Consider the following situation: A debtor owes you $1 million, and you find out that the debtor has transferred its assets to a third party without receiving reasonably equivalent value and is now unable to pay its debt to you. If you are in one of the many states that has adopted the Uniform Fraudulent Transfer Act for avoiding such transfers, the next step may be to file a fraudulent transfer action.[1] But what happens if the debtor files for bankruptcy? As the Third Circuit’s recent decision in In re Allen[2] highlights, whether the automatic stay[3] will preclude you from pursuing the third-party recipient of the fraudulent transfer will likely depend on the jurisdiction in which the debtor filed for bankruptcy.
Section 362 provides, in relevant part, that the filing of a bankruptcy petition operates as a stay of “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.”[4] Thus, if the fraudulent transfer action is deemed property of the estate, the automatic stay may prevent you from pursuing or continuing to pursue the action if already commenced. The Bankruptcy Code defines property of the estate in part under § 541(a)(1) as “all legal or equitable interests of the debtor in property as of the commencement of the case,” and under § 541(a)(3) as “[a]ny interest in property that the trustee recovers under [certain] section[s] … of this title.”[5] According to courts in the Fifth,[6] Sixth[7] and now Third[8] Circuits, an actual recovery is not required for a fraudulent transfer claim to be considered property of the estate, so actions by creditors to recover funds transferred to third parties in state court may be barred by the automatic stay. In other jurisdictions, such as the Second[9] and Tenth[10] Circuits, courts have reached the opposite conclusion.
Courts that require a recovery of property in order for property to be part of the debtor’s estate base their decisions in part on the perceived inconsistency between § 541(a)(1) and (a)(3), and the rule of statutory interpretation that “[i]n general, ‘the plain meaning of [a statute] should be conclusive, except in the rare cases in which the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters.’”[11] The Second Circuit holds that “‘[i]f property that has been fraudulently transferred is included in the section 541(a)(1) definition of property of the estate, then section 541(a)(3) is rendered meaningless with respect to property recovered pursuant to fraudulent transfer actions.’”[12] “Further ‘the inclusion of property recovered by the trustee pursuant to his avoidance powers in a separate definitional subparagraph clearly reflects the congressional intent that such property is not to be considered property of the estate until it is recovered.’”[13] “Although, section 541 is very broad … it plainly does not include fraudulently transferred property until the property is recovered. Therefore, because the statute’s plain meaning is not demonstrably at odds with Congress’s intent, it should control.”[14]
Courts requiring recovery have also noted that § 541(a)(1) defines the estate as including all legal or equitable interests. “Reading ‘equitable title’ to include any property a trustee merely alleges to have been fraudulently transferred would violate the concept of equity.”[15] “[A] mere allegation, without [a] showing of merit, cannot create ‘equitable title.’”[16] “[O]ne of the fundamental principles [of] equity jurisprudence is … that before a complainant can have [ ] standing in court, he must first show that … [he has] a good and meritorious cause of action….”[17] In other words, something more than a bald assertion that the property belongs to the estate is required.
Courts that have held to the contrary have focused on the net effect to the policies of the Bankruptcy Code. “The scope of the automatic stay under section 362 [ ] depends both upon the policies expressed in the Bankruptcy Code, considered as a whole, and upon the particular meaning of the phrase ‘all legal or equitable interests of the debtor in property.’”[18] “This result also does the most to further the fundamental bankruptcy policy of equitable distribution among creditors.… Actions for the recovery of the debtor’s property by individual creditors under state fraudulent conveyance laws would interfere with th[e] estate and with the equitable distribution scheme dependent upon it.… Any other result would produce near anarchy where the only discernible organizing principle would be first-come-first-served.”[19] “To allow a creditor of the bankrupt to pursue his remedy against third parties on a fraudulent transfer theory would undermine the Bankruptcy Code’s policy of equitable distribution by allowing the creditor ‘to push its way to the front of the line of creditors.’”[20]
Courts that have not required actual recovery for claims to be considered property of the estate have also found instruction in the plain language of § 541, finding that requiring actual recovery would render the statute internally inconsistent.[21] “Subsection (a) provides that the estate includes property ‘wherever located and by whomever held.’ If ‘recovers’ is interpreted as requiring actual possession, it would render the ‘wherever located and by whomever held’ language superfluous, since actual possession would mean that no one but the trustee could ever possess estate property.”[22]
The Fifth Circuit also relied on the Supreme Court’s analysis of property of the estate where property otherwise belonging to a debtor has been seized by a creditor. The Fifth Circuit noted that the Supreme Court has stated that the definition of property of the estate includes “any property made available to the estate by other provisions of the Bankruptcy Code.”[23] “Thus, property fraudulently conveyed and recoverable under the Bankruptcy Code provisions remains property of the estate and, if recovered, should be subject to equitable distribution under the Code.”[24]
Effect of In re Allen on the Conflicting Landscape
As discussed above, the effect of a debtor filing for bankruptcy on a state fraudulent transfer action against third parties ultimately depends on the jurisdiction in which the debtor seeks bankruptcy protection. While In re Allen adds the Third Circuit to those jurisdictions not requiring actual recovery to preclude the action, it also raises a potential new battlefield in jurisdictions where recovery is required: What constitutes recovery?
