The First Circuit penned an opinion on April 18 saying that a transfer under Maine law of a debtor’s fully encumbered property is not a transfer of an asset belonging to the debtor that can be the subject of a fraudulent transfer suit.
The appeal arose in the liquidation of Montreal, Maine & Atlantic Railway Ltd., whose runaway train derailed and killed 48 people in Lac-Megantic, Quebec, in July 2013. The catastrophe was not the subject of the case. Rather, the dispute revolved around a refinancing some two years before bankruptcy.
The Federal Railroad Administration had a senior lien on all of MM&A’s tracks. The collateral, however, was worth less than the debt owing to the FRA. To obtain additional capital, the debtor arranged to sell some of the tracks to the State of Maine. Obviously, the transaction required the FRA’s approval and release of lien.
The FRA attached several conditions to the close of the sale and the release of its lien. Those conditions included holding the proceeds in escrow until the conditions were met, a partial paydown of the FRA’s debt, and granting the FRA a replacement lien.
Some $3 million of the proceeds were applied to a partial paydown of a line of credit owing to another railroad that allegedly was an insider. The other railroad did not have a lien on the tracks being sold.
In bankruptcy, the trustee sued the alleged insider under Maine’s version of the Uniform Fraudulent Transfer Act, contending that the paydown of the line of credit was a constructively fraudulent transfer. The trustee relied on a unique provision of Maine law that makes a transfer to an insider a constructively fraudulent transfer if the transfer was in satisfaction of an antecedent debt, the debtor was insolvent, and the insider had reasonable cause to believe the debtor was insolvent.
Upheld on the same grounds in district court, the bankruptcy court dismissed the suit, reasoning that the transfer of fully encumbered assets did not entail a transfer of assets belonging to the debtor.
The lower courts, like the First Circuit, focused on another unique provision in Maine law that says that property of a debtor does not include “property to the extent that it is encumbered by a valid lien.”
First Circuit Judge Bruce M. Selya upheld the lower courts without delving into the question analyzed in the lower courts about the time when the FRA released its lien. Even if the lien had been released at the time of the transfer, he said that the “debtor did not hold an interest in that property that is voidable under Section 544(b).”
Judge Selya said that the transaction was akin to a bailment, adding that the FRA “held title to the [tracks] as a mortgagee.” The FRA, he said, “controlled” the sale of the tracks. Whatever label might be applied to the transaction, the judge said “that the debtor could not have put the proceeds to any use that was not authorized by the FRA.”
Having determined the nature of the transaction under Maine law, Judge Selya next addressed federal law to decide whether the transaction involved a transfer of the debtor’s assets.
When the debtor holds funds “as a mere disbursing agent,” he said that the trustee cannot avoid a transfer because the debtor would have been prevented from putting the money to use except as provided in the contract. The debtor, he said, “lacked a cognizable property interest” in the proceeds.
The tracks being sold, Judge Selya said, “were not ‘assets’ that belonged outright to the debtor . . . , but, rather were subject to the FRA’s mortgage and lien.”
The resulting limitations on the “scope of the bankruptcy estate,” he said, “make good commercial sense.” They “prevent unsecured creditors from sharing funds that the debtor could not have retained for its own use.”
The transaction, Judge Selya said, was “not a case in which a debtor decides to sell his assets and divert proceeds to pay certain creditors to the detriment of others. Instead, it is a case in which the senior lienholder imposes conditions that preclude the debtor from exercising effective control over the sale proceeds.”
According to Judge Selya, the proceeds paid to the holder of the line of credit “did not consist of property of the debtor’s estate.”
Properly speaking, the decision should only apply to cases involving Maine’s definition of a debtor’s assets, which excludes assets subject to liens. Unfortunately, the opinion does not explicitly say the result stems entirely from Maine’s unique law, and it contains statements, like those above, that might be transported to cases involving fraudulent transfers under Section 548 or state laws that are similar to the Bankruptcy Code’s.
Ponder the implications of the holding if it were invoked in cases under Section 548. If fully encumbered assets are not assets of the debtor, then, presumably, the automatic stay would not apply. And neither fraudulent transfers nor preferences could result from transfers of liened property.
We predict that the opinion will be the topic of much discussion, analysis and citation for erroneous principles outside of Maine’s unique law.