SO YOU VE BEEN SUED BY A TRUSTEE. by the trustee as well as the ability of the trustee to recover if successful.

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1 SO YOU VE BEEN SUED BY A TRUSTEE CHRISTOPHER CONTE HELMSING LEACH, P.C. Trustees in bankruptcy have broad powers to avoid certain transfers of the debtor to third parties. 1 This paper will discuss some of the most common avoidance actions that can be filed by the trustee as well as the ability of the trustee to recover if successful. I. PREFERENCE ACTIONS UNDER 11 U.S.C. 547 AND DEFENSES A. What is a Preferential Transfer? Section 547 of the bankruptcy code allows the trustee to set aside certain transfers that favor one creditor over another. An avoidable transfer is one that was made: (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made on or with 90 days before the filing of the petition or between 90 days and one year before the date of the filing of the petition if such creditor at the time of the transfer was an insider; and (5) that enables the creditor to receive more than such creditor would receive if the case were a case under Chapter 7 the transfer had not been made and such creditor received payment of such debt to the extent provided by the Code. 2 The trustee must prove each element above in order for a particular transfer to be avoidable under 11 U.S.C. 547(b). 3 B. Defenses Proving all of the Elements of 11 U.S.C. 547(b) In order for a preferential transfer to be avoidable, the trustee must be able to prove each of the above elements with respect to the particular transfer. Thus, an effective defense of a 1 For simplicity s sake, this article will refer to the trustee as having the power to avoid transfers of the debtor, however, it is important to note that in certain circumstances this power belong to other individuals or entities such as the debtor-in-possession or a creditors committee U.S.C. 547(b). 3 In re Howdeshel of Fort Meyers, 55 B.R. 470 (Bankr. M.D. Fla. 1985).

2 preferential transfer action can be to first show that the trustee cannot prove one of the elements contained in 11 U.S.C. 547(b). The first requisite element is that the transfer must have been made to or for the benefit of a creditor. 4 A creditor is defined by the bankruptcy code as any entity that has a claim against the debtor that arose before or at the time of the order of relief. 5 As a result, a transfer that is gratuitous, for example, is likely not a transfer to a creditor that can be avoided by the trustee under 11 U.S.C. 547, although it may well be avoidable under other sections of the Bankruptcy Code. The second element that must be proven is that the transfer was for or on account of an antecedent debt. 6 In general, this means that the debt had to have existed prior to the transfer that is being avoided by the trustee. Further, a debt is normally considered to have existed for purposes of this section when the debtor became legally bound to pay the debt. One important exception that has been created by courts is the settlement of a claim, which has been held to be a preferential transfer even though the debtor was contesting whether it was legally obligated to pay the claim. The third element of a preferential transfer is that the transfer was made while the debtor was insolvent. 7 Insolvent is defined as: financial condition such that the sum of the entity s debts is greater than all of the entity s property, at a fair valuation, exclusive of- (i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity s creditors; and (ii) property that may be exempted from property of the estate under section 522 of this title U.S.C. 547(b)(1). 11 U.S.C. 101(11). 11 U.S.C. 547(b)(2). 11 U.S.C. 547(b)(3). 11 U.S.C. 101(32)(A).

3 The element of insolvency is modified somewhat by the fact that the debtor is presumed to have been insolvent in the 90 days prior to the filing of the petition. 9 As such, the party opposing insolvency has the burden of bringing forward evidence that rebuts the presumption of insolvency. 10 However, the trustee still has the burden of proof with respect to the element of insolvency. 11 The fourth element that must be proven is that the transfer must have occurred within 90 days of the filing of the petition, or within one year of the filing of the petition if the transferee is an insider of the debtor. 12 An insider is defined by the bankruptcy code and the definition varies depending on whether the debtor is an individual or a corporate entity. 13 Generally, the proof of this element is fairly easy, however it is important to note that the initial petition date is used, and not a later conversion date if the case is converted from a Chapter 13 or Chapter 11 to a Chapter 7. Finally, the trustee must be able to prove that the transferee received more than it would have received in a hypothetical liquidation under Chapter 7 of the Bankruptcy Code. 14 Generally, this element protects secured creditors who received payment prior to the case, but who would have been paid in full anyway if the case had been liquidated. However, it can protect unsecured creditors if the estate is large enough and the debtor has significant equity. At the very least, proving this element may require that the trustee perform a liquidation analysis that, depending on the complexity of the case, may be quite expensive. C. Defenses Under 11 U.S.C. 547(c) 9 11 U.S.C. 547(f). 10 Official Committee of Unsecured Creditors of Toy King Distribution v. Liberty Sav. Bank, 256 B.R. 1 (Bankr. M.D. Fla. 2000). 11 Id U.S.C. 547(b)(4) U.S.C. 101(31)(A)-(F) U.S.C. 547 (b)(5).

