Why Can’t I Pursue My Fraudulent Transfer Action After Debtor’s Bankruptcy (and Other Interesting Information)

Bankruptcy practitioners will tell you that when a business declares bankruptcy, the representative of the estate, whether it is the debtor in possession or a trustee, has the right to pursue the fraudulent conveyance actions. They will also tell you that a creditor cannot pursue a fraudulent conveyance action under state law that relates to property previously transferred by the debtor corporation during the term of the bankruptcy, even if it was filed before bankruptcy. What they often don’t express, however, is why the creditor cannot pursue their fraudulent conveyance rights under state law against a non-debtor. As we will see, the reasoning behind this proposition is subject to some disagreement and may lead to some interesting questions.

Let’s use a simple assumption to define the problem. Suppose the creditor has a judgment against the company for $1 million. The company does not have enough money to pay this judgment, mainly because it transferred almost all of its cash, say $2 million, to its sole shareholder for no consideration. The creditor therefore files a fraudulent conveyance action against the shareholder.

We must take into account that the law on fraudulent state transfers is designed exactly for this circumstance. See The Uniform Fraudulent Conveyance Act, later amended as the Uniform Fraudulent Transfer Act (1984) then Uniform Voidable Transactions Act (2014) (passed by vast majority of states). It provides for a right of action by a creditor against the recipient of the fraudulent conveyance to recover the amount owed to the creditor. The underlying obligor, ie the transferor of the fraudulent transfer, is not a party to this lawsuit.

Returning to our assumption, the company files a Chapter 11 petition, which results in the immediate imposition of the automatic stay under Section 362 of the Bankruptcy Code. See 11 USC §101 et seq. (the Bankruptcy Code). The creditor’s attorney then immediately ceases pursuing the state law fraudulent conveyance action against the shareholder. The creditor, however, is furious and complains to the lawyer, “Why can’t we continue to exercise my legal right of action against a non-debtor?” Consider the decisions of appellate courts that have answered this question.

‘In re Mortgage America’

The Fifth Circuit addressed this same issue – why can’t a creditor bring a fraudulent conveyance action under state law against a nondebtor when the underlying debtor has filed for bankruptcy? – in its decisive decision, A m. Nat’l Bank of Austin vs. MortgageAmerica (In re MortgageAmerica), 714 F.2d 1266 (5th Cir. 1983). The court began its analysis by acknowledging that the automatic stay of Article 362 of the Bankruptcy Code “operates as a[n] [automatic] suspension, applicable to all legal persons, of … any act aimed at obtaining possession of the property of the estate or of the property of the estate. Identifier. at 1273 (citing 11 USC §362(a)) (brackets in original). He then focused on the term “estate property”, which under §541(a)(1) includes “all legal or equitable interests of the debtor in the property at the commencement of the matter”. . Identifier. (citing 11 USC §541(a)(1)).

Here’s the crux: The Fifth Circuit found that the debtor retains an equitable interest in the fraudulently transferred property. Identifier. at 1275. Thus, even in the hands of the transferee, the fraudulently transferred property remains the property of the estate as that term is defined in §541(a)(1). Identifier. The Fifth Circuit concluded: “The automatic stay under Section 362(a) therefore applies and prevents a creditor from continuing to pursue a [fraudulent transfer action] after filing a bankruptcy petition. Identifier.

‘In re Colonial Realty’

The Second Circuit took a decidedly different view by FDIC v. Hirsch (In re Colonial Realty), 980 F.2d 125 (2nd Cir. 1992). First, the Second Circuit disagreed with In re MortgageAmericathe finding that the debtor retains an interest in the property fraudulently transferred as estate property under section 541(a)(1). Identifier. at 131. Instead, the court held that under Section 541(a)(3) of the Bankruptcy Code, property fraudulently transferred does not become the property of the estate until it is ” recovered”. Identifier.

Next, the Second Circuit recognized that the automatic stay applies to actions “against the debtor” or “to collect a debt against the debtor.” Identifier. (citing 11 USC §362(a)(1)). The Court of Appeal noted: “This last category must include cases in which the debtor is not a defendant; otherwise it would be a total duplication of the old category and a pure surplus. Identifier. The court then concluded that an action for fraudulent transfer – even if brought against a third party – is in fact an action for the collection of a debt against the debtor because there is no independent basis to sue the assignee other than the collection of the sum owed by the debtor (and nothing more). Identifier. at 132 (adopting the reasoning of In re Saunders, 101 BR 303, 304-06 (Bankr. ND Fla. 1989)). Thus, because a creditor’s action for fraudulent transfer in recovery of property previously assigned by the debtor is an action “in recovery of a claim on the debtor”, it is subject to automatic stay. Identifier.

