The Ninth Circuit created a split of circuits with the Seventh by holding that the waiver of sovereign immunity under Section 106(a)(1) enables a trustee to file a derivative suit against the Internal Revenue Service for receipt of a fraudulent transfer under Section 544(b)(1).
The issue is important because the outcome determines whether a trustee can ever mount a fraudulent transfer action under state law against governmental units, in this case the IRS.
“Before the Seventh Circuit’s opinion, the bankruptcy courts were unanimous in their conclusion that 106 fully waives sovereign immunity under 544(b) — hopefully the Ninth Circuit will reassure them that was the right result,” Prof. Stephen J. Lubben of Seton Hall University School of Law told ABI in an email. In support of the trustee, Prof. Lubben submitted an amicus brief for the National Association of Bankruptcy Trustees.
The Facts
Operated as a Ponzi scheme, the debtor was a so-called subchapter S corporation that paid the IRS about $17 million on account of taxes owing by its shareholders. Under a confirmed chapter 11 plan, the trustee for a creditors’ trust sued the IRS to recover the payments.
The IRS conceded that it was liable under Section 548(a)(1)(B) for receipt of fraudulent transfers amounting to about $56,000 made within two years of bankruptcy. The government acknowledged that the waiver of sovereign immunity made the IRS subject to suit for fraudulent transfer within the ambit of the Bankruptcy Code.
To recover the remainder of the $17 million, the trustee also sued under Idaho’s version of the Uniform Fraudulent Transfer Act, invoking Section 544(b)(1), which requires the existence of an actual, unsecured creditor who could have sued under state law. The trustee relied on Section 544(b) because Idaho law has a four-year statute of limitations, compared with only two years under the Bankruptcy Code.
The government filed a motion for summary judgment on the Section 544(b)(1) claim, because any creditor would have been barred by sovereign immunity from suing the government for receipt of a fraudulent transfer. The district court granted the trustee’s cross motion for summary judgment, holding that Section 106(a)(1) waived sovereign immunity for derivative fraudulent transfer claims brought under Section 544(b)(1).
Section 106(a)(1) provides that “sovereign immunity is abrogated as to a governmental unit . . . with respect to” Section 544, among others.
The Ninth and Seventh Circuits Split
Upholding the district court in an Aug. 31 opinion by Circuit Judge Richard Z. Paez, the Ninth Circuit held that the Section 106 waiver permits suits under Section 544(b)(1), in the process creating a split of circuits with the Seventh Circuit in In re Equipment Acquisition Resources Inc., 742 F.3d 743 (7th Cir. 2014).
In EAR, the Chicago-based court held that the waiver of immunity does not extend to Section 544(b)(1) suits because any actual creditor would have been barred from suing by the government’s sovereign immunity. Judge Paez said he could find no other circuit decisions on the question.
Plain Language, Logic and Equity
Judge Paez relied on logic and the language of the statute, in particular the phrases in Section 544(b)(1) that allow a trustee to “avoid any transfer” that is “voidable under applicable law.” He said that Section 544(b)(1) “does not exist in a vacuum; rather, it must be read in concert with other sections of the Bankruptcy Code,” such as Section 106(a)(1), which “unambiguously abrogates the federal government’s sovereign immunity ‘with respect to Section 544.’”
Reading the two sections together, Judge Paez said that the abrogation of sovereign immunity is “absolute” and “thus necessarily includes the derivative state law claim on which a Section 544(b)(1) claim is based.”
In terms of logic, Judge Paez said that the government’s argument “would essentially nullify Section 106(a)(1)’s effect on Section 544(b)(1), an interpretation we should avoid.” He also said, “It would defy logic to waive sovereign immunity as to a claim which could not be brought against the government.”
Differing with the Seventh Circuit, Judge Paez appealed to a sense of equity. The Bankruptcy Code, he said, was drafted to put the IRS “on an equal footing with all other creditors.” He said “it would be unfair for the governmental unit to participate in the distributions in a bankruptcy case while at the same time shielding itself from liability,” quoting the Tenth Circuit from In re Franklin Savings Corp., 385 F.3d 1279, 1290 (10th Cir. 2004).
Saying that the waiver of immunity applies, Judge Paez held that “a trustee need only identify an unsecured creditor, who, but for sovereign immunity, could bring an avoidance action against the IRS.”
The Second Issue
The case involved another issue. In a separate, nonprecedential opinion, the Ninth Circuit remanded that facet of the case to the district court.
From the $17 million found to be avoidable, the district court had held that the trustee could not recover $3.6 million that the IRS had refunded to shareholders before bankruptcy as overpayment of taxes.
In the separate per curiam opinion, the appeals court said that the trustee’s appeal from that feature of the lower court’s decision turned on whether the IRS was an initial transferee under Section 550(a)(1). The circuit remanded because the district court had employed the “control test” rather than the Ninth Circuit’s “more restrictive dominion test.”