Bankruptcy trustees and chapter 11 debtors-in-possession ("DIPs") frequently seek to avoid fraudulent transfers and obligations under section 544(b) of the Bankruptcy Code and state fraudulent transfer or other applicable nonbankruptcy laws because the statutory "look-back" period for avoidance under many nonbankruptcy laws exceeds the two-year period governing avoidance actions under section 548. Governmental units (defined below) sometimes argue that avoidance actions against them are precluded by the doctrine of sovereign immunity under the applicable nonbankruptcy law, even though section 106(a) of the Bankruptcy Code explicitly provides that sovereign immunity is abrogated "with respect to … [section] 544."
The federal circuit courts of appeals (and many lower courts) are split regarding whether the abrogation of sovereign immunity by governmental units with respect to avoidance actions commenced under section 544(b) also extends to the causes of action arising under applicable nonbankruptcy law that a "triggering" or "predicate" creditor would be precluded from asserting outside of bankruptcy due to sovereign immunity. The U.S. Court of Appeals for the Tenth Circuit weighed in on this debate as a matter of first impression in U.S. v. Miller, 71 F.4th 1247 (10th Cir. 2023). Expanding what had been a 2–1 majority in the circuit courts on this issue, the Tenth Circuit ruled that the abrogation of sovereign immunity in section 106(a) permitted a chapter 7 trustee to sue the Internal Revenue Service to avoid and recover a fraudulent transfer under section 544(b)(1), even though an eligible existing creditor could not have sued the IRS outside of bankruptcy.
Waiver of Sovereign Immunity in the Bankruptcy Code
Pursuant to the federal system created by the U.S. Constitution, each state is a sovereign entity. In addition, both federal and state governmental bodies have sovereign immunity from suit unless that immunity has been abrogated by Congress, waived by the governmental body, or eliminated by a specific provision of the Constitution itself. See generally Collier on Bankruptcy ("Collier") ¶ 1.06.01 (6th ed. 2023).
Abrogation of sovereign immunity by Congress requires that: (i) Congress has "unequivocally expressed its intent to abrogate the immunity"; and (ii) lawmakers have acted "pursuant to a valid exercise of power." Id. (quoting Seminole Tribe v. Florida, 517 U.S. 44, 56 (1996); In re LTV Steel Co., Inc., 264 B.R. 455, 464 (Bankr. N.D. Ohio 2001)); accord LAC du Flambeau Bank of Lake Superior Chippewa Indians v. Coughlin, 143 S. Ct. 1689, 1695 (2023). The sovereign immunity of a litigant deprives a court of subject matter jurisdiction to adjudicate a dispute. See FDIC v. Meyer, 510 U.S. 471, 475 (1995) ("Sovereign immunity is jurisdictional in nature."). A waiver or abrogation of immunity must be strictly construed in favor of the sovereign, with any ambiguities to be resolved in favor of sovereign immunity. See Orff v. United States, 545 U.S. 596, 601–602 (2005).
The doctrine of sovereign immunity has been applied in bankruptcy cases to shield state and federal governments from claims asserted against them by bankruptcy trustees or DIPs. However, the Bankruptcy Code provides for a broad-ranging abrogation of such sovereign immunity. In particular, section 106(a) of the Bankruptcy Code provides that, "[n]otwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit … with respect to" nearly 60 provisions of the Bankruptcy Code specified in section 106(a)(1), including actions to enforce the automatic stay, preference and fraudulent transfer avoidance actions, and proceedings seeking to establish the dischargeability of a debt.
The abrogation in section 106(a) expressly includes litigation brought against a "governmental unit" under section 544 of the Bankruptcy Code. Section 544(b)(1) empowers a bankruptcy trustee to step into the shoes of a triggering creditor with an unsecured claim that could have sued to avoid a transfer outside of bankruptcy under applicable nonbankruptcy law (e.g., the Uniform Voidable Transfer Act (the "UVTA") enacted in many states). See generally Collier at ¶ 544.06.
