In an opinion on January 22nd, the Fifth Circuit Court of Appeals, in Matter of S. Coast Supply Co., 91 F.4th 376 (5th Cir. 2024), held that preference claims arising under 11 U.S.C. § 547 may be sold, reversing the dismissal of a complaint based on those claims for lack of subject matter jurisdiction by the district court.
Preference Actions
Preference actions are lawsuits that claim that a debtor paid a creditor preferentially over other creditors prior to a bankruptcy filing. Section 547 of the Bankruptcy Code allows a trustee (or debtor-in-possession) to avoid and recover from creditors payments made within the 90-day period before the bankruptcy filing. The policy behind this is to promote equality of distribution among creditors and to prevent aggressive collection activities, which often force a debtor into bankruptcy.
Split in Authority
Sections 547 and 550 of the Bankruptcy Code permits debtors to avoid and recover preferential transfers. Over the years, a split of authority has emerged as to whether a debtor (or trustee) may sell such avoidance actions pursuant to section 363 of the Bankruptcy Code. The Eighth and Ninth Circuits have held that preference claims are property of the estate that can be sold. In re Simply Essentials, LLC, 78 F.4th at 1011 (“Chapter 5 avoidance actions are property of the estate”); In re Lahijani, 325 B.R. 282, 288 (9th Cir. BAP 2005) (“While there is some disagreement among courts about the exercise by others of the trustee's bankruptcy-specific avoiding power causes of action, the Ninth Circuit permits such actions to be sold or transferred.”) (first citing In re P.R.T.C., Inc., 177 F.3d 774, 781 (9th Cir. 1999); and then citing In re Prof'l Inv. Props. of Am., 955 F.2d 623, 625–26 (9th Cir. 1992)). By contrast, when considering preferential actions, the Third Circuit has made a distinction between assets and property of the estate.
The Third Circuit in In re Cybergenics Corp., 226 F.3d 237, 245 (3d Cir. 2000), held that avoidance actions are not “assets” of the debtor. Id. But Cybergenics did not decide whether such actions are “property” of the estate. Id. at 246. The opinion stressed, “‘Cybergenics assets’ and ‘property of the estate’ have different meanings, evidenced in part by the numerous provisions in the Bankruptcy Code that distinguish between property of the estate and property of the debtor, or refer to one but not the other.” Id. What’s more, this holding by Cybergenics was subsequently undercut by a later Third Circuit opinion which stressed, “Cybergenics does not hold that trustees cannot transfer causes of action.” In re Wilton Armetale, Inc., 968 F.3d 273, 285 (3d Cir. 2020).
Facts
The debtor was an industrial products distributor which began experiencing financial difficulties in 2016. As a result, the debtor’s CFO loaned the debtor $800,000 which was memorialized in a loan agreement. The debtor subsequently re-paid $320,628.04 of the $800,000 loan under the terms of the agreement in 47 separate payments. When the CFO resigned in October of 2017, the debtor ceased repayment to him under the terms of the loan agreement. On October 20, 2017, the debtor filed a Chapter 11 case in the Southern District of Texas. The debtor’s sole secured creditor was Briar Capital Working Fund Capital LLC (“Briar Capital”), which filed a secured claim for approximately $2.5 million (and asserting that it was over secured by virtue of the property securing the loan being valued at a purported $4 million).
The bankruptcy court approved DIP financing from Solstice Capital, LLC (“Solstice”), pursuant to which it was given priming lien over Briar Capital on after-acquired assets of the debtor. The debtor then initiated a preference action against the former CFO to avoid and recover the $320,628.04 paid to him within the preference period. After Briar Capital objected to the debtor’s plan, the parties negotiated an agreement, memorialized in an amended plan, which provided for the following:
- The sale of all the debtor’s intangible assets to Solstice;
- Briar Capital would abandon its security interest in $700,000 of sale proceeds and waive its administrative claim; and
- Briar Capital would receive the debtor’s interest in the pending preference action against the former CFO.