4 Even if the trustee is able to prove all of the elements of a preferential transfer, the transfer may not be avoidable due to defenses enumerated in 11 U.S.C. 547(c). The difference between the defenses related to the elements of 11 U.S.C. 547(b) and the defenses set out in 11 U.S.C. 547(c) relate to who has the burden of proof. With respect to the elements of the preferential transfer, the trustee has the burden of proving the existence of each and every element; however, the defendant has the burden of proving the availability of the defenses in 11 U.S.C. 547(c). 1. Contemporaneous Exchanges A transfer is not avoidable to the extent that the transfer was intended to be a contemporaneous exchange between the debtor and creditor for new value and if the exchange was in fact substantially contemporaneous. 15 This defense requires that the debtor and creditor both have requisite intent that the transfer was to be contemporaneous and that the transfer actually was substantially contemporaneous. What qualifies as substantially contemporaneous is up for debate and has been the subject of significant litigation. Generally, courts have rejected any attempt to establish a simple hard-line test for substantially contemporaneous and have looked to the totality of the circumstances in the case Ordinary Course of Business A transfer that would otherwise be avoidable is not avoidable if the transfer was made in the ordinary course of business or financial affairs of the debtor and the transferee or [was] made according to ordinary business terms. 17 Post-BAPCPA, this defense is somewhat easier to prove as it no longer requires that the transferee prove that a transfer was in the ordinary course of business and that it was made according to ordinary business terms. The transferee must be U.S.C. 547 (c)(1). See, e.g. In re Dorholt, Inc., 224 F.3d 871 (8 th Cir. 2000). 11 U.S.C. 547(c)(2)(A)-(B).

5 prepared to prove that the debtor incurred the debt owed by it and made the payment on that debt according to the normal course of dealing between the parties. 18 This is generally done by showing the history of the business between the debtor and the transferee and establishing that this course of dealing did not change during the preference period. However, even if the course of dealing did change during the preference period, the transferee can still prevail if it can show that the transfers were made pursuant to ordinary business terms within the relevant industry. 19 Proving this latter defense may require transferee to establish the ordinary business terms of the industry through the use of expert testimony and further require the trustee to rebut that testimony with experts of its own. 3. Security Interests in New Value Generally, security interests that are in the realm of purchase money security interests are not avoidable as preferential transfers. 20 In order to prove this defense, the transferee must be able to show that the granting of the security interest by the debtor was done (1) to allow the debtor to acquire new property; (2) that was delivered after the execution of the security interest; (3) by the party to whom the security interest was granted; (4) that the debtor actually used the funds to acquire the property in question; and (5) the PMSI was properly perfected with 20 days of delivery Subsequent New Value A transfer is not avoidable to the extent that the transferee gave subsequent new value to the debtor in exchange for the transfer. 22 Proving this defense requires that the transferee be able to demonstrate the shipping of new value to the debtor and compare it to the transfers made by Id. Id. 11 U.S.C. 547(c)(3). Id. 11 U.S.C. 547 (c)(4).

6 the debtor during the preference period. Because a trustee can bring a preference up to two years after the case is filed, or one year after the appointment of the trustee the transferee may need to maintain records for far longer than it would normally in order to prove the new value defense. 23 Additionally, there is some disagreement in courts with respect to how this defense should be applied, with some Circuits recognizing that all of the new value should be netted out from the preferential transfers, but others holding that each transfer of new value can only be applied to the immediately preceding transfer of property of the debtor Miscellaneous Defenses The above described defenses are the most commonly encountered in preference litigation. However, the Bankruptcy Code also provides defenses for a floating lien on receivables and inventory of the debtor 25 which protects transferees in situations where collateral is substituted for other, like collateral during the preference term; defenses for statutory liens such as mechanics liens; 26 and defenses for bona fide payments of child-support or alimony made during the preference period. 27 II. FRAUDULENT TRANSFERS UNDER 11 U.S.C. 548 The Bankruptcy Code also gives the trustee the power to unwind transfers that are considered fraudulent. Generally, fraudulent transfers are divided into two types or classes: (1) transfers that were done with actual intent to hinder creditors and (2) transfers in which the debtor did not receive reasonably equivalent value and which were made when the debtor was either insolvent or to an insider of the debtor. 28 Like preferential transfer actions, a fraudulent U.S.C. 546 (a)(1)(a)-(b). 24 See, In re Meredith Manor, 902 F. 2d 257 (4 th Cir 1990); In re Jet Florida Systems Inc., 841 F. 2d 1082 (11 th Cir. 1988); and In re Micro Innovations Corp., 185 F. 3d 337 (5 th Cir. 1999) U.S.C. 547 (c)(5) U.S.C. 547 (c)(6) U.S.C. 547 (c)(7) U.S.C. 548 (a)(1)(a)-(b).

