Can’t Touch This: Pre-Petition Liens Fail to Reach Chapter 5 Actions

By Hannah W. Hutman

The Fifth and Eighth Circuits1 have joined the Ninth Circuit in holding that chapter 5 causes of action are estate property and, as such, may be sold. Extrapolating from the circuit courts’ reliance on § 541(a)(1) and the conclusion that a debtor has some sort of an interest in chapter 5 causes of action pre-petition, some lenders reasoned that their pre-petition liens attached to these causes of action such that they would not be available as unencumbered estate property for chapter 7 trustees to liquidate. Hon. Thad J. Collins of the U.S. Bankruptcy Court for the Northern District of Iowa2 crushed the hopes of these lenders in In re BDC Group Inc. by holding that nothing in the Fifth or Eighth Circuit decisions reverses the well-established law that pre-petition liens on “general intangibles” do not extend to chapter 5 causes of action.3

Selling Chapter 5 Actions as Property of the Estate

To understand Chief Judge Collins’s decision, a review of the circuit decisions that preceded it is helpful. Starting with the Eighth Circuit, the chapter 7 trustee in In re Simply Essentials determined that the estate did not have sufficient funds to pursue certain avoidance actions that the estate may have had against Pitman Farms, the owner of the debtor and a creditor.4 In an effort to maximize the benefit to the estate, the trustee sought bids to sell the actions, receiving bids from Pitman Farms and another creditor, ARKK Food Co. LLC.5 The trustee determined that ARKK’s offer was superior and filed a motion to approve a compromise and sale, which the bankruptcy court approved.6 Pitman Farms appealed.7

The only issue on appeal was “whether avoidance actions can be sold as property of the estate,” addressing specifically § 541(a)(1) and (7).8 “Subsection (1) states property of the estate includes: ‘all legal or equitable interests of the debtor in property as of the commencement of the case.’ Subsection (7) states property of the estate includes ‘[a]ny interest in property that the estate acquires after the commencement of the case.’”9 In affirming the bankruptcy court that avoidance actions are property of the estate that may be sold, Hon. Michael J. Melloy of the Eighth Circuit Court of Appeals provided a review of what comprises property of the estate under these subsections.

Rejecting Pittman Farms’ argument that “avoidance actions belong to the Trustee or to other creditors and are not property of the estate,” Judge Melloy emphasized that “[w]hether the avoidance action is brought by the trustee or by a creditor, the action is brought for the benefit of the estate and therefore belongs to the estate.”10 The Eighth Circuit relied on the U.S. Supreme Court’s broad definition of “property of the estate” in United States v. Whiting Pools Inc. wherein the Court stated that § 541(a)(1) may “include in the estate any property made available to the estate by other provisions of the Bankruptcy Code.”11 It is unnecessary for the debtor to hold a “possessory interest in the property at the commencement of the reorganization proceedings.”12 Relying on these principles, the Eighth Circuit found that “[b]ecause debtors have the right to file for bankruptcy and the debtor in possession [DIP] or the Trustee may file avoidance actions to recover property, the debtor has an inchoate interest in the avoidance actions,” which interest becomes property of the estate under § 541(a)(1).13

Turning to § 541(a)(7), the Eighth Circuit further found that the actions would “clearly qualify as property of the estate” as an “‘interest in property that the estate acquires after the commencement of the case.’”14 “To the extent that Pitman Farms argue[d that] the property [was] created in a third period of time, a time that is equivalent to the moment the bankruptcy proceeding commence[d],” the Eighth Circuit disagreed and found that this “[f]inding ... ‘would frustrate the bankruptcy policy of a broad inclusion of property in the estate.’”15

Pitman Farms argued that the bankruptcy court’s interpretation would create surplusage in § 541, because subsections (a)(3) and (a)(4) specifically bring in property from some avoidance actions. However, “given the drafting history and the complex nature of the Bankruptcy Code,” the Eight Circuit held that “the possibility of ... creating surplusage” did not change its decision.16

Pitman Farms finally attempted to argue that “allowing the sale of avoidance actions would violate the trustee’s fiduciary duty or undermine the purpose of avoidance actions.”17 The Eighth Circuit swiftly rejected this argument, finding that the trustee must maximize the value of the estate, and that when an estate cannot afford to pursue certain actions, “the best way to maximize the value of the estate is to sell the actions.”18 Ultimately persuaded by the consensus of courts across the country that avoidance actions are property of the estate and as such may be sold, the Eighth Circuit affirmed the order approving the trustee’s sale.19

The Fifth Circuit Confirms that Chapter 5 Causes of Action Are Property of the Estate

A few months after the Eighth Circuit addressed the issue, the Fifth Circuit joined in holding “that preference actions may be sold pursuant to 11 U.S.C. § 363(b)(1) because they are property of the estate under 11 U.S.C. §§ 541(a)(1) and (7).”20 Prior to bankruptcy, South Coast Supply Co. borrowed funds from its then-chief financial officer (CFO),21 who subsequently resigned and demanded payment on his note. South Coast filed a voluntary chapter 11 petition in the Southern District of Texas.22

During the pendency of the case, South Coast filed a preference suit against the former CFO under § 547.23 The plan that was ultimately confirmed provided for South Coast to transfer the cause of action against the former CFO to a pre-petition secured lender.24 In exchange, the pre-petition secured lender waived its lien on $700,000 in collateral and waived its right to pursue an administrative claim.25

Notably, the lender had no obligation to return anything to the debtor if it were to recover more than its secured claim.26 The plan was confirmed over the former CFO-turned-preference-defendant’s objection.27