Section 101(27) of the Bankruptcy Code defines the term "governmental unit" as:
United States; State; Commonwealth; District; Territory; municipality; foreign state; department, agency, or instrumentality of the United States (but not a United States trustee while serving as a trustee in a case under this title), a State, a Commonwealth, a District, a Territory, a municipality, or a foreign state; or other foreign or domestic government.
11 U.S.C. § 101(27).
Section 106(a)(2) provides that "[t]he court may hear and determine any issue arising with respect to the application of [the specified Bankruptcy Code provisions] to governmental units."
Other subsections of section 106 address a bankruptcy court's power to issue process, orders, or judgments against governmental units (sections 106(a)(3) and (a)(4)), a governmental unit's deemed waiver of sovereign immunity with respect to certain counterclaims by filing a proof of claim (section 106(b)), and permitted setoffs, despite any assertion of sovereign immunity, of claims owned by the bankruptcy estate against claims asserted by governmental units (section 106(c)).
Enacted as part of the Bankruptcy Code in 1978, section 106 was amended in 1994 to clarify lawmakers' intent to abrogate sovereign immunity of governmental units with respect to actions for damages as well as declaratory and injunctive relief under the specified provisions of the Bankruptcy Code. The change was designed to overrule two U.S. Supreme Court decisions—Hoffman v. Connecticut Department of Income Maintenance, 492 U.S. 96 (1989), and United States v. Nordic Village, Inc., 503 U.S. 30 (1992)—holding that section 106 did not state with sufficient clarity lawmakers' intent to abrogate the sovereign immunity of the states and the federal government in bankruptcy cases.
Controversy in the Courts
Even though section 106(a)(1) expressly abrogates sovereign immunity with respect to section 544, courts disagree as to whether the abrogation of immunity extends to both an action brought by the trustee or DIP under section 544(b)(1) and the avoidance causes of action that, but for sovereign immunity, the triggering creditor could have brought under applicable nonbankruptcy law. Three federal circuit courts of appeals had addressed this question prior to Miller, with two of them concluding that section 106(a)'s abrogation of sovereign immunity extended to causes of action under state law that could be asserted by a trustee or DIP under section 544(b)(1).
In In re Equip. Acquisition Res., Inc., 742 F.3d 743 (7th Cir. 2014) ("EAR"), the U.S. Court of Appeals for the Seventh Circuit ruled that section 106(a)(1) does not modify the triggering creditor requirement in section 544(b)(1). The court acknowledged that section 106(a)(1) abrogates a governmental unit's sovereign immunity with respect to avoidance litigation commenced by a DIP under section 544(b)(1) and Illinois fraudulent transfer law. However, applying a two-tiered approach, the Seventh Circuit concluded that because the governmental unit's sovereign immunity was not abrogated as to the underlying state law cause of action, the litigation under section 544(b) was barred.
The Ninth and Fourth Circuits have staked out a different approach. In In re DBSI, Inc., 869 F.3d 1004 (9th Cir. 2017), the Ninth Circuit held that "[s]ection 106(a)(1)'s abrogation of sovereign immunity is absolute with respect to Section 544(b)(1) and thus necessarily includes the derivative state law claim on which a Section 544(b)(1) claim is based." Id. at 1010. Examining the language of section 106(a) in the framework of the Bankruptcy Code as a whole, the Ninth Circuit concluded that "we cannot read the plain text of Section 544(b)(1)—i.e., the triggering creditor requirement—devoid of the declaration in Section 106(a)(1) that 'sovereign immunity is abrogated as to a governmental unit … with respect to [Section 544].'" Id.
The Ninth Circuit also explained that Congress enacted section 106(a)(1) (in its current form) after section 544(b)(1) and that lawmakers understood that the latter provision codified a trustee's power to invoke state law when they "waived sovereign immunity with respect to Section 544." Id. at 1011. Finally, the Ninth Circuit emphasized that the Seventh Circuit's approach would preclude any action against a governmental unit under section 544(b)(1) to avoid a transfer without an additional waiver or abrogation of sovereign immunity by Congress or a state legislature with respect to the underlying state law cause of action. Id. at 1011–12 (stating that "the interpretation offered by the government would essentially nullify Section 106(a)(1)'s effect on Section 544(b)(1), an interpretation we should avoid").