7 transfer case may be brought by the trustee in a Chapter 7 case, or the debtor-in-possession in a Chapter 11 or 13 case. 29 A. Transfers With Actual Intent to Hinder Creditors The first type of fraudulent transfer requires that the trustee prove that the transfer was made with actual intent to hinder, delay, or defraud any entity to which the debtor was or became indebted. 30 However, it is not required that the trustee prove intent to hinder a specific creditor, rather, the trustee can simply prove a general intent to hinder the creditors of the debtor. 31 Additionally, the trustee need only prove intent to do one of the three actions enumerated and not all three. It is exceedingly rare that anyone admits that a transfer was done with actual intent to hinder creditors; therefore, most courts look to the so-called badges of fraud to determine if actual intent exists. There is not definitive list of the badges of fraud; however, a basic list includes: 1) the lack of or inadequacy of consideration, 2) the relationship of the parties, 3) the debtor s retention of possession or use of the property, 4) the financial condition of the parties involved, 5) the pattern of transactions, and 6) the chronology of the transfers involved U.S.C. 548(a) and 11 U.S.C. 1107(a). 11 U.S.C. 548(a)(1)(A). See, In re Blatstein, 192 F. 3d 88 (3 rd Cir. 1999). See, In re Soza, 542 F. 3d 1060 (5 th Cir. 2008).

8 B. Constructively Fraudulent Transfers Because actual intent is often difficult to prove, the majority of fraudulent transfers are brought as constructive fraud cases. In order to prove a case based on constructive fraud, the trustee must show that the debtor received less than a reasonably equivalent value in exchange for such transfer and that: 1) the debtor was insolvent, or 2) intended to incur debts beyond its ability to pay, or 3) was unreasonably under-capitalized, or 4) the transfer was to the benefit of an insider under an employment contract and outside of the ordinary course of business. 33 In order to set aside a transfer as constructively fraudulent, the trustee must first show that the debtor received less than a reasonably equivalent value for the property that was transferred. Value is defined by the Bankruptcy Code to mean property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor. 34 In examining this element, courts must first determine if the debtor received any value, using the definition stated above, and then determine if the value received was reasonably equivalent. This is done by first determining the value, if any, given and received by the debtor and then comparing the value given and the value received to determine if the two are reasonably equivalent. It is not required that the value received by the debtor be in the form of tangible assets, and courts have held that services are sufficient to render value to the debtor. 35 There is no bright-line test for U.S.C. 548(a)(1)(B)(i)-(ii). 11 U.S.C. 548 (d)(2). In re Terry Mfg. Co., 358 B.R. 429 (Bankr. M.D. Ala. 2006).

9 what constitutes reasonably equivalent value and courts have to look to the totality of the facts and circumstances to determine if sufficient value was received by the debtor. 36 It is not enough for the trustee to show that the debtor did not receive reasonably equivalent value in exchange for the transfer of property. In addition, the trustee must be able to prove one of the four remaining elements off 11 U.S.C. 548(a)(1)(B), which focus on the financial condition of the debtor at the time of the transfer. If the debtor was insolvent at the time of the transfer, then the transfer may be avoidable by the trustee. As discussed above, insolvency is defined in the bankruptcy code and generally means that the value of the debtor s liabilities exceeds the value of the debtor s assets. Generally, determining insolvency will require expert testimony regarding the value of the debtor s assets and liabilities. III. POST-PETITION TRANSFERS UNDER 11 U.S.C. 549 Section 549 of the Bankruptcy Code provides that: (a) Except as provided in subsection (b) or (c) of this section, the trustee may avoid a transfer of property of the estate (1) that occurs after the commencement of the case; and (2) (A) that is authorized only under section 303(f) or 542(c) of this title; or (B) that is not authorized by this title or by the court. The avoidance powers of the trustee pursuant to 11 U.S.C. 549 are quite broad, but are still subject to important limitations of which potential defendants need to be aware. A. Transfers pursuant to Section 303(f) or 542(c). Generally, the avoidance powers of the trustee pursuant to section 549 make a lot of sense to non-bankruptcy practitioners. Obviously, a debtor cannot file bankruptcy and then 36 Generally, when examining reasonably equivalent value, the value must have been received by the debtor and not by a third party, such as a guaranty of the debts of another.

