Bankruptcy Trustee May Sell State-Law Avoidance Claims, Jones Day Business Restructuring Review

In In re Moore, the Fifth Circuit Court of Appeals recently addressed two issues that have created a split of authority among the federal circuits: (i) whether a trustee in bankruptcy may sell causes of action that arise from the trustee's avoidance powers under section 544(b) of the Bankruptcy Code; and (ii) whether the proposed settlement of an avoidance action should be scrutinized under section 363(b) as well as Rule 9019 of the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules") because a creditor offered to purchase the claim for more than the proposed settlement amount. 

The Trustee's Avoidance Powers

Among the powers conferred upon a bankruptcy trustee or chapter 11 debtor in possession ("DIP") under the Bankruptcy Code is the ability to avoid asset transfers that are either actually or constructively fraudulent. Section 548 of the Bankruptcy Code provides in part that the trustee can avoid any transfer made, or obligation incurred, by the debtor in the two years preceding a bankruptcy filing if it is effected with the "actual intent to hinder, delay, or defraud" creditors. Section 548 also authorizes avoidance of certain transfers made or obligations incurred in the absence of intent as constructive fraudulent transfers.

Transfers may also be avoided under applicable state law by operation of section 544(b) of the Bankruptcy Code. Section 544(b) allows a DIP or trustee to "avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim" against the debtor. The primary advantage of this provision over section 548 is that a two-year reach-back period from the petition date applies to actions brought under section 548. By contrast, many state fraudulent-conveyance laws (in most jurisdictions, a version of the Uniform Fraudulent Transfer Act) provide for a longer statutory reach-back period.

Compromise and Settlement in Bankruptcy

Bankruptcy Rule 9019 provides a framework for bankruptcy-court review of settlements of claims or causes of action in a bankruptcy case. It provides in part that "[o]n motion by the trustee and after notice and a hearing, the court may approve a compromise or settlement." The purpose of the rule is to allow the trustee or DIP, subject to court review, to avoid the expenses and burdens associated with litigating sharply contested and dubious claims. Rule 9019 is silent, however, on the standard the court should apply in determining whether to approve a proposed settlement. The courts have devised a number of different tests designed to gauge the reasonableness and fairness of settlements proffered by a bankruptcy trustee or DIP.

Moore

In In re Moore, the chapter 7 trustee filed a motion for approval of a settlement of an adversary proceeding commenced against the debtor, his wife, and two affiliated companies that were allegedly alter egos of the debtor (collectively, the "defendants") by a prepetition judgment creditor of the debtor, The Cadle Company ("Cadle"). Cadle had sued the defendants in state court in 2005, attempting to collect the judgment and asserting claims of reverse veil piercing, fraudulent conveyance, and constructive trust. After the debtor filed a chapter 7 case in Texas in 2006, Cadle removed the state-court claims, which became part of the debtor's bankruptcy estate, to the bankruptcy court, where the litigation continued as an adversary proceeding with the trustee substituted as plaintiff. Cadle, however, continued to fund the litigation due to the absence of sufficient estate assets.

Upon learning of the proposed settlement, Cadle filed an objection and offered to purchase the causes of action from the trustee for an amount slightly greater than the proposed settlement offer. After concluding that, as a matter of law, the claims could not be sold, the bankruptcy court approved the proposed settlement as being fair and reasonable and in the best interests of the estate pursuant to Bankruptcy Rule 9019. The district court affirmed on appeal.

The Fifth Circuit's Decision

Cadle appealed to the Fifth Circuit. A three-judge panel of the court ruled that both the reverse veil-piercing and fraudulent-conveyance claims were property of the estate that could be sold, and it therefore reversed the bankruptcy court's ruling and remanded the case below for further proceedings. In addition, the Fifth Circuit ordered the bankruptcy court to consider the propriety of an auction and section 363 sale procedures in light of Cadle's offer to purchase the claims, as well as the propriety of the settlement of the claims under Bankruptcy Rule 9019.

Section 544(b) Claims Can Be Sold

With respect to whether the claims could be sold, the Fifth Circuit began its analysis by considering whether the reverse veil-piercing and fraudulent-conveyance claims were property of the debtor's estate. Previous cases under Texas state law, the court explained, have established that both veil-piercing and reverse veil-piercing claims are property of a debtor's bankruptcy estate under section 541 of the Bankruptcy Code, rather than assets of individual creditors. By contrast, the Fifth Circuit explained that there is conflicting authority under its own precedent as to whether state-law fraudulent-transfer claims may be property of a debtor's estate under section 541.

The Fifth Circuit panel emphasized that deeming a claim belonging exclusively to a creditor prior to the commencement of a bankruptcy case property of the debtor's estate would conflict with the general rule that a cause of action is part of a debtor's estate only if the debtor could have prosecuted the action immediately prior to filing for bankruptcy. The court proceeded to analyze whether a fraudulent-transfer claim may become property of a debtor's estate pursuant to section 544(b) and, if so, whether such a cause of action may be sold.