Recent developments?

The cases discussed above are somewhat dated –In re MortgageAmerica was decided in 1983 and In re Colonial Realty in 1992. So what has happened since then? Not that much, frankly. The tenth circuit (see Rajala vs. Gardner709 F.3d 1031, 1038 (10th Cir. 2013)) adopted the view of the Second Circuit of In re Colonial Realty. However, the sixth circuit (see NLRB vs. Martin Arsham Couture873 F.2d 884, 887 (6th Cir. 1989)) apparently adopted the Fifth Circuit view of In re MortgageAmerica. (I say “apparently” because some courts have different interpretations of the Sixth Circuit’s opinion. See Rajala vs. Gardner709 F.3d to 1038 n.4.) That said, courts generally conclude that the Second Circuit’s analysis in In re Colonial Realty is the majority opinion. See, for example, Waldron v. Dreyer (In re Huber)no. 13–04267, 2013 WL 6184986 at *3 (Bankr. WD Wash. Nov. 25, 2013) (concluding In re Colonial Realty is the majority view and more convincing); Duckworth vs. Peoria Speakeasy (In re Duckworth)no. 11-8092, 2013 WL 1397456 at *6 (Bankr. CD Ill. 5 April 2013) (identical).

The Fifth Circuit, for its part, has somewhat distorted its own MortgageAmerica To analyse. First come In re SI Acquisitionhe interpreted In re MortgageAmerica as concluding that a fraudulent conveyance action could only be asserted by a creditor and that the cause of action itself did not belong to the debtor company. To see IS Acquisition c. Eastway Delivery Serv. (In re SI Acquisition), 817 F.2d 1142, 1150 (5th Cir. 1987). However, the automatic stay applies because the action seeks to recover the assets of the estate. Subsequently, in In re Educators Group Health Trusthe clearly attributed the opposite proposition to In re MortgageAmerica that because a fraudulent conveyance action seeks to recover property that is properly owned by the debtor, the underlying cause of action must therefore belong to the debtor. To see Schertz-Cibolo-Universal City, Indep. Sch. Dist. v. Wright (In re Educators Group Health Trust), 25 F.3d 1281, 1284 and 1285 n.5 (5th Cir. 1994). More recently, in In re Moorehe had to resolve his own internal division on how to interpret In re MortgageAmerica and argued that In re Educators Group Health Trustthe interpretation of In re MortgageAmerica controlled – a fraudulent conveyance action under state law belongs to the estate. To see Le Cadle v. Moore (In re Moore)608 F.3d 253, 259 (5th Cir. 2010) (determining that the analysis in In re SI Acquisition was a saying).

Why do we care?

If all courts agree that a creditor’s fraudulent conveyance action is subject to the automatic stay, why do we care about the underlying analysis? One of the reasons is that the analysis can have an impact on other questions. The Bankruptcy Code should fit together — the concepts should carry over from issue to issue.

On the one hand, if a debtor retains an interest in property fraudulently transferred, then any action taken with respect to such property would in itself constitute a breach of the stay. So what would be the result if the transferee of the property tried to sell it? Or what would happen if a creditor of the assignee with respect to a completely unrelated debt sought to seize fraudulently transferred funds? Are these actions prohibited by automatic suspension?

On the other hand, if a fraudulent transfer procedure under state law is an action “to recover a debt against the debtor”, should this analysis apply to other situations? Should the action of a creditor to collect a guarantee from a non-debtor or to draw on a letter of credit be considered as subject to the automatic stay as an action “to recover a claim on the debtor »? (This author would disagree with this analysis, but others may find support in the reasoning of the Second Circuit.) One court grappled with such a question when a creditor asserted a claim for enrichment without cause against a non-debtor. Meoli v. The Huntington Nat’l Bank (In re Teleservices Group)463 BR 28, 34 (Bankr. WD Mich. 2012) (stating that claim against nondebtor for unjust enrichment was subject to automatic stay).

Ultimately, even if these decisions come to the same conclusion with respect to the imposition of a stay of creditors’ fraudulent conveyance actions, the reasoning of these courts does not entirely align. The conflicting parts of their analysis have an impact on our understanding of the scope of the concept of “ownership of the estate” and the concomitant application of the automatic stay in various contexts. We cannot necessarily correct all incongruities in the analysis, but we need to understand them so that incongruities can be investigated when more difficult issues arise.

James H. Millar is a corporate restructuring partner at Faegre Drinker Biddle & Reath, resident in the New York office.