10 freely transfer property unless the Bankruptcy Code or the Bankruptcy Court authorizes such a transfer. However, in certain limited circumstances, section 549 actually gives the trustee the ability to avoid post-petition transfers even if they were authorized by the Bankruptcy Code, specifically if the transfers were authorized only by either section 303(f) or 542(c). This avoidance power seems somewhat counter-intuitive: How can the Code authorize a transfer in one section and then authorize the trustee to avoid that transfer in another section? The answer requires a brief examination of sections 303(f) and 542(c). Section 303(f) of the Bankruptcy Code deals with transfers that are made by a debtor after the filing of an involuntary petition but before the petition is granted. During this gap period, the debtor may still conduct its affairs as though it is not in bankruptcy and, as such, significant transfers of property may take place. Section 303(f) authorizes a debtor to make such transfers. On its face, this seems incredibly unfair to the recipients of such transfers who may have been operating under the belief that they were protected by the bankruptcy code and allowed to receive property from the debtor. However, the ability of the trustee to avoid transfers that took place pursuant to 303(f) is subject to a significant limitation. Section 549(b) provides that a trustee may not avoid a transfer that was authorized by 303(f) to the extent that any value was given to the debtor in exchange for the transfer, regardless of whether the transferee had knowledge of the commencement of the case or not. There is one catch: the value given to the debtor in exchange for the transfer must also be given post-petition. If the transfer is made by the debtor on account of value given pre-petition, then it may still be subject to the trustee s avoidance powers. Section 542(c) protects agents, bailees and banks who make transfers in good faith for the benefit of the estate after the commencement of the case. Section 542(c) codified protections

11 recognized by the United States Supreme Court in Bank of Marin v. England 37 which recognized that such entities should not be punished for making good faith transfers without knowledge of the commencement of the bankruptcy case. Section 549 allows the trustee to avoid such transfers because 542(c) was never meant to protect transferees. In that context in makes perfect sense that the bankruptcy code would allow the trustee to avoid such transfers. B. Limitations on Post-Petition Avoidance Powers. The power of the trustee to avoid post-petition transfers is not absolute. As will be discussed below the bankruptcy code places certain limitations on the trustee and also provides certain defenses for targets of post-petiton avoidance actions. 1. General Limitations on Post-Petition Avoidance Powers Importantly, the transfer sought to be avoided by the trustee must be a transfer of property of the estate. While the definition of property of the estate is broad, it is not allinclusive, and certain property is excluded from the bankruptcy estate. Perhaps the most significant such property is post-petition earnings of a debtor in a Chapter 7 case and transfers of such are not avoidable under section 549. Further, the transfer must occur after the commencement of the case for section 549 to have any operation. Normally, it will be clear whether a transfer occurred after the commencement of the case; however, it is possible for a transfer to essentially straddle the date of the commencement of the case (for example a check that is delivered pre-petition, but honored post-petition). Transfers that are authorized by the bankruptcy code or by the bankruptcy court are not avoidable by the trustee. A debtor-in-possession in a case under Chapter 11 or 12, or authorized to operate under Chapter 13, can generally make transfers in the ordinary course of business U.S. 99 (1966).