The Fourth Circuit recently agreed with this approach in In re Yahweh Ctr., Inc., 27 F.4th 960 (4th Cir. 2022), where it held that sovereign immunity did not bar litigation against the IRS by a chapter 11 plan trustee seeking, under section 544(b)(1) and the North Carolina UVTA, to avoid tax penalty payments made by the debtor. According to the Fourth Circuit, even if the IRS had not waived sovereign immunity by filing a proof of claim in the chapter 11 case (triggering a waiver under section 106(b)), section 106(a) expressly abrogated sovereign immunity with respect to the avoidance provision invoked by the trustee and as to "any issue arising with respect to" applying that provision against the IRS, which encompassed the North Carolina UVTA. Id. at 966.
Lower courts also disagree on the impact of section 106(a) on state fraudulent transfer claims asserted by a trustee or DIP under section 544(b). Compare In re Affiliated Physicians & Emps. Master Tr., 2022 WL 16953555 (Bankr. D.N.J. Nov. 15, 2022) (ruling that avoidance litigation commenced by a DIP against the IRS under section 544(b) and New Jersey law was barred because the IRS had sovereign immunity from suit under New Jersey law, which is not abrogated under section 106(a)(1)), with In re Lewiston, 528 B.R. 387, 395 (Bankr. E.D. Mich. 2015) (agreeing with DBSI that "§ 106(a)(1) accomplishes the elimination of sovereign immunity for all purposes with respect to § 544, and requires no additional waiver as to any specific nonbankruptcy law causes of action that a trustee may bring under § 544(b)(1)").
The Tenth Circuit weighed in on this debate as a matter of first impression in Miller.
Utah-based transportation company All Resort Group. Inc. (the "debtor") filed for chapter 11 protection in 2017 in the District of Utah. After the case was converted to chapter 7, the chapter 7 trustee commenced an adversary proceeding against the IRS under section 544(b) and the Utah UVTA, seeking to avoid approximately $145,000 in payments made by the debtor to the IRS in 2014 to satisfy its principals' personal tax debts. The triggering creditor for purposes of section 544(b) was an individual asserting an employment discrimination claim against the debtor.
The IRS did not dispute that all of the elements for avoidance were satisfied. Instead, it argued that, because any suit by the triggering creditor under the Utah UVTA was barred by sovereign immunity, the trustee could not satisfy section 544(b)(1)'s triggering creditor requirement. The trustee countered that the abrogation of sovereign immunity in section 106(a) extended to both the trustee's adversary proceeding under section 544(b)(1) and the underlying state law cause of action. Both parties moved for summary judgment.
The bankruptcy court ruled in favor of the trustee, concluding that "§ 106(a)(1) unequivocally waives the federal government's sovereign immunity with respect to the underlying state law cause of action incorporated through § 544(b)." In re All Resort Group, 617 B.R. 375, 394 (Bankr. D. Utah 2020), aff'd, 2021 WL 5194698 (D. Utah. Sept. 8, 2021), aff'd, 2023 WL 4190456 (10th Cir. June 27, 2023). It accordingly avoided the transfers and entered a judgment against the IRS in the amount of approximately $145,000. The district court affirmed the ruling on appeal, and the IRS appealed to the Tenth Circuit.
The Tenth Circuit's Ruling
A three-judge panel of the Tenth Circuit also affirmed.
Writing for the panel, Circuit Judge Bobby Baldock explained that the crux of the dispute was whether the abrogation of sovereign immunity in section 106(a) "reaches the underlying state law cause of action that § 544(b)(1) authorizes the Trustee to rely on in seeking to avoid the transfers at issue." Miller, 71 F.4th at 1252. The Tenth Circuit panel held that it does.
