28: AVOIDING POWERS – OVERVIEW, TRUSTEE AS SUCCESSOR, STRONG ARM CLAUSE© CHARLES TABB 2010

WHAT IS “AVOIDANCE”?

Set aside, invalidate A transfer by or obligation of Dr

Based on one of the powers given trustee in 544-549

EFFECTS: AVOID OUTRIGHT TRANSFER

If avoidance is of an outright transfer of property, then the trustee will then seek to recover the property transferred or its value

EFFECTS: AVOID A LIEN

If lien is avoided, then effect is simple: the lienholder loses its lien, and becomes unsecured

The property is no longer subject to the lien

WHAT IS “RECOVERY”?

“Recovery” is the trustee’s attempt to recover the transferred property, or its value, following the avoidance of the transfer

Under 550

FROM WHOM MAY TRUSTEE RECOVER?

Under 550(a)(1): 1st : from the “initial transferee” of the

avoided transfer, or, alternatively, 2nd, from the entity for whose benefit that

transfer was made For example, if Dr pays off a guaranteed debt,

also “benefits” the guarantor, who is no longer liable

Trustee has choice – but of course only a single satisfaction possible, 550(d)

Liability absolute under 550(a)(1)

FROM WHOM?

Under 550(a)(2): from a subsequent transferee i.e., Not the initial transferee, but down the line

More protections for subsequent transferees: 1st – if took in good faith, for value, and w/o

knowledge that transfer was voidable – immune from recovery, 550(b)(1)

2nd –if take from a protected transferee – and if in good faith, also immune, 550(b)(2) Concept of derivative title

502(H) CLAIM

If entity is subjected to recovery of an avoided transfer, then it has a general unsecured claim in bankruptcy case is that amount, 502(h)

Restores status quo ante

Example: Cr paid $10K preference – avoided & recovered in bk case – so now Cr has $10K claim again (just as it would have if had not been paid preference in the 1st place)

WHAT IS “PRESERVATION”?

“preservation” of avoided transfer ensures that the estate actually will capture the economic value of that avoided transfer by stepping into the transferee’s shoes

Example: property worth $20K, subject to two liens: a senior lien

for $10K, and junior lien for $25K senior lien, but not the junior lien, is avoided Without preservation, nothing would be left for the

estate, b/c 2nd lien of $25k would take entire $20K value With preservation under 551,though, the estate takes

the place of the avoided senior lien. I.e., estate steps into 1st lien’s shoes and is entitled to the first $10K of value in the property (the amount of the senior lien avoided), and the junior lien takes the residue.

VOIDABLE, NOT VOID

Avoiding powers must be exercised by trustee bringing a lawsuit in the bankruptcy case

Are not self-executing

i.e., transfers subject to avoidance are “voidable” and not “void”

STATUTES OF LIMITATIONS

Under avoiding powers for pre-petition transfers (e.g., 544, 545, 547, 548, 553):

General rule (546(a)(1)) Later of: 2 years after bk filing,

Or One year after trustee 1st appointed, if appointed

before 2 years is up --

Absolute cutoff (546(a)(2)) – when bk case is closed or dismissed

LIMITATIONS, CONT.

For avoidance of a post-petition transfer (549):

Two years after the date of that transfer, and before the case is closed or dismissed (549(d))

LIMITATIONS, CONT.

For a recovery action – one year after transfer avoided, and before case closed or dismissed, 550(f)

VIDEO DEPOT –RECOVERY FROM WHOM?

Facts: Jeffrey Arlynn Prez of Video Depot, Ltd. Arlynn, personally, ran up huge gambling debts

at Las Vegas Hilton June 1990 – Arlynn caused Video Depot to

purchase a cashier’s check for $65K payable to Hilton – check shows Video Depot as the purchaser of the check

Arlynn delivered cashier’s check to Hilton Sept. 1990 Video Depot filed bankruptcy Trustee sought to avoid transfer of cashier’s

check as a fraudulent transfer, and to recover the $65k from Hilton

ISSUE IN VIDEO DEPOT

Was the Hilton the “initial” transferee of the cashier’s check, and thus absolutely liable under 550(a)(1), or was it a subsequent transferee under 550(a)(2), and thus potentially protected if a good faith transferee for value and without knowledge under 550(b)(1)?

