Fraudulent Transfer: A Case Where Strong Arm Powers Were “An Inch Too Short”

by Pepper Hamilton LLP

Casey v. Rotenberg (In re Kenny G Enterprises, LLC), 512 B.R. 628 (C.D. Cal. 2014)

A Chapter 11 trustee sought to avoid a transfer of property under Section 544 of the Bankruptcy Code that occurred after (1) the bankruptcy petition was filed and (2) a chapter 11 plan of reorganization was confirmed. The defendants moved to dismiss on the basis that Section 544 applies only to prepetition transfers. The bankruptcy court denied the motion, and the defendants appealed.

The debtor listed a residential rental property valued at $1.2 million in its bankruptcy schedules. Under its plan of reorganization, it proposed to continue to use the property as rental property to provide income to fund the plan. In fact, this property was the only income-generating asset in the entire bankruptcy estate.

However, a couple of months after the plan of reorganization was confirmed, the debtor sold the property for ~$3.1 million, of which ~$1.9 million was deposited into the debtor’s bank account, and then ~$1.7 million was wired to another entity that the trustee alleged was just a newly formed shell entity.

As background, filing a petition creates a bankruptcy estate that includes interests of the debtor in property as of the commencement of the case. In a Chapter 11 reorganization, once the court confirms a plan of reorganization, the estate property revests in the debtor.

Section 544 of the Bankruptcy Code authorizes avoidance of fraudulent transfers. Since Section 544 simply refers to avoiding a transfer “of an interest in property of the debtor” that is avoidable under state law, there is an ambiguity about the timing:

  • Section 544 clearly applies to pre-petition transfers.
  • There is a separate provision – Section 549 – that applies to avoiding the transfer of property of the bankruptcy estate (i.e. after the petition is filed and before a plan is confirmed).
  • Theoretically Section 544 could also apply to post-confirmation transfers (i.e. after property revests in the debtor).

The district court found that there were indications that Congress intended to address only prepetition transfers. The strong arm powers under Section 544(a) are described in terms of giving the trustee the rights and powers of various creditors and bona fide purchasers “as of the commencement of the case.” Similarly, there is a two-year statute of limitations that runs from the filing of the case. This is in contrast to Section 549, which measures the statute of limitations from the date of the transaction. This suggests that it is likely that Congress intended that the avoidance actions authorized by Section 544(b) be limited to pre-petition transfers.

The bankruptcy court had recognized that the majority rule is that Section 544 is limited to prepetition transfers. However, in its view counterbalancing the apparent language of the Bankruptcy Code is the point that as a policy matter this would leave a gap where the trustee would not have any remedy – namely for postpetition post confirmation misbehavior.

However, the district court was not persuaded. A trustee’s strong arm powers are broad, but not unlimited. The U.S. Supreme Court held that it is “well settled that the bankruptcy trustee has no standing generally to sue third parties on behalf of the estate’s creditors, but may only assert claims held by the bankrupt corporation itself.”

Consequently, the district court concluded “§ 544 is an inch too short for the Trustee to reach the [property] transfer.” An individual creditor of the post-confirmation debtor may be able to assert a fraudulent conveyance claim, but the trustee does not have the ability to assert those claims if Congress did not give it that avoidance power.

As a practical matter, actions by individual creditors are not nearly as effective as an action by a trustee on behalf of all creditors given standing, scope of recovery and other matters. Note that this may not be the end of the story because the trustee has filed an appeal of the district court’s decision to the 9th Circuit.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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