Do Preference Actions Survive a Pledge or Assignment

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Apr 1999

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In a recent case, a debtor-in-possession (DIP) lender requested preference and avoidance

actions as part of its collateral package. The debtor's counsel declined, saying that granting such

a lien could actually create something that the DIP would never want—releasing the very rights

that the liens sought to encumber. Was he right by being overly conservative, or was he

completely off of his rocker? Should unsecured creditors object to the request if it is presented

as part of the DIP financing package? Would the reaction be different if the creditor thought it

had received a large preference?

<h3>Possible Release of Avoidance Actions</h3>

There is a growing body of case law where preference actions by assignees are defeated based

simply on who is prosecuting the actions. Sometimes the actions are brought by lenders who

foreclosed on the actions, and other times the actions are dismissed because the "causes of

action" were "sold" to third parties. Since either action ends the suit, the defendant (creditor)

can walk away with no liability to the estate or its creditors.

This recently occurred in <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Metal Brokers International Inc., 225 B.R 920 (Bankr. E.D.

Wis. 1998)</a>. The chapter 7 trustee sold the rights to three preference claims for $15,000. The

assignee then filed a preference action against one of the targets who filed a motion to dismiss

based on the assignee's lack of standing. Understandably, the assignee responded that the

transfer had been authorized by the court where the preference suit was then pending.

The court dismissed the preference adversary proceeding on the grounds that the assignee lacked

standing to pursue it, relying on <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Xonics Photochemical Inc., 841 F.2d 198, 202 (7th Cir.

1988)</a> and <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Vitreous Steel Products Co., 911 F.2d 1223, 1230-31 (7th Cir. 1990)</a>.<a href="#1" name="1a">1</a>

Responding to the argument that the court had already effectively ruled that the assignment

could be made (and implicitly that it would be effective), the court distinguished its ruling

allowing the transfer of the cause of action. It ruled that the preference target's due process

rights to challenge standing could not be waived by the bankruptcy court. While the court could

allow the chapter 7 trustee to sell (by a type of quit claim) the ligation rights, it could not

simultaneously prevent the preference target from raising the assignee's lack of standing as

part of its defense—particularly where the target never received notice of the proposed

assignment.

Other cases where avoidance actions by assignees were dismissed or otherwise disposed of

include <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re North Atlantic Millwork Corp., 155 B.R. 271, (Bankr. D. Mass. 1993)</a>, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re AK

Services Inc., 159 B.R. 76, (Bankr. D. Mass. 1993)</a> and <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re S&D Foods Inc., 110 B.R. 34

(Bankr. D. Colo. 1990)</a>. Contrary cases allowing an assignee to pursue avoidance actions include

<a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Professional Investment Properties of America, 955 F.2d 623 (9th Cir. 1992), cert.

denied, 506 U.S. 818, 113 S.Ct. 63, 121 L.Ed.2d 31 (1992)</a>.

<h3>Recovery Solely for Lender's Benefit</h3>

A case with a peculiar twist<a href="#2" name="2a">2</a> had the secured lender (Congress Financial Corp.) asserting a

claim to the proceeds of the trustee's preference claims. When the chapter 7 trustee did not

respond to the adversary proceeding, judgment in Congress' favor was entered. The trustee then

filed a preference suit against AJC International and others that was met by a motion to dismiss.

The court, relying on <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §550</a>, analyzed the case on the issue of whether the preference

recovery would benefit the estate. Following authorities on the question of whether a recovery

will benefit the estate was evaluated on a case-by-case basis,<a href="#3" name="3a">3</a> and the court outlined a

three-prong analysis of (1) whether it was a chapter 7 or 11 trustee, (2) whether secured

creditors had a claim to the recovery, and (3) whether the unsecured creditors would benefit

from the recovery.

The type of bankruptcy was significant because it had been held that a chapter 7 trustee was to

safeguard unsecured creditors' rights and not work solely for the secured creditors. It had

already been adjudicated that Congress had a lien on the recovery. The trustee and Congress

agreed that the recovery would go to Congress and would not benefit the unsecured creditors.

In dismissing the adversary proceeding with prejudice, the court distinguished between the

avoidability of the preference and the ability to recover the property. Since the property could

only be recovered under <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §550</a> and there was no benefit to the estate from avoiding the

transfer, the adversary proceeding was dismissed.

<h3>Not All Assignments Are Prohibited</h3>

The distinction drawn between chapter 7 and 11 cases is critical. Chapter 11 includes a

provision in <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §1123</a> that allows a plan of reorganization to include a provision for

retaining and enforcing causes of action by the reorganized debtor, a trustee or "a

representative of the estate appointed for such purpose."<a href="#4" name="4a">4</a> This provision has been relied upon

in cases where a liquidating trustee was appointed to liquidate the estate pursuant to a plan of

reorganization.<a href="#5" name="5a">5</a>

<h3>Reacting to Proposed Pledge or Sale of Preference Actions</h3>

The effect of a sale or pledge of preference causes of action remains in flux. Consequently, the

debtor's attorney described above was correct to raise the issue. Having been raised, the real

question is how creditors should respond to a proposal that includes selling or pledging

avoidance powers.

As with most things in life, reacting to a proposed pledge or sale of preference action depends

upon the facts of the specific case. If your unsecured creditor clients received substantial

preferential payments during the 90 days before bankruptcy, they might be eager to have

preference claims end up somewhere other than in the hands of the DIP or trustee. Such a

transfer could give them a defense they would not otherwise have. In fact, some creditors might

encourage a sale of the causes of action to give them the best of both worlds—cash for the estate

(from the buyer) and a new defense to the preference suit.

On the other hand, if your clients did not receive payments during the 90 days before the

bankruptcy and are relying on preference recoveries for a distribution, they would probably

oppose the pledge or sale since it could actually reduce the estate through releasing causes of

action. Either way, creditors should consider the pleadings coming across their desks in these

cases to learn the effects of each.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Where a creditor receives standing to prosecute avoidance and other action for the benefit of the estate, courts have upheld that delegation of the trustee's powers. See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re

Natchez Corp., 953 F.2d 184 (5th Cir. 1992)</a>, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re The Gibson Group Inc., 66 F.3d 1436 (6th Cir. 1995)</a> and <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Vogel Van & Storage, 210 B.R. 27 (N.D.N.Y. 1997)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Credit Corp. v. AJC Intl., 186 B.R. 555 (D. P.R. 1995)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Pearson Industries Inc., 178 B.R. 753 (Bankr. C.D. Ill. 1995)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §1123(b)(3)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Texas General Petroleum Corp., 52 F.3d 1330 (5th Cir. 1995)</a>; <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Mako Inc., 985 F.2d 1052 (10th Cir. 1993)</a>; In re Sweetwater, 994 F. 2d 1323 (10th Cir. 1989); and

<a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Chase & Sanborn Corp., 813 F2d 1177 (11th Cir. 1987)</a>. <a href="#5a">Return to article</a>

Journal Authors

John D. Penn

Journal Date

Thursday, April 1, 1999 - 12:00