INITIAL VS SUBSEQUENT TRANSFEREE

Initial transferee – absolute liability Subsequent transferee – protected if

innocent and gave value

Reason? Ability to monitor – put duty of inquiry (and risk) on the party who deals with the fraudulent transferor

But not hold downstream transferees to same duty, b/c (i) would interfere with free flow of commercial transactions and (ii) not in a position to monitor original fraud

HILTON ARGUED?

Hilton said it was a subsequent transferee (from Arlynn), and was innocent of the fraud, and gave Arlynn value (the debt was paid)

i.e., Hilton theory:Video Depot Arlynn Hilton

HILTON “INITIAL” TRANSFEREE

Court held: Hilton initial transferee and thus absolutely liable

Video Depot Arlynn Hilton

WHY?

Why did court hold that Hilton was initial transferee and thus absolutely liable?

FORM: Cashier’s check

Video Depot Arlynn Hilton

Monitoring – didn’t Hilton wonder why it got a $65K cashier’s check from Video Depot to pay Arlynn’s debt??

IS ARLYNN ALSO LIABLE?

Note that the bankruptcy trustee ALSO could have gotten recovery from Arlynn under 550(a)(1)

He was the entity “for whose benefit” the transfer from Video to Hilton was made b/c his debt was getting paid off!

CHECK TO ARLYNN 1ST?

Would result be different if Video Depot wrote a check payable to Arlynn, who then endorsed it over to Hilton?

check endorsed

Video Depot Arlynn Hilton

CHANGES RESULT

If instead Video Depot had written check payable to Arlynn (not the Hilton) and Arlynn then endorsed over to the Hilton, then for sure Arlynn would be the initial transferee, and Hilton a subsequent transferee (from Arlynn)

Arlynn would have had “dominion and control” over the check made payable to him

And policy served as well – now Hilton is getting a check from Arlynn (their Dr) and not from Video Depot – so less (no?) reason for them to monitor the Video Depot-to-Arlynn transfer

OVERVIEW OF AVOIDING POWERS

Basic premises & goals:1st, facilitate & maintain integrity of

bankruptcy as a collective proceeding – protect Crs from each otherPreserve equality paradigm

Avoid transfers that undermine, recover value

invalidate secret liens & transfers

2nd, protect creditors from Dr (fraudulent transfer law)

OVERVIEW

“equality” based avoiding powers The most fundamental aspect of bankruptcy as a

collective proceeding is to promote equal treatment of all similarly situated parties – rather than the “race” of non-bankruptcy law So if some creditors get paid (especially if see

bankruptcy coming), and others don’t, have to unwind those transfers and restore equality

Avoiding powers:Preferences (547) – paid in 90 days before bkSetoff (553(b)) – within 90-day periodPost-bankruptcy (549)Statutory liens (545(1))

OVERVIEW

“Secret” transfers & principle of ostensible ownership

If parties could deal with Dr in private, but not record liens or property transfers in public records, and yet later enforce those liens or transfers anyway, then other creditors of Drs would potentially be misled to their detriment as to the true state of Dr’s finances

Avoiding powers: Strong-arm clause (544(a)) – not filed in public records at

time of bankruptcy Preference (547) – not in public records until last 90 days Statutory liens (545(2)) - unrecorded

OVERVIEW

Independent of collective proceeding (cr v cr) – focus is on protecting creditors as a group from a naughty Dr

Fraudulent transfer law

Avoiding powers: 548 – bankruptcy fraudulent transfer law 544(b) – incorporate state fraudulent transfer

laws

TRUSTEE AS SUCCESSOR, 544(B)

Criteria 1st, an actual unsecured Cr who has standing to

bring an avoidance power under non-bk law (typically state law)

2nd, that Cr still has an unsecured claim in the bankruptcy case

In short – Trustee under 544(b) takes over that avoidance power from the unsecured cr and exercises for benefit of the estate

544(B) ROLE

Most important application – bring state fraudulent transfer laws into the trustee’s avoidance arsenal

Biggest difference in state fraudulent transfer laws and bk law (548) – much longer reachback period (e.g., 4 years, not 2)

MOORE V BAY

Cryptic & much-maligned – but reaffirmed by Congress in 1978 – decision of the Supreme Ct by J. Holmes in 1931 (at age 90 – and it showed!)