The bankruptcy court approved the settlement and confirmed the plan. The confirmation order specifically addressed the assignment of the preference action to Briar Capital, making clear that Briar Capital had standing to prosecute such action on its own behalf and keep any amounts recovered in such action.
Briar Capital and the former CFO litigated the preference action in the district court. Shortly before trial, the former CFO filed a motion to dismiss asserting that Briar Capital lacked standing to prosecute the action. The district court agreed, reasoning that since a recovery would not benefit the debtor’s estate, Briar Capital had no standing to prosecute an action under section 547 of the Bankruptcy Code. The district court, citing cases from bankruptcy courts which had ruled that sale of preference actions were impermissible, dismissed the action for lack of subject matter jurisdiction. Briar Capital thereafter appealed to the Fifth Circuit Court of Appeals, which reversed the decision of the district court.
Fifth Circuit Reasoning
A. Estate Property Under Section 541(a)(1)
The Fifth Circuit first addressed the question of whether avoidance actions are estate property under Section 541(a)(1). The subsection states that estate property “is comprised of ... all legal or equitable interests of the debtor in property as of the commencement of the case.”
The court began by citing U.S. v. Whiting Pools Inc., 462 U.S. 198 (1983), where the Supreme Court held that estate property includes property that had been repossessed before bankruptcy in which the debtor had no possessory interest. There, the Supreme Court stated that the section “is intended to include in the estate any property made available to the estate by other provisions of the Bankruptcy Code.” Id. at 205.
The court then cited a prior Fifth Circuit opinion, asserting that, “The scope of property rights and interests included in a bankruptcy estate is very broad: The conditional, future, speculative, or equitable nature of an interest does not prevent it from being property of the bankruptcy estate.” In re Kemp, 52 F.3d 546, 550 (5th Cir. 1995); see also In re Greenhaw Energy, Inc., 359 B.R. 636, 642 (Bankr. S.D. Tex. 2007) (citing In re Equinox Oil Co., 300 F.3d 614, 618 (5th Cir. 2002) (“Section 541 is read broadly and is interpreted to ‘include all kinds of property, including tangible or intangible property’ [and] causes of action[.]”)).
Bringing this analysis full circle, the Fifth Circuit opined that, “[p]reference actions are a mechanism in the Bankruptcy Code by which additional property is made available to the estate, fitting squarely within the Whiting Pools definition. ... Thus, preference actions plainly fit the statutory definition of ‘property of the estate’ and may validly be sold under § 363(b).” Matter of S. Coast Supply Co., 91 F.4th at 382.
B. Estate Property Under Section 541(a)(7)
Briar Capital also argued that preference actions generally may qualify as property of the estate under section 541(a)(7). Section 541(a)(7) provides that property of the estate includes “any interest in property that the estate acquires after the commencement of the estate.” Briar Capital contends that “a right of action that accrues post-petition is estate property if it is created with or by property of the estate or related to or arises out of property that is already part of the estate.” Similar to Section 541(a)(1), the Fifth Circuit has held that, “Congress enacted § 541(a)(7) to clarify its intention that § 541 be an all-embracing definition and to ensure that property interests created with or by property of the estate are themselves property of the estate.” Id. (citing In re TMT Procurement Corp., 764 F.3d 512, 525 (5th Cir. 2014). The Fifth Circuit then stated: “Preference actions clearly qualify as ‘property of the estate’ under this section. ... Keeping in mind our own precedent mandates a broad reading of § 541(a)(7), it is apparent that ‘[t]he Bankruptcy Code makes these assets available to the estate after the commencement of the case.’ Id. Thus, we also hold that the preference actions qualify as property of the estate under § 541(a)(7).” Id.
C. Other Supporting Authority
Beyond the clear statutory language, the Fifth Circuit held that its decision was bolstered by the decisions of the “Eighth and Ninth Circuits in finding that preference claims are property of the estate that can be sold.” Id. (citing In re Simply Essentials, LLC, 78 F.4th at 1011 (“Chapter 5 avoidance actions are property of the estate”); In re Lahijani, 325 B.R. 282, 288 (9th Cir. BAP 2005) (“While there is some disagreement among courts about the exercise by others of the trustee's bankruptcy-specific avoiding power causes of action, the Ninth Circuit permits such actions to be sold or transferred.”)).
