[1]A trustee for a bankrupt entity or a debtor has the power to bring an action to avoid and recover constructive or actual fraudulent transfers. Section 544(b) of the Bankruptcy Code specifically allows a trustee or debtor to step into the shoes of an actual creditor of the debtor, who could have avoided the transfer outside of bankruptcy using state law. The U.S. Court of Appeals for the Seventh Circuit recently analyzed a debtor’s power to bring a state law fraudulent-transfer action under § 544(b) against the Internal Revenue Service (IRS) for receiving a federal tax payment from a chapter 11 debtor, which was organized as subchapter S corporation. The federal government’s sovereign immunity generally prevents creditors from suing the IRS using state law; however, § 106(a)(1) of the Bankruptcy Code annuls the government’s sovereign immunity with respect to § 544. Which power prevails: avoidance or immunity?
The Seventh Circuit’s decision in In re Equipment Acquisition Resources Inc.[2] is significant because it addresses an issue of first impression, namely a trustee’s ability to bring a constructively fraudulent-transfer action against the IRS for shareholders’ tax payments made by an S corporation on behalf of those shareholders. The U.S. District Court for the Northern District of Illinois had previously held that a trustee may proceed with its avoidance action against the IRS, ultimately concluding that the government cannot employ the sovereign immunity doctrine because Congress specifically excepted it under the Bankruptcy Code. The Seventh Circuit disagreed and its decision may have wide-reaching implications, including potentially placing a significant roadblock on trustees’ power to sue federal government entities under § 544(b).
Factual Background
The debtor, Equipment Acquisition Resources Inc., was an Illinois subchapter S corporation that sold and serviced semiconductor-manufacturing equipment. Since it had elected to be treated as a subchapter S corporation, the company itself was not subject to federal income tax. Instead, its shareholders were allocated any income that the corporation had and they were required to pay any income taxes arising therefrom. Unfortunately for the debtor, one of its shareholders perpetrated a massive fraud and the debtor’s officers and directors resigned. A chief restructuring officer was appointed, who subsequently filed a voluntary chapter 11 reorganization petition.
The debtor initiated a lawsuit against the IRS under §§ 544 and 548 of the Bankruptcy Code for avoidance and recovery of nine tax payments, which covered the shareholders’ tax liabilities.[3] The debtor also sued the shareholders whose tax liabilities were paid by the debtor.[4] A settlement was reached among the IRS, the shareholders and the debtor for the eight tax payments that were made within two years before the filing of the petition.[5] However, the IRS filed a motion to dismiss the debtor’s action to avoid the ninth payment, which was made more than two years before the petition date.
The IRS made three arguments in its motion to dismiss. First, it argued that because an unsecured creditor could not bring a fraudulent-transfer suit under state law as the government is immune from these suits, the result should not be different in a bankruptcy case. Second, even if the debtor could bring a state law fraudulent-transfer suit against the IRS under the Bankruptcy Code, the debtor is essentially requesting a tax refund under the Internal Revenue Code, and such a request was not timely made. Third, the Illinois Uniform Fraudulent Transfer Act does not allow avoidance of a transfer to an innocent creditor that received a voluntary payment in satisfaction of a valid, antecedent debt.
The bankruptcy court denied the government’s motion to dismiss, focusing primarily on the sovereign immunity argument. The court reasoned that § 106(a)(1) communicated Congress’s intent to abolish the government’s immunity from suit under certain bankruptcy causes of action, including those under § 544. The court grounded its conclusion on “[t]he plain, unambiguous language of § 106, the deliberate inclusion of § 544 in § 106(a), and the policy consideration favoring recovery for the benefit of all creditors.”[6] On appeal, the district court agreed, but the Seventh Circuit reversed, holding that the IRS was immune from liability under state fraudulent-transfer law.
Fraudulent-Transfer Actions and Sovereign Immunity
The Seventh Circuit explained that § 544(b) is unique, insofar as it allows a trustee to borrow from a state’s fraudulent-transfer statute, allowing “the trustee to do in a bankruptcy proceeding what a creditor would have been able to do outside of bankruptcy.”[7] It is also unique in another regard: “[I]ts terms require the actual existence of an unsecured creditor that could have brought the state-law action itself.”[8] Therefore, the trustee stands in the shoes of an actual creditor and if that creditor could not succeed for any reason, then that trustee is similarly barred.
However, the analysis did not stop there for the Seventh Circuit. There are two levels of inquiry in determining a federal agency’s (in this case, the IRS) liability. The first is whether there was a waiver of sovereign immunity. The parties agreed that § 106(a) evinces a waiver but the second level of inquiry is “whether the source of substantive law upon which the [plaintiff] relies provides an avenue for relief.”[9]
The Seventh Circuit rejected the lower courts’ and trustee’s analysis (i.e., that § 106(a) is unambiguous). Instead, the court of appeals reasoned that § 544(b) requires “that a creditor exists who could use a state’s ‘applicable law.’”[10] The court concluded that there is no creditor outside of bankruptcy court that could sue the IRS for an Illinois fraudulent-transfer action. Thus, since a creditor outside of bankruptcy would be precluded from bringing a state law fraudulent-transfer action, the trustee is likewise barred.