Problem is what to do when a transfer is avoidable under non-bk law by some -- but not all – of the unsecured creditors

2 questions: 1st – extent of avoidance? 2nd – who shares in the distribution of recovery?

MOORE

Facts: Delay in recording a chattel mortgage Under state law, creditors whose claims arose before

recordation (Group A) had priority over the mortgagee, while those whose claims arose after (Group B) did not

The lower courts held (1) that avoidance was possible only up to amount of claims held by Group A creditors, and (2) that distribution should go only to those Group A creditors

The Supreme Court reversed: (1) amount – avoid entire mortgage, (2) distribution to groups A and B

PROBLEM 9.1 Facts:

Dr has total of $20k in unsecured claims when it files bankruptcy

Three years prior to filing bankruptcy, Debtor made a constructively fraudulent transfer of property worth $18K to Party X

Only remaining creditor in the bankruptcy with standing to avoid the old transfer to X under the state fraudulent transfer law is Creditor A (who had a “present” claim at the time of the transfer to X). A’s claim is just $100.

The rest of the Debtor's creditors, with total claims of $19,900, had “future” claims and thus could not have avoided the transfer to X under state law.

9.1

$18,000 transfer to X

A $100

$19,900 unsecured claims other than Creditor A

9.1 ISSUE ONE

How much avoid?

Options: Just the amount A itself could avoid (e.g., $100) The whole transfer (e.g., $18K)

Result?

avoid the entire transfer

Serious bummer for X!

9.1 ISSUE TWO Who gets the distribution of the recovery?

Options: Just A (i.e., the only party who could have gotten

the distribution outside of bk) All unsecured crs

Result?

goes to all unsecured creditors – even including those who could not have reached the $ outside of bankruptcy

* another of those blatant bankruptcy wealth redistribution rules

STRONG ARM CLAUSE

General policy – set aside secret (i.e., not recorded in the public records) liens and transfers, as of the date the bankruptcy is filed

Implements notion of ostensible ownership Renders actual that which was apparent

STRONG ARM – 3 PARTS

544(a)(1) – trustee as lien Cr – avoid unperfected personal property security interests

544(a)(2) – trustee as unsatisfied execution Cr (just ignore this one – never comes up in real world)

544(a)(3) – trustee as bona fide purchaser of real property – avoid unrecorded real estate mortgages and transfers

STRONG ARM – KEY ASPECTS

1st: time frame – when bankruptcy is commenced

2nd: trustee = hypothetical lien creditor or bfp i.e., do not need an actual lien creditor or bfp,

unlike 544(b)

3rd: knowledge of trustee is irrelevant i.e., trustee is conclusively deemed not to have

knowledge

4th: avoid under applicable nonbankruptcy law, usually state law (e.g, Article 9 UCC)

TRUSTEE AS LIEN CREDITOR

544(a)(1) – trustee given power of lien cr

Important to knock out unperfected security interests in personal property

REPRISE, UCC 9-317(A)(2)

Critical priority rule in Article 9 given effect in bankruptcy via § 544(a)(1) is the rule of U.C.C. § 9-317(a)(2):“A security interest … is subordinate to the rights of … a person who becomes a lien creditor before … the security interest … is perfected.”

Thus, under Article 9 a lien creditor takes priority over an unperfected security interest

UCC RULE APPLIED IN 544(A)(1)

Applying UCC 9-317(a)(2) to strong arm clause leads to result that bankruptcy trustee, who has powers of “lien creditor” under § 544(a)(1), will be able to avoid a security interest that is unperfected at the time of bankruptcy. By inference, under the strong arm clause the

trustee will not be able to avoid a security interest that is perfected at the time of bankruptcy.