The Third Circuit found that even if recovery were required, obtaining a judgment without collection on the judgment was sufficient to be considered recovered.[25] It went on to observe that “neither the Second, Fifth, nor Tenth Circuit decisions addressed the crucial question in this case — what it means to “recover” fraudulently transferred property for purposes of section 541(a)(3). Instead, the courts … looked to whether funds remained property of the debtor’s estate under section 541(a)(1) absent the recovery provision in section 541(a)(3).”[26] With the Third Circuit holding that obtaining a judgment without physical recovery is sufficient to be considered recovered for the purpose of § 541(a)(3),[27] this leaves open the possibility that jurisdictions requiring recovery may find that “recovery” is something short of physical recovery.
[1] The Uniform Fraudulent Transfer Act allows for certain remedies against the property transferred to third parties if it can be proven that the transfer was made with actual intent to defraud or that the transfer was constructively fraudulent. See, e.g., Cal. Civ. Code § 3439-3439.12, Fla. Stat. ch. 726.101-112, Minn. Stat §§ 513.41-51.
[2] In re Allen, 768 F.3d 274 (3d Cir. 2014).
[3] 11 U.S.C. § 362.
[4] 11 U.S. C. § 362(a)(3).
[5] 11 U.S.C. § 541(a)(1) and (a)(3).
[6] Am. Nat’l Bank of Austin v. MortgageAmerica Corp. (In re MortgageAmerica Corp.), 714 F.2d 1266 (5th Cir. 1983).
[7] National Labor Relations Board v. Martin Arsham Sewing Co., 873 F.2d 884 (6th Cir. 1989).
[8] In re Allen, 768 F.3d 274.
[9] Federal Deposit Insurance Corp. v. Hirsch (In re Colonial Realty Co.), 980 F.2d 125 (2d Cir. 1992).
[10] Rajala v. Gardner, 709 F.3d 1031 (10th Cir. 2013).
[11] Rajala, 709 F.3d at 1038, citing United States v. Ron Pair Enters. Inc., 489 U.S. 235, 242 (1989).
[12] In re Colonial Realty Co., 980 F.2d at 131 quoting In re Saunders, 101 B.R. 303, 305 (Bankr. N.D. Fla 1989).
[13] Id.
[14] Rajala, 709 F.3d at 1038.
[15] Id. at 1038, citing Michael R. Cedillos, Note, Categorizing Categories: Property of the Estate and Fraudulent Transfers in Bankruptcy, 106 Mich. L. Rev. 1405, 1416-17 (2008).
[16] Id. at 1038.
[17] Id. at 1038, quoting Keystone Drillers Co. v. Gen. Excavator Co., 290 U.S. 240, 244 (1933).
[18] In re MortgageAmerica, 714 F.2d at 1274 quoting 11 U.S.C. § 541.
[19] Id. at 1275-76.
[20] National Labor Relations Board v. Martin Arsham Sewing Co., 873 F.2d at 888, citing In re Central Heating & Air Conditioning Inc., 64 B.R. 733, 737 (N.D. Ohio 1986).
[21] In re Allen, 768 F.3d at 283.
[22] Id.
[23] National Relations Board, 873 F.2d at 887 quoting United States v. Whiting Pools Inc., 462 U.S. 198, 205.
[24] Id.
[25] In re Allen, 768 F.3d at 282.
[26] Id.
[27] Id.