Avoidance Powers Under Section 544 of the Bankruptcy Code In Whose Shoes Are You Standing

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Sep 2003

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Upon the filing of a bankruptcy petition, the Bankruptcy Code vests a debtor-in-possession (DIP) with unique
remedies otherwise unavailable to a debtor outside of bankruptcy. Among these remedies is the power to alter the
legal effect of a pre-petition transfer, including the transfer of a security interest in property.

One such remedy mirrors the ability of certain, specified creditors to take priority over previously-existing
secured creditors under certain, specified circumstances. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §544</a>. And, much like preference- and
fraudulent-transfer provisions, such remedies are potentially available to creditors outside of bankruptcy, though not
necessarily to the underlying debtor, pursuant to "applicable non-bankruptcy law." In bankruptcy, however, only the
DIP has such remedies, and unsecured creditors are, under most circumstances, unable to enforce whatever rights and
powers they might otherwise have.

The basis for the apparent limitation of remedies to a DIP is to insure the fair and even distribution to all creditors,
not just creditors that rush to the courthouse, as well as in furtherance of the underlying premise of the Bankruptcy
Code: the fresh start. However, what is important to note about §544's "strong-arm provisions" is that they entitle
a DIP to enforce the rights of a hypothetical judicial lien creditor, not all creditors. Nonetheless, many question
whether a DIP can enforce the rights and powers of a specific creditor in bankruptcy when only that specific creditor
has such rights and powers outside of bankruptcy.

<h3>Section 544's "Strong-arm" Provisions</h3>

Pursuant to <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C. §544(a)</a>, the trustee (or DIP) shall have, as of the commencement of the case, and
without regard to any knowledge of the trustee (or DIP) or of any creditor, the rights and powers of, or
may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by:

<blockquote>
(1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains,
at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple
contract could have obtained such a judicial lien, whether or not such a creditor exists; 
(2) a creditor that extends credit to the debtor at the time of the commencement of the case and obtains, at such time
and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time, whether or
not such a creditor exists;...
</blockquote>

The basic premise of §544(a) is to provide standing and a procedural vehicle by which a DIP can avoid an
unperfected security interest under the rights and powers of certain, specified creditors; specifically, a hypothetical
judicial lien creditor. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Paramount Int'l., 154 B.R. 712 (Bankr. N.D. Ill. 1993)</a>. Such rights and powers are
determined by the rights and powers that a hypothetical judicial lien creditor would have. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re May, 19 B.R. 655,
658 (D. Fla. 1982)</a>. Thus, these rights and powers are determined by applicable non-bankruptcy law, not §544. See

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… re Michigan Lithographing Co., 997 F.2d 1158 (6th Cir. 1993)</a>. Accordingly, a trustee can "avoid" a security
interest, which actually results in the subordination of such security interest as opposed to the "avoidance" of the
debt as a whole, if applicable non-bankruptcy law provides such rights and powers to a judicial lien creditor. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=U… §9-317(a)(2)</a>; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Munsey Corp., 10 B.R. 864, 866 (Bankr. E.D. Pa. 1981)</a>.

If, however, a judicial lien creditor has no such rights and powers under applicable non-bankruptcy law, then the
DIP has no such rights and powers. For example, if the security interest that the DIP seeks to avoid is perfected
under most applicable non-bankruptcy law (i.e., that state's version of the UCC), then it will defeat §544(a)'s
hypothetical judicial lien as it exists only as of the petition date, thereby arising subsequently in time. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… v. Easy Living Furniture, 52 B.R. 706, 710 (Bankr. S.D. Ohio 1985)</a>. Similarly, if applicable non-bankruptcy law
would not subordinate a security interest to a judicial lien creditor due to the express provisions of the applicable
non-bankruptcy law, then a DIP likewise has no rights or powers to avoid such a security interest. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re Surplus Furniture Liquidators Inc. of High Point, 199 B.R. 136, 143 (Bankr. M.D.N.C. 1995)</a> (declining to avoid a
security interest arising by virtue of an equitable lien); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… re N. Merberg & Sons Inc., 166 B.R. 567, 570-71 (Bankr.
S.D.N.Y. 1994)</a> (holding that §544's strong-arm powers do not override PACA's equitable trust); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re World
Auxiliary Power Co., 244 B.R. 149, 152-53 (Bankr. N.D. Ca. 1999)</a> (noting that a hypothetical judicial lien
creditor's recording of its lien in the Copyright Office does not give priority over an unperfected security interest
under 17 U.S.C. §205(d)).