Decisive issue will be whether the security interest was perfected at the instant the bankruptcy case was filed

PURCHASE MONEY EXCEPTION

U.C.C. § 9-317(e) -- secured party has grace period of 20 days to perfect a PMSI after the debtor takes possession of the collateral perfection within grace period is deemed to relate

back to the time security interest attaches

Thus, if SP with PMSI has not yet perfected when bankruptcy is filed, but is still within the applicable relation-back grace period, SP is permitted to perfect within the grace period and upon doing so is not vulnerable to strong-arm avoidance Note that the postpetition perfection of the security

interest would not violate the automatic stay. § 362(b)(3).

PROBLEM 9.2(A)

Facts: On May 1, Debtor grants Creditor a security

interest in tangible personal property worth $10,000 to secure a $10,000 debt

On May 10, Debtor files chapter 7 Creditor has not perfected its security interest by

May 10

ANALYSIS 9.2(A)

Avoid Cr’s security interest under 544(a)(1)

CR had not perfected at time of bankruptcy

Thus trustee as a hypothetical “lien creditor” would be able to beat Cr (under 9-317(a)(2))

9.2(B)

Facts: On May 1, Debtor grants Creditor a security

interest in tangible personal property worth $10,000 to secure a $10,000 debt

May 9 Creditor perfects On May 10, Debtor files chapter 7

ANALYSIS 9.2(B)

Not avoid

At time bankruptcy was filed, Cr was perfected, so would defeat a “lien cr” whose rights arose at time of bk (inference from 9-317(a)(2))

9.2(C)

Facts: May 1 Debtor granted Creditor a mortgage in

real property worth $10,000 to secure a $10,000 debt

May 10 Debtor filed chapter 7 Creditor had not recorded mortgage in real

property records by May 10, when Debtor filed Under state law, a bona fide purchaser for

value without actual knowledge of an unrecorded conveyance of real estate would take free of that conveyance, but a judgment creditor that obtains a judicial lien on a debtor’s real property is not considered a bona fide purchaser

ANALYSIS 9.2(C)

Not avoid under 544(a)(1)

Under the state recording statute, a “lien cr” does NOT beat an unrecorded mortgage

9.2(D)

Facts: May 1, Creditor sells Debtor a gizmo on credit

and Debtor grants Creditor a purchase money security interest in the gizmo to secure the payments. Debtor takes possession of the gizmo immediately.

May 5, Debtor files chapter 7 May 8, Creditor files a financing statement

perfecting the security interest

ANALYSIS 9.2(D)

Not avoid

Creditor as holder of a PMSI has 20-day grace period of 9-317(e) to perfect, and when does so on May 8 (which, note, may do w/o violating stay, 362(b)(3)), perfection relates back to time of attachment on May 1

So is as if WAS perfected at time of bankruptcy (once allow relation-back perfection)

TRUSTEE AS BONA FIDE PURCHASER

Rule: trustee is given power of a hypothetical bona fide purchaser of real property

Important to knock out unrecorded real estate mortgages and conveyances

ISSUES UNDER BFP CLAUSE

1st, what if Dr as DIP DOES have actual knowledge of transfer, and state law would not allow avoidance by party w/ knowledge

2nd, can a transferee who doesn’t record still be protected by constructive notice?

3rd, DR holds bare legal title, subject to equitable interests, but that limited status is not recorded – can trustee as bfp defeat equitable interests? Seen as possible conflict 544(a)(3) vs 541(d)

ACTUAL KNOWLEDGE OF DIP

1st case is easy – even though under state law a bfp who had actual knowledge of an unrecorded mortgage or conveyance could not get priority over that unrecorded interest, the strong arm clause invests the trustee (or DIP) with status of a hypothetical bfp without knowledge Even if the particular DIP happens to have actual

knowledge – which it would since it made the transfer!

But are treating Dr/DIP as the estate representative And if DID appoint a trustee, then that trustee in

fact would NOT have actual knowledge

So can still avoid – ignore actual knowledge

CONSTRUCTIVE NOTICE

What if state law would accord priority over a bfp to a transferee who had not recorded, BUT who had done something that would provide constructive notice? Example – adverse possession

Does the strong arm clause negation of “knowledge” go this far?

