section 541(a)(7). As after-acquired property, recoveries could not be “proceeds” from preexisting property. Furthermore, Section 552 would cut off the attachment of security interests in property acquired after filing.

In sum, Judge Collins said that avoidance actions “arise post-petition as after-acquired property, not proceeds.” Indeed, he said that the debtor “could not have encumbered those actions pre-petition.”

Judge Collins denied the lender’s motion for summary judgment, effectively ruling that the lender had no security interest in avoidance actions.

Observations

Bankruptcy law may not provide the only answer to whether there can be a valid security in avoidance actions. Applying Uniform Commercial Code may result in the same answer as Judge Collins’s.

To have a perfected security interest, there must be attachment, and attachment cannot occur until the borrower has an interest in the collateral. Assuming, as Judge Collins said, that a pre-filing debtor has no property interest in avoidance actions, there could have been no attachment before filing and therefore no perfected lien to survive the filing of the petition.