As noted, section 544(b) generally provides that a bankruptcy trustee may prosecute under applicable nonbankruptcy law avoidance claims of creditors holding allowable unsecured claims against the estate. Thus, the Fifth Circuit panel remarked, "[t]he right to recoup a fraudulent conveyance, which outside of bankruptcy may be invoked by a creditor, is property of the estate that only a trustee or debtor in possession may pursue once bankruptcy is under way."

There is, however, a split of authority on whether a trustee or DIP may sell a state-law fraudulent-transfer action back to a creditor after the commencement of a bankruptcy case. On the one hand, the Ninth Circuit held in In re P.R.T.C., Inc. in 1999 that such actions can be sold or transferred. On the other, the Third Circuit ruled in In re Cybergenics Corp. the following year that the power to avoid a debtor's prepetition transfers and obligations to maximize the value of the bankruptcy estate for the benefit of creditors pursuant to section 544 of the Bankruptcy Code "neither shift[s] ownership of the fraudulent transfer action to the debtor in possession, nor [constitutes] a debtor's assets" and therefore cannot be sold or transferred.

The Fifth Circuit followed the Ninth Circuit's approach. The court reasoned that fraudulent-transfer claims are property of the estate under section 541(a)(1) or, in the alternative, become property of the estate pursuant to section 544(b) and may therefore be sold pursuant to section 363(b) of the Bankruptcy Code, which authorizes the trustee DIP to sell estate assets outside the ordinary course of business, after notice and a hearing. According to the Fifth Circuit panel, the ability to sell fraudulent-transfer claims is generally consistent with: (i) the ability of a trustee or DIP in section 1123(b)(3)(B) to transfer the right to exercise avoidance powers under a chapter 11 plan; (ii) the right of a single creditor to prosecute an avoidance action on behalf of the estate after court approval under the principle of "derivative standing"; and (iii) the reimbursement of creditors for successfully pursuing, at their own risk and expense, a transfer avoidance action for the benefit of the estate pursuant to section 503(b)(3)(B).

Settlement Subject to Scrutiny Under Section 363(b)

Whether a proposed settlement of estate claims should be analyzed as a sale transaction under section 363(b) is likewise subject to a split of authority. In 1998, for example, the First Circuit concluded (without analysis) in In re Healthco Int'l Inc. that a settlement should not be subjected to scrutiny as a sale, whereas the Third Circuit and a Ninth Circuit bankruptcy appellate panel ruled to the contrary in In re Martin and In re Mickey Thompson Entm't Group, Inc., respectively.

In Moore, the Fifth Circuit panel determined that subjecting a proposed settlement to scrutiny under section 363(b) and Bankruptcy Rule 6004 (delineating procedural requirements for a proposed use, sale, or lease of estate property) as well as Bankruptcy Rule 9019 is the better-reasoned approach. According to the court, although the decision to implement formal sale/auction procedures when considering a settlement of claims should remain in the discretion of the bankruptcy court, under the specific facts of Moore, the offer from the debtor's major creditor to purchase claims for a higher amount than the proposed settlement "obligated the bankruptcy court to consider whether an auction and § 363 sale were appropriate." The bankruptcy court's failure to do so, the Fifth Circuit panel observed, meant that "the true value of the claims [remained] undetermined" and was an abuse of discretion.

However, the court limited the scope of its ruling to "causes of action that [the trustee] has inherited from creditors under § 544(b)—causes of action that exist independent of the bankruptcy proceeding." It expressly declined to address "the broader question [of] whether a trustee may sell all chapter 5 avoidance powers, such as the power to avoid preferences under § 547 or to avoid fraudulent transfers under § 548."

Outlook

The Fifth Circuit's ruling in Moore adds another chapter to the continuing controversy regarding a bankruptcy trustee's ability to sell estate claims and the standards that should be applied by bankruptcy courts in assessing proposed compromises designed to augment the pool of assets in the bankruptcy estate available for distribution to creditors. At its most basic level, the ruling adopts a practical approach to a common problem in many bankruptcy cases—a shortage of estate assets to bankroll litigation that may represent the only realistic chance for creditor recoveries. In cases where the estate cannot bear the costs of prosecuting colorable claims, the only alternative may be a sale of the claims to generate cash.

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Cadle Co. v. Mims (In re Moore), 608 F.3d 253 (5th Cir. 2010).

Ducker Spradling & Metzger v. Baum Trust (In re P.R.T.C., Inc.), 177 F.3d 774 (9th Cir. 1999).

Official Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery (In re Cybergenics Corp.), 226 F.3d 237 (3d Cir. 2000).

Hicks, Muse & Co., Inc. v. Brandt (In re Healthco Int'l Inc.), 136 F.3d 45 (1st Cir. 1998).

Myers v. Martin (In re Martin), 91 F.3d 389 (3d Cir. 1996).

Goodwin v. Mickey Thompson Entm't Group, Inc. (In re Mickey Thompson Entm't Group, Inc.), 292 B.R. 415 (Bankr. 9th Cir. 2003).