Eleven days before the preference action trial (and three years following confirmation of the plan and substitution as assignee of the secured lender as plaintiff), the former CFO filed a motion to dismiss under Rule 12(b)(1) of the Federal Rules of Civil Procedure.28 The district court29 agreed with the former CFO, “holding that since a successful recovery would not benefit South Coast’s estate or its unsecured creditors, [the secured lender] lacked standing to bring the preference claim against [the former CFO] as a representative of the estate under 11 U.S.C. § 1123(b)(3)(B) of the Bankruptcy Code.”30 Therefore, the district court dismissed the suit for lack of subject-matter jurisdiction, and the secured lender appealed.31

Hon. James L. Dennis of the U.S. Court of Appeals for the Fifth Circuit noted at the outset of his analysis that the dispositive issue on appeal was “whether preference claims — a type of avoidance action — may validly be sold.”32 The court ultimately held that preference actions may be validly sold and that the secured lender had standing to bring the action.33 In reaching this decision and reversing the district court, the Fifth Circuit examined the definition of “estate property” in much the same fashion as the Eighth Circuit in Simply Essentials.

The court noted that the definition of “property of the estate” is very broad, and that “the conditional, future, speculative, or equitable nature of an interest does not prevent it from being property of the bankruptcy estate.”34 The court found that preference actions fall within the scope of § 541(a)(1) as being a cause of action that is “created by federal bankruptcy law to avoid a transfer of property.”35 The court noted that “claims to avoid allegedly preferential transfers arise with the filing of the bankruptcy petition, making them property that the debtor has an interest in as of the commencement of the case.”36

Finding that preference actions fit the statutory definition of “property of the estate,” the court further concluded that they may be validly sold under § 363(b).37 The court further found that preference actions also qualify as property of the estate under § 541(a)(7).38

The court stated that its decision was bolstered by other courts around the country, specifically the Eighth and Ninth Circuits.39 The court agreed with the reasoning in Simply Essentials that selling avoidance actions can be consistent with a trustee’s duties to maximize the value of the estate.40 The Fifth Circuit adopted a broad view of what benefits the estate.41

A Lender Still Cannot Have a Lien on Chapter 5 Causes of Action

Following the Simply Essentials and South Coast decisions, the door appeared to have been opened to allow lenders to assert that their pre-petition blanket liens would therefore encumber avoidance actions arising under chapter 5. After all, if a debtor has some sort of “inchoate” interest in these actions prior to filing for bankruptcy, the debtor must be able to pledge that interest, right? Is this interest sufficient to allow the future debtor to grant a lien prior to bankruptcy or sufficient to allow the lender’s lien to attach prior to bankruptcy? Chief Judge Collins said “no.”

In In re BDC Group Inc., Chief Judge Collins found that nothing in Simply Essentials changed well-established case law holding that “a pre-petition lien does not attach to rights or actions by the trustee of a bankruptcy estate that did not exist prior to the bankruptcy filing.”42 In analyzing the inchoate rights of a debtor discussed in Simply Essentials, Chief Judge Collins found that that rights were limited “to something that is essentially legal — a right to file [for] bankruptcy and invoke the Bankruptcy Code, including its powers to have the trustee or DIP undo debtor’s own transfers.”43 Furthermore, the court held that the debtor did not own the right to avoidance actions because the cause of action arose only after bankruptcy and “only for the trustee or [DIP] ... to pursue, and only for the benefit of the estate — not a single creditor.”44

In reaching this conclusion, Chief Judge Collins engaged in a lengthy discussion of the nature of avoidance actions and fundamental bankruptcy principles. He stated that nothing in the lender’s arguments changed the “three bedrock principles”: “(1) avoidance actions arise by statute post-petition; (2) the trustee or DIP has the sole right to pursue avoidance actions; and (3) those avoidance actions can only be pursued for the benefit of all the estate’s creditors, unless the Trustee or DIP sells them after filing.”45 Chief Judge Collins rejected the lender’s arguments as a “matter of law and common sense,”46 and ultimately noted that the Simply Essentials decision “furthered the policy of maximizing the estate for all creditors,” and that the position advanced by the lender, “in addition to being wrong as a matter of law — would do the opposite —diminish what is available to the estate” by funneling it to a single creditor.47

Chief Judge Collins went to painstaking lengths to explain the nature of a debtor’s pre-petition inchoate interest, at one point comparing the interest to a dower interest.48 Ultimately, he found the interest to be simply the right to file for bankruptcy.49 He summarily pointed out that the lender in BDC ignored the portion of Simply Essentials that also found the interest in avoidance actions to be property of the estate under § 541(a)(7).50

Conclusion

It seems that the whole issue could have been avoided had the Eighth and Fifth Circuits simply relied on § 541(a)(7) alone and found that avoidance actions are after-acquired property that arise post-petition. There was no need to find an interest under § 541(a)(1).

If the actions do not exist until after bankruptcy has been filed, the debtor cannot have an interest that could be attached by a creditor prior to filing the petition. The reliance by the Fifth and Eighth Circuits on §§ 541(a)(1) and 541(a)(7) was unnecessary and accomplished little more than providing lenders with false hope and determination to find a judge willing to read more into the elusive “inchoate interest” that has now been created.

Hannah Hutman is a partner at Hoover Penrod, PLC in Harrisonburg, Va., a member of the panel of chapter 7 trustees for the Western District of Virginia and a 2018 ABI “40 Under 40” honoree.