Trustee Allowed to Sue for Fraudulent Transfer on an Unenforceable Contract

Even if a contract is unenforceable under state law, a bankruptcy trustee still has the ability to recover the value provided by the debtor as a constructive fraudulent transfer, according to Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y.

The corporate debtor had a contract with a municipality to build sidewalks and curbs for the city. To be enforceable under state and municipal law, the original contract had been subjected to competitive bidding and was approved by the town board.

About two weeks after the original contract expired, the debtor agreed to build more sidewalks and curbs for a price of about $450,000. Once the new job was completed and the time for payment arrived, the city refused to pay, citing state law and the lack of approval of the new agreement by the town board. According to the city, the local laws are designed to prevent corruption and favoritism.

Before bankruptcy, the debtor sued in state court, seeking a money judgment for the $450,000 called for in the new agreement. Before the suit was resolved, the debtor filed a chapter 11 petition and removed the action to bankruptcy court. The bankruptcy court granted the city’s motion for mandatory abstention, returning the suit to state court.

Back in state court, the judge granted the city’s motion to dismiss because the agreement was unenforceable under local and state law. The state judge said that the public interest in preventing collusion precluded the debtor from enforcing the contract.

Meanwhile, the chapter 11 case had been converted to chapter 7, and a trustee was appointed. The trustee commenced an adversary proceeding in bankruptcy court against the town under Section 544, seeking the same $450,000 and alleging that the debtor’s uncompensated work was a constructive fraudulent transfer under the New York Debtor & Creditor Law. (The transfers occurred more than two years before filing, preventing the trustee from suing under Section 548. Thus, the trustee used his status as a creditor under Section 544 to sue under state fraudulent transfer law.)

The city filed a motion to dismiss the adversary proceeding, contending that the state’s interest in preventing corruption and collusion was superior to the right of a trustee to recover avoidable transfers under Section 544. The city also contended that the Rooker-Feldman doctrine was the death knell of the suit in bankruptcy court.

On several grounds — including federal preemption and the inapplicability of Rooker-Feldman — Judge Grossman denied the motion to dismiss in an opinion on July 10.

Preemption

The city argued that Congress did not intend for trustees to violate state law by relying on the Bankruptcy Code. Judge Grossman countered by saying that the suit would not compel the city to violate state law. Rather, he said that the suit was designed to recover property for which the city gave no consideration.

Judge Grossman then ruled that the Bankruptcy and Supremacy Clauses in the U.S. Constitution meant that the Bankruptcy Code and Section 544 preempted state law under the rubric of “conflict preemption.” He said that “the interests protected by these state laws must be subservient to [the avoidance powers in Section 544], which promote the objectives of protecting a debtor’s creditors from harm as a result of transfers made by a debtor for less than fair consideration.”

He went on to say that “the public’s health and safety is not at risk if the Trustee is permitted to recover the value of the materials and labor provided to the town” under Section 544 and New York’s fraudulent transfer law.

Rooker-Feldman

Next, the city argued that the trustee’s suit should be dismissed for lack of jurisdiction under the Rooker-Feldman doctrine. Named for two Supreme Court decisions, Rooker-Feldman stands for the proposition that federal courts lack subject matter jurisdiction to review judgments by state courts. It means that a plaintiff cannot appeal a state court judgment in federal court.

Judge Grossman rejected the Rooker-Feldman argument, wrapping himself in the flag sewn last year by the Third Circuit in In re Philadelphia Entertainment & Development Partners, 879 F.3d 492 (3d Cir. 2018). To read ABI’s report on Philadelphia Entertainment, click here.

For starters, Judge Grossman said that Rooker-Feldman might not even apply because courts “routinely” hold that the doctrine is not relevant when the Bankruptcy Code is modifying or avoiding a state court judgment under Sections 544 or 548.

Even if it were applicable, Judge Grossman explained why Rooker-Feldman did not kick in: The bankruptcy court would not be disturbing the findings by the state court. Citing Philadelphia Entertainment, he said that the “trustee was not inviting review and rejection” of the ruling in state court.

Instead, the trustee is seeking “recovery for the materials and labor provided by the Debtor without the benefit of a contract.”

Issue and Claim Preclusion

Next, Judge Grossman dismissed the city’s contentions based on issue and claim preclusion, which he referred to as collateral estoppel and res judicata.

Judge Grossman “easily rejected” collateral estoppel because the Section 544 claim could not have been asserted in state court. Moreover, the state court did not consider the “identical issue” of dealing with fraudulent transfer law and the trustee’s right to sue under Section 544.

Likewise, res judicata did not apply, because the lawsuit in state court was not between the same parties and did not entail the same causes of action. Even if the trustee were in privity with creditors whose claims he was asserting under Section 544, the suit in state court did not concern fraudulent transfer claims.

Substantive Law

The city contended that New York law on fraudulent transfer does not allow recovery for personal services.

Because the debtor was a corporation, Judge Grossman said the suit sought to recover for materials and labor provided by third parties, not personal services.

Judge Grossman denied the motion to dismiss. The gist of the opinion implies that the city will have few defenses when there is a trial on the merits of the fraudulent transfer claim. Because the trustee is not suing under contract, the trial may boil down to a dispute about damages.

Observation: A mediated settlement would be a good idea, unless the city is intent on taking federal preemption and Rooker-Feldman to the Second Circuit.