12 without seeking the approval of the Bankruptcy Court. 38 Of course, what constitutes the ordinary course of business will often be a question of fact and will obviously depend on the business of the debtor and whether the transfer made fell within the operation of that business and was conducted pursuant to normal business terms. Likewise, if the Bankruptcy Court authorizes a particular transfer or series of transfers, then those transfers are not avoidable by the trustee. The Bankruptcy Court has broad equitable powers to authorize post-petition transfers and routinely does so if there is a benefit to the bankruptcy estate. Common types of postpetition transfers include: (1) foreclosures authorized by relief from the automatic stay, (2) transfers of real property outside the ordinary course of business, (3) payments of pre-petition claims to employees and (4) payments of pre-petition claims to certain critical vendors of the debtor. 2. Specific Limitations with Respect to Transfers of Real Property Section 549(c) provides some protection for post-petition purchasers of real property of the debtor, provided that the purchaser had no knowledge (or reasonable means of knowledge) of the commencement of the bankruptcy case and provided present fair equivalent value for the property. 39 The purchaser must also perfect its interest in the real property before a copy of the petition is recorded. 40 The Bankruptcy Code requires that a purchaser of real property provide present fair equivalent value for the property transferred. What this means is a matter of some debate and the term is not defined in the Bankruptcy Code. However, present fair equivalent value is not the same thing as fair market value and requires a more exacting review of the value of the See, 11 U.S.C. 1107, 1108, 1203, For purposes of section 549(c) a transfer of property includes the granting of a lien on real estate. 11 U.S.C. 549(c)

13 transferred property and what was paid for the transferred property. 41 However, even if the Court determines that the transferee did not pay present fair equivalent value it can still give the transferee protection in the form of a lien on the property in an amount equal to the present value actually given, provided that the purchaser had no knowledge of the bankruptcy case. 42 Finally, the protections of 549(c) are limited to voluntary transfers of property. The term transfer, as used in the Bankruptcy Code, generally includes involuntary transfers (such as foreclosures). However, section 549(c) uses the term purchaser which is limited under the Bankruptcy Code to one who is a transferee at a voluntary sale. 43 As such, someone who purchased property at a foreclosure or a tax sale would be unlikely to be able to assert the protections of section 549(c), even if the purchase was made with no knowledge of the pending bankruptcy case. IV. LIABILITY OF TRANSFEREES PURSUANT TO 11 U.S.C. 550 The above discussed sections of the Bankruptcy Code define the causes of action that a trustee can bring to recover assets for the benefit of the estate. Section 550 of the Bankruptcy Code defines exactly what the trustee is entitled to recover, and from whom. Generally speaking the trustee may recover the property transferred or, after approval from the Bankruptcy Court, the value of that property. The trustee may recover from both the initial transferee and any subsequent transferees, although the liability of subsequent transferees is limited if they took the property in good faith. 41 See, In re Miller, 454 F. 3d 899, (8 th Cir. 2006) U.S.C. 549(c). However, note that the purchaser must perfect the lien in order to be protected and that perfection must occur before a notice of the petition is filed U.S.C. 101.

14 A. Property or Its Value. The Bankruptcy Code provides that the trustee may either recover the property that was transferred or may, with approval of the Bankruptcy Court, recover the value of the property transferred. The Bankruptcy Code provides no guidance regarding when the Court should allow the recovery of value rather than the recovery of the property itself. In making this determination, courts have considered the following factors: 1) whether the property itself is recoverable; 2) whether the property has diminished in value; 3) whether there is conflicting evidence as to the value of the property to the estate; and 4) whether a monetary award would result in a savings to the estate. The term value refers to fair market value and generally means the value at the time of the transfer. 44 As such, if the property has diminished in value post-transfer, the Court may order that the trustee is entitled to recover the value of the property at the time of the transfer and not be saddled with the recovery of diminished real property. A more controversial issue is whether the trustee is entitled to recover additional value if the property has increased post-transfer. At least one court in the Eleventh Circuit has held that the trustee is entitled to this increase in value. 45 B. Recovery Against Initial and Subsequent Transferees. The Bankruptcy Code provides that a trustee can recover against the initial transferee, or the entity for whose benefit the transfer was made, or any subsequent transferee, or any combination of the above. The ability to recover from multiple sources gives the trustee flexibility when the ability to recover has been frustrated by the initial transferee or when the initial transferee has no assets or means to satisfy a judgment. 44 See, In re Da-Sota Elevator Co., 939 F.2d 654 (8 th Cir. 1991). 45 See, In re American Way Service Corp., 229 B.R. 496 (Bankr. S.D. Fla. 1999) and In re Blitstein, 105 B.R. 133 (Bankr. S.D. Fla. 1989).

