Overview of Avoidance Actions

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Mar 2004

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Editor's Note:

This is the seventh installment of Chapter 11-"101," a monthly column
intended to instruct
readers in the nuts and bolts of chapter 11 practice. Consider obtaining
and reading the six prior installments if you have not already done so,
as each installment builds on the background built in prior
installments.

</blockquote>

The way to understand a chapter 11 debtor's
avoiding powers is to recognize that it wears two hats. For the first
hat,
think the Lone Ranger, or at least Burl Ives in East of Eden.
He's the stranger who comes in on the game and
scoops all the money off the table to distribute it in an equitable
manner.

For the second hat, think Hagar the Horrible, with helmet and horns.
Under this hat, he is the representative of
creditors and can do things that the debtor cannot do.

To grasp this point, recall the history of bankruptcy law: In the
beginning, bankruptcy was a kind of
proto-class action, where creditors clubbed together to collect their
debts. They selected the trustee; he was, in a
sense, their agent. It is not surprising, therefore, that he could do
things they could do. Specifically, he gets to set
aside, unravel, treat as a nullity—or in the jargon of bankruptcy
law, "avoid"—certain transactions that the debtor
engaged in before bankruptcy.

The bite is that these transactions are often perfectly valid between
debtor and transferee. But they won't be binding
on creditors—and the trustee (in his Hagar headgear) is the
creditors' voice.

The Supreme Court got this point interestingly wrong in a case
decided nearly a century or so ago, just after the
beginning of our modern bankruptcy law. The case is York
Manufacturing Co. v. Cassell, 201 S.Ct. 344 (1906). A
creditor held a conditional sales contract that was valid against the
debtor, but was not filed in the public records
and so was invalid against creditors. The Supreme Court held that the
trustee stepped into the shoes of the debtor
and took the property of the debtor subject to any encumbrances that
would have been binding on the debtor.

The Court thus got the Lone Ranger point, but missed the Hagar point
altogether. Congress responded quickly with
amendments giving the trustee the powers of a lien creditor and a
judgment creditor. The legislative history made it
clear that Congress intended to overrule York, but in a broader
sense, you might say it was merely reestablishing the
traditional view that the trustee (or DIP, acting as trustee) has
powers, exercisable for the benefit of creditors, that go
beyond those rights that the pre-petition debtor would have.

In our current Bankruptcy Code, we have half a dozen or more
"avoiding powers," most of which are the progeny of
this overruling amendment. Each of these avoiding powers is codified in
chapter 5 of the Bankruptcy Code (and are
thus sometimes referred to as "chapter 5 causes of actions"). Explaining
the various avoiding powers is easiest by
illustration.

<h3>Hypothetical Lien Creditor and BFP Rights</h3>

Start with the most intelligible case. Fredco borrows $10 million
from Barney Bank and gives it a security interest
in its Dinobarn, hitherto owned by Fredco free and clear.

In addition to the security agreement signed by Fredco granting
Barney Bank a security interest in Dinobarn, it also
signs a financing statement. However, Barney Bank forgets to file the
financing statement in the public records.
Another creditor, Gazoo Corp., who does not hold a security interest,
gets a judgment against Fredco and sends the
sheriff out to levy on Dinobarn. As between Barney Bank and Gazoo Corp.,
who wins?

The answer is Gazoo Corp. The Uniform Commercial Code says (with
Byzantine indirectness) that an unperfected
security interest is subordinate to the rights of a lien creditor. On
levy, Gazoo Corp. becomes a lien creditor. Barney
Bank's financing statement remains unfiled, therefore unperfected, so
Gazoo Corp. prevails.

So much for state law. What of bankruptcy? The answer is in
§544(a)(1), which provides that the trustee has the
rights of a lien creditor. Fredco goes into bankruptcy owing Barney
Bank, Gazoo Corp. and others: Barney Bank
has a security interest, but unfiled; Gazoo Corp. has a claim, but not a
lien. If Gazoo Corp. had got a lien at state
law before Barney Bank filed, then Barney Bank's security interest would
have been subordinate to Gazoo Corp.'s
claim.

So, per §544(a)(1), Barney Bank's security interest is
subordinate to the rights of the trustee. Barney Bank retains
its claim, but loses its security interest; it has to go to the back of
the queue and share with the other unsecured
creditors (including Gazoo Corp.), pro rata.

