The Fifth Circuit handed down an opinion on June 27 expounding on a sometimes overlooked aspect of Section 544(a): The strong arm power on occasion can enable a chapter 11 debtor to retain property, not just avoid transfers or obligations.
The opinion by Circuit Judge W. Eugene Davis also demonstrates how Louisiana law can lead to surprising results.
A landowner sued in Louisiana state court and recorded a lis pendens, alleging that an operator of an oil and gas lease had breached the lease. The landowner wanted the court to dissolve or terminate the lease.
Just before trial, they settled by signing a written agreement where the operator paid $650,000 in cash and gave the landowner an installment promissory for $1 million. The parties recorded a lease ratification that recited that the lease was affirmed and ratified. For consideration, the ratification recited “the promises and covenants exchanged below, and other good and valuable consideration . . . , the receipt and sufficiency of which is hereby acknowledged . . . .”
The recorded ratification said nothing about the installment note or the $1 million obligation.
When the second payment of $100,000 was due on the note, the operator filed a chapter 11 petition. In bankruptcy court, the landowner filed a motion asking the judge to compel assumption or rejection of the lease as an executory contract. Alternatively, the landowner wanted the judge to dissolve the lease on account of the debtor’s nonpayment, thus stripping the lease out of the debtor’s chapter 11 estate.
The bankruptcy judge ruled that the lease was not an executory contract because no obligations remained aside from the payment of money. With regard to dissolving the lease, the bankruptcy judge concluded that the landowner could not overcome the recitation in the lease ratification that the consideration had been paid in full.
The district court affirmed, and so did the Fifth Circuit. In his 17-page opinion, Judge Davis said the appeal dealt with the “interplay” between the strong arm power in Section 544(a) and Louisiana law.
Section 544(a) provides that a trustee (or a chapter 11 debtor) “shall have . . . the rights and powers of, or may avoid any transfer . . . or any obligation incurred by the debtor that is voidable by . . . (3) a bona fide purchaser of real property” who obtains and perfects that status as of the commencement of the case, whether or not such a purchaser actually exists.
The landowner argued that the strong arm power only enables a chapter 11 debtor to avoid transfers or obligations. To the contrary, Judge Davis said that reading “is much too narrow.” Rather, he said that Section 544(a) endows a debtor in possession “with ‘the rights and powers’” that “it would have as a bona fide purchaser of the debtor’s interests” in the lease.
Having established that the debtor had the rights of a good faith purchaser of the lease, Judge Davis turned to the consequences of the recorded documents. In that regard, he said that the Fifth Circuit had previously held in In re Zedda, 103 F.3d 1195, 1201–02 (5th Cir. 1997), that a bona fide purchaser under Section 544(a) qualifies as a third person under Louisiana law.
From that point on, it was downhill for the landowner, because Louisiana law provides that any documents altering an interest in real property must be recorded to be effective against a third party, such as a chapter 11 debtor in possession.
In analogous Louisiana cases “where a conveyance record indicates that consideration has been paid in full,” Judge Davis said that “a third party is not susceptible to the remedy of dissolution, which would be available between the original contractual parties.”
In other words, the debtor in chapter 11 had more rights than the debtor possessed before bankruptcy. Although the debtor had defaulted on the note, Judge Davis said that the debtor in possession had the status of a “hypothetical bona fide purchaser [who] may avoid the result of dissolution because the public record indicates that consideration has been fully paid.”
Unable to dissolve the lease, the landowner ended up with nothing more than a $900,000 general unsecured claim.