The court of appeals also rejected the trustee’s argument, which has been adopted by other courts, that Congress knowingly decided to include state law causes of action with the § 106(a) category of suits.[11] However, the court refused to look to congressional intent when the text of § 544(b) is unambiguously clear. The court further explained that even if federal sovereign immunity were not an issue, a creditor outside of bankruptcy would face constitutional issues such as the Federal Appropriations Clause of the Constitution.[12] Finally, from a policy standpoint, the Seventh Circuit refused to expose the federal government to suits based on various states’ laws, some of which extend beyond “the typical four years.”[13]
Lessons of In re Equipment Acquisitions Resources Inc.
The Seventh Circuit distinguished between causes of action brought under § 548 and those brought under § 544. Both §§ 548 and 544 are included in the § 106 list of Code provisions for which sovereign immunity is abrogated. However, § 548 is different, according to the Seventh Circuit, because § 548 is a cause of action that is a creature of the Code itself. In addition, the court recognized that it has diverged “from all of the bankruptcy and district courts to consider the issue in the context of the federal government.”[14]
The Seventh Circuit proffered an explanation as to why those courts wrongly interpret §§ 106 and 544, and why its interpretation of § 106 does not render § 544 meaningless.[15] It pointed out that § 544 includes § 544(a), which authorizes a trustee to assume the rights of a hypothetical judgment lien creditor, execution creditor or bona fide purchaser. The court reasoned that sovereign immunity does not limit a trustee from using § 544(a) against the federal government because it allows a trustee to rely on § 2410 of title 28, which allows judgment lien creditors, execution creditors, and bona fide purchasers to quiet title to property on which the U.S. claims a lien.[16] Therefore, per the court, there would be no sovereign immunity issue under a trustee’s § 544(a) “strong-arm” power, which “could also explain why Congress included § 544 in § 106(a)’s list.”[17]
Conclusion
The Equipment Acquisition Resources decision answers the question of which power prevails — avoidance or immunity — resoundingly for immunity. As a result, the decision could have far-ranging implications on the powers of trustees to sue federal government entities for constructively fraudulent transfers under § 544(b). The Seventh Circuit’s conclusion that § 544(b) “unambiguous[ly]” requires that an actual creditor be able to sue the federal government may deeply dent § 106’s shield against sovereign immunity because there are a wide range of state law defenses that the government could apply to fraudulent-transfer suits outside of bankruptcy.[18] Likewise, the Seventh Circuit’s policy reasoning about the federal interest in not having the federal government exposed to state law fraudulent-transfer actions might erode the rationale underlying § 106.[19] Trustees and federal government entities should note this decision in taking inventory of their powers and defenses in fraudulent transfer lawsuits under § 544(b).
[1] The views expressed herein are solely those of the authors.
[2] 742 F.3d 743 (7th Cir. 2014).
[3] The theory of liability was premised on the idea that the tax payments made to the IRS were the shareholders’ responsibilities and not that of the debtor. Thus, the debtor did not receive value for those transfers because it was not obligated to make those payments.
[4] The debtor argued that the transfers made to the IRS were made for the benefit of the shareholders because the shareholders were required to make those payments, not the debtor.
[5] The payments made to the IRS were allegedly avoidable under § 548, which allows a debtor or a trustee to avoid fraudulent transfers two years before a petition is filed.
[6] In re Equipment Acquisition Resources Inc., 451 B.R. 454, 464 (Bankr. N.D. Ill. 2011).
[7] In re Equipment Acquisition Resources Inc., 742 F.3d at 746. Section 544(b) provides, in relevant part, that a “trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim.” 11 U.S.C. § 544(b)(1).
[8] Id.
[9] Id. at 747 (quoting FDIC v. Meyer, 510 U.S. 471, 484 (1994)).
[10] In re Equipment Acquisition Resources Inc., 742 F.3d at 747.
[11] Id.
[12] Id. at 747-48 (citations omitted).
[13] Id. at 750.
[14] Id. at 748.
[15] Id. at 748-49.
[16] In re Equipment Acquisition Resources, Inc., 742 F.3d at 749.
[17] Id. at 749.
[18] Id. at 747.
[19] The Seventh Circuit denied the trustee’s petitions for rehearing and the trustee has not yet sought certiorari from the Supreme Court. (See Docket, No. 13-1480 (7th Cir.), ECF No. 45 (Mar. 6, 2014).)