Consequently, a DIP has the rights and powers that applicable non-bankruptcy law provides only, and not a blanket
ability to avoid unperfected security interests. However, as most courts have held, a DIP's rights and powers under
§544(a) are not the rights and powers of specific creditors. Instead, §544(a) limits such rights and powers to those of
a hypothetical judicial lien creditor or an unsatisfied execution creditor.

<h3>The Avoidance of Rights of Individual Creditors</h3>

Section 544(a) states that a DIP stands in the shoes of a creditor, whether or not such a creditor exists. This
language, at times, has been misinterpreted to read that a DIP has the rights and powers of a creditor, as opposed to
a hypothetical creditor of the type set forth in §544(a).

Nonetheless, a DIP does not stand in the shoes of individual creditors and does not have standing to pursue causes
of action on behalf of individual creditors. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4… v. Marine Midland Grace Trust Co. of New York, 406 U.S.
416, 492-31, 92 S.Ct. 1678, 1686, 32 L.Ed.2d 195 (1972)</a>. In response to Caplin, Congress initially drafted certain
provisions in §544 to overrule Caplin and allow a DIP to avoid a security interest based on the rights of any
creditor. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=D…. on Bankruptcy Laws, H.R. Doc. No. 93-137</a>, Part II, 93d Cong., 1st Sess. 160 (1973). This
provision, however, did not survive the Bankruptcy Code's enactment. See H. Rep. 95-595, 95th Cong., 2d Sess.
370 (1977). Congress, therefore, clearly intended Caplin's holding to remain intact. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… re Ozark Restaurant
Equipment Co. Inc., 816 F.2d 1222 (8th Cir. 1987)</a>.

Other circuit appeals courts have followed Caplin's holding, and Ozark Restaurant's adoption thereof, that a DIP
has no standing to pursue third parties on behalf of specific, individual creditors. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… v. California
First Bank, 859 F.2d 664 (9th Cir. 1988)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…. Hutton & Co. Inc. v. Hadley, 901 F.2d 979 (11th Cir. 1990)</a>.
Thus, if a secured creditor has rights and powers under applicable non-bankruptcy law that would allow it to avoid,
or subordinate, another creditor's security interest, that remedy is unavailable to the DIP. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…; Stated otherwise, a
DIP may only use §544(a)'s strong-arm provisions to benefit the bankruptcy estate as a whole, not an individual
creditor's rights.

In determining whether a claim is asserted on behalf of a bankruptcy estate or an individual creditor, courts consider
whether a claim is a general one, with no particular injury arising from it, and if that claim could be brought by any
creditor of the debtor, the DIP is the proper person to assert the claim. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…. Paul Fire and Marine Insurance Co. v.
PepsiCo Inc., 884 F.2d 688, 700-01 (2d Cir. 1989)</a>. As such, §544(a) allows a DIP to challenge the perfection of a
security interest as a judicial lien creditor, but not as a purchase-money security interest-holder or some other holder
of a priming security interest.

Thus, the test of whether a DIP may enforce the rights and powers of a creditor pursuant to §544(a)'s strong-arm
provisions comes from the express language of §544(a), and the rights and powers of a creditor of the type expressly
described therein under applicable non-bankruptcy law.

<h3>Conclusion</h3>

As stated above, §544(a)'s strong-arm provisions empower a DIP to take advantage of applicable non-bankruptcy
law rights and powers, which would otherwise belong to unsecured creditors, in adjusting its debts. Such rights and
powers are not without limit, and only certain circumstances will allow a DIP to employ §544(a)'s remedies.

When such circumstances occur, §544(a)'s strong-arm provisions provide a powerful remedy for the encumbered
DIP. Nonetheless, such circumstances are limited to the express provisions, and therefore remedies, set forth in
§544(a). As such, the rights and powers of specific creditors outside bankruptcy remain the rights and powers of
specific creditors inside bankruptcy.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Monday, September 1, 2003 - 12:00

Bankruptcy Rule

2003