NO – could not avoid – give effect to a notice that is good against the world In effect here have a substitute for recordation

STRONG ARM VS 541(D)??

Situation: Dr holds just legal title to real property at time of

bankruptcy, subject to superior equitable interests.

However, that limited title is not recorded And under state law, a bfp w/o knowledge could

defeat unrecorded equitable interests

Can trustee avoid equitable interests?

Concern raised – 541(d) – estate only got Dr’s limited property interest, and this conflicts with 544(a)(3)

FALSE CONFLICT

There actually is no conflict between 541(d) and 544(a)(3)

1st, one of the functions and effects of avoiding powers is to bring property into estate that previously was not there

2nd, as statutory matter, have provision bringing into property of the estate (541(a)(3)) any property that trustee recovers under 550 Which would include strong arm recoveries

BUT ARGUABLY 544(A)(3) N/A EITHER

Note, though, that in the Dr-has-bare-legal-title case, even though 541(d) is not a concern, it seems that avoidance might not be warranted under 544(a)(3) anyway.

Why not? -- the language empowers the trustee to “avoid any transfer of property of the debtor” and in retained legal title cases there is no operative transfer BY the debtor Indeed there may be a transfer TO the debtor

(e.g., from investors)

WHY HAVE BFP STRONG ARM CLAUSE? Effect – transfer property from holder of unrecorded

real estate interest to unsecured creditors of estate

At least plausible justification for lien cr rule (544(a)(1)), b/c a general unsecured Cr possibly COULD beat an unperfected security interest (by getting a judicial lien, e.g., execution lien) So effect of strong arm is to call it a “tie”

But unsecured creditors CANNOT defeat unrecorded real property interests – not in the protected class why give “unsecured creditors” the fruits of the

powers of a bona fide purchaser?

PROBLEM 9.3(A)

Facts: (same as 9.2(c)) May 1 Debtor granted Creditor a mortgage in

real property worth $10,000 to secure a $10,000 debt

May 10 Debtor filed chapter 7 Creditor had not recorded mortgage in real

property records by May 10, when Debtor filed Under state law, a bona fide purchaser for

value without actual knowledge of an unrecorded conveyance of real estate would take free of that conveyance, but a judgment creditor that obtains a judicial lien on a debtor’s real property is not considered a bona fide purchaser

ANALYSIS 9.3(A)

Avoid 544(a)(3) Even though could not avoid under 544(a)(1),

recall, from 9.2(c)

Under bfp rule, though, the state law says that an unrecorded mortgage loses to a bfp

And trustee takes those bfp powers in 544(a)(3)

9.3(B)

Facts: Debtor conveys Blackacre to X, but the

conveyance is not recorded. Under state law, a bona fide purchaser for value

without actual knowledge of an unrecorded conveyance of real estate would take free of that conveyance.

Debtor files chapter 7.

ANALYSIS 9.3(B)

Avoid unrecorded conveyance, recover property (or its value) from X

Again, 544(a)(3) gives trustee bfp status, and state law says bfp wins

9.3(C)

Facts: Debtor conveys Blackacre to X, but the

conveyance is not recorded. Under state law, a bona fide purchaser for value

without actual knowledge of an unrecorded conveyance of real estate would take free of that conveyance.

Debtor files chapter 11 and continues as DIP.

ANALYSIS 9.3(C)

Avoid Same analysis exactly as 9.3(b)

No difference that Dr as DIP is avoiding

Fact that DR / DIP itself had “actual knowledge” of transfer is ignored under 544(a)

9.3(D)

Facts: Debtor conveys Blackacre to X, but the

conveyance is not recorded. However, X takes up residence on Blackacre. Under state law:

a bona fide purchaser for value without actual knowledge of an unrecorded conveyance of real estate would take free of that conveyance.

BUT a purchaser who establishes "clear and open possession" provides constructive notice to the world of the purchaser's interest.

Debtor files chapter 7.

ANALYSIS 9.3(D)

NOT avoid

Constructive notice from possession, which is recognized and given effect under state law, precludes avoidance under 544(a)(3)