Actually, the provision is even more powerful than we have seen so
far. Based on what we have seen, we can say
that the trustee "steps into the shoes" of Gazoo Corp. But the section
provides that the trustee gets this right
"whether or not such a creditor exists." In other words, if a creditor
could have trumped Barney Bank on the petition
date, then the trustee can trump Barney Bank. As a practical matter,
this may not seem to amount to much: At least
in our example, there virtually always will be a creditor with the right
to trump Barney Bank. But the practical
point is that the trustee doesn't have to prove it; he can operate on
the rule of "as if."

So far, this sounds like "classic bankruptcy"—trustee as a kind
of "class representative" doing what a creditor could
do. But go back and tweak our first example. Suppose that Fredco gave
Barney Bank a security interest in not
Dinobarn, but in Blackacre, a parcel of real estate. Note that the
Uniform Commercial Code (UCC)no longer
governs. We are in the realm of real estate law. Suppose as before that
Fredco signs, but that Barney Bank neglects
to record, a mortgage. Fredco does not pay. As between Barney Bank and
Gazoo Corp., who gets first dibs on
Blackacre?

You might think that the answer would be the same as before, and in
some states, indeed it is. But in many states,
real estate priority rules differ from the rules under the UCC. Many
states say that the unrecorded mortgage is void
against "a bona fide purchaser," or words to that effect. However, quite
a few cases hold that a "lien creditor" is not
a "bona fide purchaser." So if Gazoo Corp. is a (mere) lien creditor, it
may lose the priority conflict with an
unrecorded mortgage—even though it would win it against an
unperfected security agreement in personal property.

This rule may or may not make sense, but that is beside the point.
The point—in bankruptcy—is this: If Fredco
goes into bankruptcy and the trustee had nothing but the "lien creditor"
power of §544(a)(1), then Barney Bank's
mortgage retains its priority, even though unrecorded. Another avoiding
power, however, provides that the trustee
has the rights of "a bona fide purchaser," and thus the trustee can
avoid the unrecorded mortgage on real property
just as he can set aside the unperfected security interest in personal
property.

<h3>Fraudulent Transfers</h3>

Under non-bankruptcy fraudulent transfer law, a creditor may avoid a
transaction between the debtor and a third
party if the transaction is, on appropriate standards, adverse to the
creditor. Bankruptcy law "annexes" fraudulent
transfer laws in two interesting ways.

First, §544(b) provides that the trustee may avoid a transfer
that is "voidable by a creditor" at state law. This rule is
both broader and narrower than the rule under §544(a), which we
examined above. It is broader in that it grants
rights to "creditors" without qualification—not just to the
narrower class of "lien creditors," as in §544(a). It is
narrower in that, to use the power, the trustee (or DIP) has to prove
the existence of an actual creditor by whom the
transfer might have been avoidable. This is not trivial: If the trustee
fails to prove the existence of such a creditor,
he loses. There are plenty of cases where the trustee has identified
what looks like a promising fraudulent-transfer
avoidance action, only to lose it because he can't make the link to an
actual creditor offended at state law.

Second, §548 is a fraudulent-transfer provision in its own
right, giving the trustee the authority to avoid
fraudulent transfers without having to rely on §544(b)'s
incorporation of state law. Under §548(a)(1)(A), the
trustee may avoid a transfer that was made with the actual intent
to "hinder, delay or defraud" a creditor—call it
an "actual fraud" fraudulent transfer. Under §548(a)(1)(B), the
trustee may avoid a transfer made for "less than a
reasonably equivalent value." If he is relying on this "constructive
fraud" premise, then he must also show one
of three additional facts. That is (somewhat simplified), he must show
that the debtor was either:

<ul>
<li>insolvent at the time of the transfer, or rendered insolvent
thereby;
</li><li>engaged in a business or transaction for which his remaining
property was "unreasonably small capital;" or
</li><li>intending to incur debts beyond his capacity to repay.
</li></ul>

The critical distinction here is the matter of intent. If the
trustee can show the relevant intent, then he doesn't have
to worry about issues of solvency or value. If he has the right evidence
on value and solvency, he doesn't have to
worry about intent.

