Split Heading to the Tenth Circuit on Sovereign Immunity for Section 544(b) Claims

The Internal Revenue Service seems to be setting up the Tenth Circuit to take sides on the following circuit split:

Does the waiver of sovereign immunity under Section 106(a)(1) bar a trustee from suing the government under Section 544(b) for receipt of a fraudulent transfer based on state law?

In 2017, the Ninth Circuit held in Zazzali v. U.S. (In re DBSI Inc.), 869 F.3d 1004 (9th Cir. Aug. 31, 2017), that the waiver of sovereign immunity under Section 106(a)(1) allows a trustee to file a derivative suit against the IRS for receipt of a state-law fraudulent transfer under Section 544(b)(1). To read ABI’s report, click here.

The Ninth Circuit had split with a Seventh Circuit opinion rendered three years earlier, In re Equipment Acquisition Resources Inc., 742 F.3d 743 (7th Cir. 2014). The Chicago-based appeals court had reasoned 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.

The same issue is coming up in the Tenth Circuit from a district court decision in favor of the trustee finding a waiver of sovereign immunity.

Same Facts as DSBI

A corporation filed a chapter 11 petition in 2017. The case was converted to chapter 7.

More than three years before bankruptcy, the corporation had paid the IRS about $150,000, representing tax liabilities for two individuals who were officers, directors and shareholders of the debtor corporation.

Utilizing Section 544(b)(1), the chapter 7 trustee sued the IRS to recover the payments as fraudulent transfers under Utah’s version of the Uniform Fraudulent Transfer Act.

The IRS agreed that the debtor corporation received no value and that the debtor was insolvent at the time of the transfer. The IRS also conceded there was an unsecured creditor in existence at the time who still held an allowable claim at the time of bankruptcy, to supply the requirement of an actual creditor under Section 544(b)(1).

The IRS argued, however, that no actual creditor could exist because any actual creditor would be barred from suing the government under the doctrine of sovereign immunity.

Bankruptcy Judge R. Kimball Mosier of Salt Lake City ruled in favor of the trustee on motion for summary judgment. Miller v. United States (In re All Resort Group Inc.), 617 B.R. 375 (Bankr. D. Utah 2020).

The IRS appealed but lost again in an opinion on September 8 by District Judge Bruce S. Jenkins.

Judge Jenkins adopted Bankruptcy Judge Mosier’s memorandum decision and order and affirmed “for the reasons set forth” by Judge Mosier.

We shall therefore discuss the opinion by Judge Mosier. To read Judge Mosier’s opinion in full text, click here.

Same Facts as DBSI

The circumstances before Judges Mosier and Jenkins were the same as in DBSI, except that the IRS was held liable in the Ninth Circuit where the stakes were larger. In DBSI, the IRS was nailed for $17 million in fraudulent transfers resulting from tax payments made by a corporation on behalf of shareholders. In the Utah case, the trustee was only after $150,000.

After losing in the Ninth Circuit, the IRS twice sought and obtained extensions of time from the Supreme Court for filing a petition for certiorari that would have raised the split with the Seventh Circuit. Ultimately, either the IRS or the U.S. Solicitor General decided against filing a ‘cert’ petition.

The IRS was represented before District Judge Jenkins by attorneys from the Tax Division of the Justice Department in Washington. With comparatively few dollars in the balance, it’s a reasonable assumption that the IRS will appeal to the Tenth Circuit, aiming for a result like the Seventh Circuit’s.

Win or lose, an enlarging circuit split may spin off a petition for certiorari to come before the Supreme Court in the term to begin in October 2022.

The Arguments on Sovereign Immunity

The Bankruptcy Code of 1978 contained a waiver of sovereign immunity, but the Supreme Court held that the waiver was not “unequivocally expressed.” United States v. Nordic Village Inc., 503 U.S. 30, 33. (1992). Congress legislatively overruled Nordic Village in the Bankruptcy Reform Act of 1994 by rewriting Section 106(a) entirely and listing 59 sections of the Bankruptcy Court as to which sovereign immunity was “abrogated as to a governmental unit.”

Section 544 is one of the listed sections.

Judge Mosier acknowledged the spilt among the circuits and among lower courts with regard to the waiver of immunity for state-law claims under Section 544(b). He framed the question as whether the waiver extends to claims under state law.

Further complicating the question, the trustee admitted that sovereign immunity would have barred the “actual” creditor from suing the IRS if there were no bankruptcy. In other words, could there be an actual creditor to satisfy the requirement in Section 544(b) if no actual creditor could have sued successfully before bankruptcy?

Judge Mosier held that “the plain text of § 106(a)(l) unequivocally abrogates sovereign immunity as to the underlying state law cause of action.” The statute, he said, “contains no exceptions, qualifiers or carve-outs in its language.”

Regarding the disability of the actual creditor to sue the IRS on its own, Judge Mosier said it has no bearing on the availability of that defense against a trustee inside bankruptcy.

Judge Mosier buttressed his conclusion by legislative history and the “goal of estate maximization.”

Preemption

The IRS made a second argument: federal “field” preemption.

The IRS Code would not allow someone to sue the IRS to recover funds voluntarily paid by someone else. The IRS therefore argued that Utah fraudulent transfer law intruded into an area exclusively controlled by federal law.

Judge Mosier saw no federal preemption. To begin with, the trustee’s claim was under federal law, namely Section 544(b). Second, the trustee was not aiming to recover a tax payment. The trustee was after a fraudulent transfer.

Judge Mosier granted the trustee’s motion for summary judgment and denied the IRS’s cross-motion for summary judgment. He held that “§ 106(a)( 1) unequivocally waives the federal government's sovereign immunity with respect to the underlying state law causes of action incorporated through § 544(b) and that the IRC does not preempt such claims.”