15 Recovery against the initial transferee is generally pretty straightforward. However, it can become more complicated where a party acts merely as a conduit by which property is transferred from the debtor to someone else. In such cases, bankruptcy courts have generally held that an entity acting as a mere conduit is not the initial transferee for purposes of section 550, and the initial transferee is the next entity in the chain. Typically, the determination of whether someone is the initial transferee or a mere conduit turns on the degree of control that can legally be exercised over the transferred property. 46 As against subsequent transferees, the trustee s recovery is limited by section 550(b), which is why the determination of who is the initial transferee is so important. The trustee cannot recover from a subsequent transferee if the subsequent transferee takes the property for value given in good faith and without knowledge of the voidability of the transfer. 47 Value includes the satisfaction or securing of a debt and there is no requirement that the value given is reasonable or equivalent to the property transferred. The value considered is also not value given to the debtor. Further, there is no statutory definition of good faith and the courts only look at the good faith, or lack thereof, of the subsequent transferee and not the transferor. Additionally, the subsequent transferee must be without knowledge of the avoidability of the transfer. There is little guidance as to exactly what constitutes the requisite knowledge for purposes of 550(b). Keep in mind that the majority of avoidance actions deal with transfers that occurred prior to the bankruptcy case being filed, so knowledge of the avoidability of the transfer may well require that the subsequent transferee have some knowledge of the financial affairs of the debtor such that it is aware that the debtor may be near bankruptcy. The determination of In re Pony Express, 440 F. 3d 1296 (11 th Cir. 2006). 11 U.S.C. 550(b)(1).

16 whether a subsequent transferee had the requisite knowledge will be fact driven and specific to the given case. While the Bankruptcy Code recognizes that more than one entity may be liable to the trustee, the trustee is limited to a single recovery and the recovery cannot exceed the value of the property or the recovery of the property itself. 48 This makes sense given that the stated purpose behind most avoidance actions is to restore the estate to the position it would be in had the transfers not occurred. Allowing the trustee to recover more than the value of the property would result in a windfall, which goes beyond the intentions of the Bankruptcy Code. C. Liens for Improvements to Property A good faith transferee, even the initial transferee, is entitled to a lien on property to secure amounts expended to improve, repair or preserve the property. 49 To benefit from this lien, the transferee must have taken the property in good faith. Typically, this means that the transferee took the property without knowledge of the transferor s precarious financial position or that the transferor was contemplating filing bankruptcy. 50 The amount of the lien is limited to the lesser of: 1) the amount actually expended (less any profit to the transferee); or 2) the increase in value to the property. Section 550(e) defines the allowed improvements as: 1) physical additions to the property; 2) repairs to the property; 3) payment of a tax on the property; 4) payment of any debt secured by a lien that superior or equal to the rights of the trustee; and 5) preservation of the property U.S.C. 550(d) U.S.C. 550(e). 50 See, In re O Connell, 119 B.R. 311 (Bankr. M.D. Fla. 1990).

17 While section 550(e) grants a lien, it gives no guidance as to the priority of that lien, although it is presumably behind any pre-petition liens that existed. With respect to post-petition liens, it may be up to the Court to review the equities and determine the priority of the lien granted by 550(e). D. Time Limitation to Recovery Section 550 is subject to its own statute of limitations. An action to recover on an avoided transfer must be instituted by the earlier of one year after the transfer is avoided or before the case is closed or dismissed. 51 This separate limitations period underscores the fact that the action to recover on an avoided transfer is distinct from the action to avoid the transfer in the first place. As a practical matter, the action to recover on the transfer is typically brought in the same case as the action to avoid the transfer U.S.C. 550(f).

