On January 27, 2012, Judge Peter J. Walsh of the United States Bankruptcy Court for the District of Delaware held that states do not have sovereign immunity from fraudulent transfer actions brought by a liquidation trustee pursuant to section 544(b)(1) of the Bankruptcy Code and incorporated state laws.  Zazzali v. Swenson (In re DBSI, Inc.), 463 B.R. 709 (Bankr. D. Del. 2012).  This decision clarifies the application of the United States’ Supreme Court’s decision in Cent. Va. Cmty. Coll. v. Katz, 546 U.S. 356 (2006) to section 544 and the various state laws incorporated by a cause of action brought pursuant to that section.

The trustee of the debtors’ liquidation trust commenced an adversary proceeding to recover allegedly fraudulent transfers made by various of the debtors’ insiders to 22 states pursuant to, inter alia, section 544(b)(1) and applicable Idaho fraudulent transfer law.  Section 544(b)(1) of the Bankruptcy Code grants a bankruptcy trustee the power to “avoid any transfer of an interest of the debtor in property . . . that is voidable under applicable law by a creditor holding an unsecured claim . . . .”  11 U.S.C. § 544(b)(1).  In other words, section 544(b) allows a trustee to assert state law fraudulent transfer claims, if an actual unsecured creditor could assert the same causes of action outside of bankruptcy.

The defendant states moved to dismiss the trustee’s section 544 counts pursuant to Federal Rule of Civil Procedure 12(b)(6), arguing that the states did not waive their sovereign immunity with respect to the Idaho statutes incorporated by section 544.  In response, the trustee argued that, as provided by section 106(a)(1) of the Bankruptcy Code, state sovereign immunity is abrogated with respect to section 544 and, by implication, the applicable Idaho statutes.

The Court found that its decision in this case was controlled by Katz, where the Supreme Court held that state sovereign immunity is abrogated with respect to actions to avoid preferential transfers pursuant to sections 547(b) and 550(a) of the Bankruptcy Code.  To establish whether states’ sovereign immunity was abrogated with respect to section 544, the Court found that it must, pursuant to Katz, “determine (1) whether those who crafted the Bankruptcy Clause intended to give Congress the power to authorize courts to avoid fraudulent transfers and recover the relevant property, and (2) whether there is a relevant law on the subject of bankruptcy that Congress applied to the [states] and other creditors in the same way.”  DBSI, 463 B.R. at 712 (citing Katz, 546 U.S. at 372, 379).  Applying this standard, the Court found that the states’ sovereign immunity defense failed.

The Court first determined that “avoiding fraudulent transfers and recovering the attendant property fell within the scope of Congress’ understood authorizing power.”  Id. at 715.  The Court’s analysis was informed by the Supreme Court’s conclusion in Katz that avoiding preferential transfers was a core aspect of bankruptcy administration since at least the 18th century, and therefore the Framers would have understood that the Bankruptcy Clause grants Congress the power to authorize courts to avoid such transactions.  The Court determined that avoiding fraudulent transfers had similar historical roots (as the Supreme Court also concluded in Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 43 (1989)), and is clearly within the scope of Congress’ authorizing power under the Bankruptcy Clause.

Finally, the Court held there is a relevant law on the subject of bankruptcy that Congress applies to states and other creditors equally that authorizes courts to avoid fraudulent transfers: specifically section 106(a) of the Bankruptcy Code, which provides that state sovereign immunity is abrogated with respect to section 544.  The Court determined that section 106(a) reflected a Congressional intent that section 544 apply to both states and other creditors with equal force.  In so holding, the Court rejected the states’ argument that section 106(a)’s abrogation of sovereign immunity did not include the state law causes of action that are incorporated into section 544 (as opposed to section 544 itself), finding that because state law is a necessary element of a section 544 action, this result would be absurd and render the abrogation of sovereign immunity with respect to section 544 meaningless.  The Court also rejected the states’ argument that section 544(b)(1) is not a uniform law on the subject of bankruptcy because it permits the application of differing state fraudulent transfer laws, finding that the enforcement of varying states’ laws in bankruptcy raises no constitutional concerns and that fraudulent transfer statutes are, in any event, practically uniform amongst the fifty states.

This decision makes clear that the state sovereign immunity defense is meritless with respect to section 544 of the Bankruptcy Code.  Furthermore, by reaffirming the central tenet of Katz, that “[n]o state sovereign immunity protection exists in proceedings pursuant to laws on the subject of bankruptcies, where such laws are properly labeled,” the decision likely negates any assertion of sovereign immunity with respect to the other Bankruptcy Code sections explicitly referenced in section 106(a) of the Bankruptcy Code.