Section 548 parallels and in many respects duplicates state law as
codified via the Uniform Fraudulent Transfer Act.
So the question arises, given §548, is there any reason for
§544(b)? The answer is "yes." There are at least two
reasons.

One, §544(b) may pick up some fraudulent transfers that
§548 misses. For example, under §548, the trustee can
reach back to undo transactions made only within a year before
bankruptcy. The state law reach-back period is
longer—typically three to five years. Two, §544(b) gives the
trustee the power to avoid any transaction that is
voidable under state law—i.e., not just fraudulent transfer
laws. State law may present opportunities for avoidance
aside from fraudulent transfer law. For example, a few states retain
so-called "bulk-transfer" statutes, permitting an
aggrieved creditor to avoid bulk transfers of inventory. In the
appropriate case, this right, too, will pass to the
trustee.

<h3>Preferences</h3>

All the rights we have examined so far are predicated more or less on
non-bankruptcy law. There is one important
avoidance power that exists independently of non-bankruptcy law. This is
the power to avoid preferences under
§547.<a href="#1" name="1a">1</a>

To understand preferences, you must understand what they are not.
Consider the case of Delbert, who owes $100
each to Butcher, Baker and Candlestick Maker, all unsecured. Delbert
pays $100 in cash to Butcher and then files
for bankruptcy, holding no other assets. Baker and Candlestick Maker
have claims against the estate of Delbert, but
the claims are worthless. Butcher has no claim because he was paid in
full. The first thing to note about this case is
that Delbert's conduct is not "wrong" in any global sense, because it is
not wrong to pay a debt.

The trouble is that a first principle of bankruptcy law is that
similarly situated creditors share pro rata. If you allow
the debtor to pick and choose which creditors it pays on the eve of
bankruptcy, then you undercut this first
principle. So it is not surprising to find in the Bankruptcy Code a rule
that allows the trustee to undo certain
pre-bankruptcy transactions, otherwise unobjectionable, that would have
the effect of undercutting the principle of
pro rata distribution.

The core of preference law is in §547. The prima facie
case is in §547(b). It provides (slightly simplified):

The trustee may avoid a transfer

<ul>
<li>to a creditor
</li><li>for an antecedent debt (a debt that existed before the transfer)
</li><li>made while the debtor was insolvent
</li><li>and within 90 days before bankruptcy (or one year if the recipient
is an insider)

</li><li>if it permits the creditor to get more than it would get in chapter
7.
</li></ul>

So in our example, Delbert is clearly insolvent: he has $100 and owes
$300. If the transfer had not occurred, then
creditors would have taken (1/3)($100) = $33.33 each (ignoring costs),
so Butcher clearly got more via the
transaction than he would have under chapter 7. The only open question
is timing: If the transaction was made
within 90 days before bankruptcy, then it would appear to be avoidable.
If it was made earlier—say, 91 days before
bankruptcy—then it would seem to be bulletproof.

Most preferences involve payment of money to satisfy a debt, but
there is one other case that is important but
perhaps not so obvious—i.e., suppose that Delbert, rather
than paying Butcher, merely gave him a security interest
in all his property to secure his antecedent debt, and that Butcher
perfected that security interest within 90 days of
bankruptcy. Assuming the other conditions are met, then this giving of
security may also be a preference and
avoidable under §547.

The prima facie elements of a preference are not, however, the
end of the story. There are many cases where the
debtor made a payment that meets the elements of a preference, but will
not be avoidable because it falls within one
of the defenses set forth in §547(c).

The most common of these is probably the "ordinary course of
business" defense, which exempts from preference
recovery payments made in the ordinary course of business between the
debtor and the recipient and on customary
terms. A second common defense is "subsequent new value" which exempts a
payment from avoidance to the extent
that, after receiving the payment, the recipient gives some additional
value (say, ships new goods) to the debtor.
This defense essentially allows the creditor to offset the value it gave
to the debtor after receiving a preferential
payment against its preference liability.

There are many other defenses, and one of the first tasks of a lawyer
defending a preference action is to go through
the list in §547(c) to see which defenses might apply.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> But note that some states
have their own preference laws. <a href="#1a">Return to article</a>

Journal Authors

John D. Ayer

Jonathan P. Friedland

Michael L. Bernstein

Journal Date

Monday, March 1, 2004 - 12:00

Bankruptcy Rule

2004