In seeking to protect rights in collateral during the course of a bankruptcy case, secured creditors should be aware of potential fraudulent transfer liability and its far-reaching effect on the ability to protect collateral. While most secured creditors are aware that the Bankruptcy Code permits the avoidance of transfers and encumbrances in certain circumstances, a recent decision out of the Sixth Circuit held that potential fraudulent transfer liability could also be asserted to defeat a motion seeking relief from the automatic stay, even after the limitations period on the fraudulent transfer action has long passed.
In Grant, Konvalinka & Harrison, P.C. v. Still (In re McKenzie),[1] the U.S. Court of Appeals for the Sixth Circuit joined with the U.S. Court of Appeals for the Ninth Circuit in holding that a bankruptcy trustee may assert avoidance actions defensively pursuant to § 502(d) of the Bankruptcy Code following the expiration of the statute of limitations set forth in § 546 of the Bankruptcy Code. In McKenzie, a secured creditor filed a motion seeking entry of an order granting relief from the automatic stay and, following two evidentiary hearings, the bankruptcy court entered an order granting relief from the automatic stay with respect to certain real estate and denied relief as to certain pledged equity interests.[2] Following a third evidentiary hearing, the bankruptcy court entered a second order denying the remainder of the motion for relief.[3] In denying the balance of the motion for relief, the bankruptcy court held, inter alia, that the bankruptcy trustee could use his hypothetical lien-creditor status and avoidance powers defensively to defeat the security interests asserted by the secured creditor, notwithstanding the fact that the limitations period set forth in § 546 of the Bankruptcy Code had expired.[4] Following the bankruptcy court’s decision, the secured creditor appealed the bankruptcy court’s ruling to the district court, which affirmed the bankruptcy court’s decision.[5]
On appeal to the U.S. Court of Appeals for the Sixth Circuit, the secured creditor contended, among other things, that the bankruptcy court had erred in allowing the bankruptcy trustee to use his hypothetical lien-creditor status and avoidance powers defensively despite the expiration of the statute of limitations.[6] In support of its position, the secured creditor urged the Sixth Circuit to adopt a minority position arguing that the bankruptcy court’s decision results in a “procedural windfall” to the bankruptcy trustee.[7] In addition, the secured creditor attempted to distinguish decisions from the majority position cited by the bankruptcy trustee and bankruptcy court on the ground that they involved claim objections rather than oppositions to motions for relief.[8]
In addressing the secured creditor’s arguments, the Sixth Circuit noted that (1) a bankruptcy trustee could affirmatively set aside certain liens on a debtor’s property but that a trustee must take such action no later than two years after the bankruptcy court enters an order for relief,[9] and (2) § 502(d) of the Bankruptcy Code requires the complete disallowance of a claim asserted by a transferee of a voidable transfer if such transferee has not paid the amount received or turned over the property received as required by the section under which the transferee’s liability arises.[10]
Having noted the relevant statutory language, the Sixth Circuit acknowledged that the position urged by the secured creditor was the minority position, with a majority of courts ruling that a bankruptcy trustee could use § 502(d) defensively after the relevant statute of limitations had expired.[11] Turning to the minority position urged by the secured creditor, the Sixth Circuit espoused that such a position suffered from several flaws. First, the minority position failed to distinguish between an avoidance action in which affirmative relief is sought and defenses where no affirmative relief is sought.[12] Second while the secured creditor argued that the bankruptcy trustee received a “procedural windfall,” no such windfall was received because the bankruptcy trustee was limited under § 502(d) of the Bankruptcy Code solely to offsetting the claim asserted by the secured creditor and could make no additional recovery.[13]
In addition, the Sixth Circuit found that the authority relied upon by the secured creditor distorted prior decisions addressing the issue and overlooked the plain text of § 502(d) and pre-Bankruptcy Code precedent.[14] On this point, the Sixth Circuit examined the plain text of § 502(d) of the Bankruptcy Code and noted the absence of any reference to the limitations period set forth in § 546 of the Bankruptcy Code.[15] Based on the absence of such reference, the Sixth Circuit concluded that “nothing in the text of section 502(d) prevents a trustee from using his avoidance powers defensively after the expiration of the statute of limitations set forth in section 546(a)(1)(A).” In addition, the Sixth Circuit pointed to two pre-Bankruptcy Code circuit court decisions in which courts permitted a bankruptcy trustee to object to claims after the limitations period had run,[16] which the Sixth Circuit noted comported with the general principle that statutes of limitations are not applicable to defenses.[17]
Finally, the Sixth Circuit found that the majority view – i.e., that § 502(d) could be used defensively after the expiration of the limitations period – furthered the Bankruptcy Code’s purpose of ensuring the “equality of distribution among creditors of the debtor.”[18]
Based on all of the foregoing, the Sixth Circuit concluded that the bankruptcy court properly adopted the majority view in permitting the bankruptcy trustee to assert avoidance actions defensively pursuant to § 502(d) of the Bankruptcy Code, notwithstanding the fact that the statute of limitations had expired.[19]
[1] Grant, Konvalinka & Harrison, P.C. v. Still (In re McKenzie), 737 F.3d 1034 (6th Cir. 2013)
[2] Id. at 1036-37.
[3] Id. at 1037.
[4] Id.
[5] Id.
[6] Id.
[7] Id. at 1041.
[8] Id.
[9] Id. (citing 11 U.S.C. §§ 547(b) and 546(a)(1)(A)).
[10] Id. (citing 4 Collier on Bankruptcy ¶ 502.05 (16th ed. 2011)).
[11] Id. (citing In re Am. W. Airlines Inc., 217 F.3d 1161, 1168 (9th Cir. 2000); In re McLean Indus. Inc., 196 B.R. 670, 676 (Bankr. S.D.N.Y. 1996)).
[12] Id. at 1042.
[13] Id. (citing In re Mid Atl. Fund Inc., 60 B.R. 604, 611 (Bankr. S.D.N.Y. 1986)).
[14] Id. (citing In re Mktg. Assocs. of Am. Inc., 122 B.R. 367, 370 (Bankr. E.D. Mo. 1991)).
[15] Id. (citing 11 U.S.C. § 502(d); McLean Indus., 196 B.R. at 676-77).
[16] Id. (citing In re Meredosia Harbor & Fleeting Serv. Inc., 545 F.2d 583, 590 (7th Cir. 1976); In re Cushman Bakery, 526 F.2d 23, 36 (1st Cir. 1975)).
[17] Id. (citing In re KF Dairies Inc., 143 B.R. 734, 737-38 (B.A.P. 9th Cir. 1992)).
[18] Id. (citing Union Bank v. Wolas, 502 U.S. 151, 161 (1991)).
[19] Id.