In doing so, the Fifth Circuit specifically noted that the Eighth Circuit, in Simply Essentials, addressed the CFO’s principal argument:
[T]he Eighth Circuit addressed Remmert's chief argument in this case—that the avoidance powers are unique powers belonging to the trustee and that should not have been sold to someone who would not exercise those powers for the benefits of all creditors. Specifically, the appellants in In re Simply Essentials argued that ‘allowing the sale of avoidance actions would violate the trustee’s fiduciary duty or undermine the purpose of avoidance actions.” In re Simply Essentials, LLC, 78 F.4th at 1010. In response, the court succinctly explained that the trustee’s fiduciary duties require it to maximize the value of the estate, which may include and even require the sale of an avoidance action. Id. The court held that allowing the sale of avoidance actions ‘is consistent with the congressional intent behind including a fiduciary duty to maximize the value of the estate.’ Id.
Id. at 383.
Relying on the Ninth Circuit BAP’s decision in Lahijani, the court stated: “A Bankruptcy Appeals Panel within the Ninth Circuit rejected the appellants' argument that the estate received no benefit where there was no specific portion of future recoveries reserved for the estate. It decided that ‘[t]he benefit to the estate in such circumstances is the sale price, which might or might not include a portion of future recoveries for the estate.’” Id.
The Fifth Circuit concluded:
In rejecting these arguments, the courts took a broad view of what benefits the estate, which we adopt here. This logic of maximization of the estate applies even under circumstances like these, where a creditor is not pursuing the claim for the benefit of all creditors. In this case, Briar Capital waived the right to recover administrative expenses and its security interest in $700,000 of sales proceeds, in exchange for the right to pursue this preference claim. Although Briar Capital does not owe any percentage of the possible recovery in this case to the estate, its waiver of the right to collect administrative expenses and its release of its claim to $700,000 are concrete benefits to the estate. Interpreting the Bankruptcy Code to allow the sale of preference actions does not undermine the purpose of avoidance actions. Rather, it is consistent with the trustee's duty to maximize the estate.
Id.
Observations
A. Taken as a Whole, the Decision is Likely a Good Result for Debtors and Creditors.
With the Fifth Circuit joining the Eighth and Ninth Circuits, three circuit courts of appeal have now held that preference actions can be sold by a debtor or trustee. The core holding of these cases enhances bankruptcy estates in a number of ways. For example, a debtor or trustee with little funds on hand sufficient to pursue avoidance litigation may not sell such claims to third parties and bring in immediate cash for distribution to creditors.
B. Certain Portions of the Decision Could Signal Bad News for Debtors and Creditors.
As one well regarded commentator aptly noted, the South Coast Supply decision may not be altogether great news for debtors and creditors because it “opens the door for prepetition lenders to perfect liens on avoidance actions arising after bankruptcy.” Rochelle’s Daily Wire, Avoidance Actions Are Estate Property that May Be Sold, the Fifth Circuit Says (available here). According to Mr. Rochelle, the Fifth Circuit’s opinion in South Coast Supply and the Ninth Circuit BAP’s decision in Simply Essentials “could be read to mean that avoidance actions are property interests that exist before bankruptcy and could therefore be subject to lien.” Id. As a result, pre-petition secured lenders may attempt to take liens on avoidance actions which, if permitted by the Bankruptcy Code, could result in the depletion of assets of the estate available to unsecured creditors. As Mr. Rochelle points out,* it is not entirely clear that such liens would be valid, but the prospect for secured creditors to assert such liens is nevertheless something to consider.
*As noted by Mr. Rochelle: Whether pre-petition secured lenders can take liens on avoidance actions may not be a question answered entirely by the Bankruptcy Code, since a debtor must have an interest in collateral before a security interest can attach. Does an inchoate or contingent interest give rise to an interest in collateral sufficient to allow attachment before bankruptcy?