According to Judge Baldock, in accordance with Supreme Court precedent, the phrase "with respect to" in section 106(a) must be construed broadly and "clearly expresses Congress's intent to abolish the [IRS's] sovereign immunity in an avoidance proceeding arising under § 544(b)(1), regardless of the context in which the defense arises." Id. at 1253. He also noted that the broad language of section 106(a)(2) authorizing a bankruptcy court "to hear and determine any issue with respect to the application of § 544" bolsters this interpretation because it presumes that the court has subject matter jurisdiction, which would not be the case if the government were immune from suit. "The authority which [section 106(a)(2)] plainly confers," Judge Baldock wrote, "would be substantially curtailed if Congress had intended an assertion of sovereign immunity to preclude a bankruptcy court from considering whether a trustee has satisfied the substantive elements of an underlying state law cause of action invoked pursuant to § 544(b)(1)." Id. at 1254.
The Tenth Circuit panel distinguished EAR, noting that the Seventh Circuit "never meaningfully addressed the scope of § 106(a) as reflected in its text" and its ruling was likely motivated by federal tax policy considerations that were not based on the text of the provision, including concerns regarding the proliferation of actions seeking to recover tax payments. Id.
The Tenth Circuit panel found the decision in DBSI to be "more faithful to the text of § 106(a)" because the Ninth Circuit relied on established principles of statutory construction. The Tenth Circuit also agreed with the Ninth Circuit's reasoning that: (i) Congress was aware that section 544(b)(1) codified a trustee's power to invoke state law when it enacted section 106(a)(1); and (ii) adopting the government's position would render section 106(a)(1) "largely meaningless" with respect to section 544(b)(1) because a trustee would always be required to show that a governmental unit provided for a separate waiver of sovereign immunity with respect to the underlying nonbankruptcy law.
Finally, the Tenth Circuit rejected the IRS's argument that the Internal Revenue Code (the "IRC") trumps the Bankruptcy Code under the doctrine of "field preemption." According to Judge Baldock, field preemption does not apply because the Bankruptcy Code (including section 544(b)(1)), like the IRC, is a federal statute, and Congress has demonstrated its ability to harmonize federal statutes in cases of conflict. In this case, he noted, lawmakers could have done so by adding an express provision to section 544(b) exempting the government from its operation (as lawmakers did in section 544(b)(2) by excepting transfers involving charitable contributions). Moreover, the Tenth Circuit panel explained, "[t]he argument for field preemption based on federal tax collection policy is surely rather weak where Congress is aware of the operation of state law in a field of federal interest, i.e., bankruptcy law, and has decided to place the policy of equal distribution and fairness among creditors on equal footing and tolerate whatever tension exists between the two policies." Id. at 1256.
The ability of a bankruptcy trustee or DIP to step into the shoes of a triggering creditor to seek avoidance of transfers or obligations under applicable nonbankruptcy law is an important component of the Bankruptcy Code's "strong-arm" powers designed to augment the bankruptcy estate for the benefit of all stakeholders. In many cases, litigation to avoid transfers or obligations under section 544(b) and applicable nonbankruptcy law can cast a far wider net than avoidance litigation under section 548 because the look-back period under state avoidance laws (and other nonbankruptcy laws, such as the IRC) can significantly exceed section 548's two-year look-back period.
Governmental units, including the IRS, have long combatted bankruptcy litigation seeking avoidance and recovery of transfers by arguing, among other things, that the extended look-back periods under applicable nonbankruptcy law should not apply, that avoidance either conflicts with or is preempted by other federal law consistent with policy considerations (e.g., tax revenue enhancement), or that the governmental unit in question is immune to suit under the doctrine of sovereign immunity.
The Tenth Circuit's decision in Miller is significant for several reasons. First, the ruling widens a split among the circuits on the interaction between sections 106(a) and 544(b). Second, the (growing) majority approach on this important issue is that Congress abrogated sovereign immunity for purposes of both section 544(b) and causes of action under applicable nonbankruptcy laws that could have been asserted outside of bankruptcy by a triggering creditor. This is a positive development for trustees and DIPs seeking to add value to the bankruptcy estate. However, until the circuit split has been resolved, awareness of the approach adopted by the courts in any particular jurisdiction will be vital.
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