18 A Primer on Claims under Sections of the Bankruptcy Code J. Leland Murphree, Esq Alabama State Bar Annual Meeting When a bankruptcy is filed under Chapter 7 or Chapter 11 of the Bankruptcy Code 1, whether by an individual, corporation, LLC or other type of eligible entity under the Bankruptcy Code, a bankruptcy estate is created and a trustee is appointed. 2 The Bankruptcy Code establishes the broad contours of the property that composes the bankruptcy estate, including claims and causes of action of the estate, and a trustee s duties and powers with respect to the estate. This article provides an overview of Sections 541 through 545 of the Bankruptcy Code and the claims and causes of action assertable by a trustee, either as property of the estate or as specifically provided under these sections of the Bankruptcy Code. I. Section 541 Property of the Estate U.S.C. 101, et seq. 2 This presentation does not address the concepts of property of the estate and trustees under Chapter 13 of the Bankruptcy Code. The term trustee in the Chapter 7 context will always refer to a bankruptcy trustee described in Sections of the Bankruptcy Code. However, in the Chapter 11 context, a debtor may retain possession and control of its bankruptcy estate as a debtor in possession pursuant to Sections of the Bankruptcy Code, but acts, and is endowed with the same duties and powers, as a trustee under Chapter 7, as amended by the provisions of Chapter 11. Therefore, the term trustee, used herein, applies not only to third party trustees under Chapter 7 (and Chapter 11 trustees appointed under Section 1104 of the Bankruptcy Code), but also Chapter 11 debtors in possession U.S.C. 541 provides, in part, as follows: (a) The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held: (1) Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case. (2) All interests of the debtor and the debtor's spouse in community property as of the commencement of the case that is-- (A) under the sole, equal, or joint management and control of the debtor; or (B) liable for an allowable claim against the debtor, or for both an allowable claim against the debtor and an allowable claim against the debtor's spouse, to the extent that such interest is so liable. (3) Any interest in property that the trustee recovers under section 329(b), 363(n), 543, 550, 553, or 723 of this title. (4) Any interest in property preserved for the benefit of or ordered transferred to the estate under section 510(c) or 551 of this title. (5) Any interest in property that would have been property of the estate if such interest had been an interest of the debtor on the date of the filing of the petition, and that the debtor acquires or becomes entitled to acquire within 180 days after such date-- (A) by bequest, devise, or inheritance; (B) as a result of a property settlement agreement with the debtor's spouse, or of an interlocutory or final divorce decree; or (C) as a beneficiary of a life insurance policy or of a death benefit plan. 1

19 The filing of a voluntary, involuntary, or joint petition creates an estate pursuant to Section 541 of the Bankruptcy Code. The estate consists of various categories of property interests identified under Section 541, including all legal or equitable interests of the debtor in property as of the commencement of the bankruptcy case. 4 Put simply, the reach of Section 541 is broad. It extends to all types of property, including tangible or intangible property, as well as property recovered by the bankruptcy trustee pursuant to other sections of the Bankruptcy Code. 5 In effect, under Section 541, the trustee steps into the shoes of the debtor and succeeds to all of the debtor s legal and equitable interests as of the petition date, as modified by the Bankruptcy Code. While federal law broadly defines the categories constituting property of the estate, the extent of the estate s interest in property is largely defined by state law. 6 Moreover, [a debtor s bankruptcy estate] includes legal causes of action the debtor had against others at the commencement of the bankruptcy case. 7 If a legal cause of action is deemed property of the estate, the bankruptcy trustee may have exclusive standing to pursue that cause of action. 8 However, the bankruptcy trustee cannot pursue a cause of action if the debtor could not pursue that action outside of bankruptcy. 9 Although these principles appear to create a seemingly simple framework from which a bankruptcy trustee may pursue a debtor s pre-petition claims, they have continued to perplex both courts and practitioners in application, especially with respect to the assertion of claims under state law. While the traditional, and more common sense, rule is that a trustee can assert, pursuant to Section 541, any cause of action that the debtor could assert under state law as of the petition (6) Proceeds, product, offspring, rents, or profits of or from property of the estate, except such as are earnings from services performed by an individual debtor after the commencement of the case. (7) Any interest in property that the estate acquires after the commencement of the case. (b) Property of the estate does not include-- (1) any power that the debtor may exercise solely for the benefit of an entity other than the debtor; U.S.C. Section 541(a). 5 See 11 U.S.C. 541(a)(3), See Butner v. United States, 440 U.S. 48 (1979)); Steyr-Daimler-Puch of Am. Corp. v. Pappas, 852 F.2d 132, 135 (4th Cir. 1988). 2004). 7 See Baillie Lumber Co., LP v. Thompson (In re Icarus Holding, LLC), 391 F.3d 1315, 1319 (11th Cir. 8 See Nat l Am. Ins. Co. v. Ruppert Landscaping Co., Inc., 187 F.3d 439, 441 (4th Cir. 1999) ( If a cause of action is part of the estate of the bankrupt then the trustee alone has standing to bring that claim. ); see also In re Icarus Holding, 391 F.3d at 1319 ( In order to stay [the creditor] s separate... action against [the non-debtor thirdparty], [the trustee] must have standing to bring its own... action under 11 U.S.C. Section ). 9 See Edwards Wood Prods. Inc. v. Thompson (In re Icarus Holdings, LLC), 290 B.R. 171, 177 (Bankr. M.D. Ga. 2002) ( If the debtor could not bring a cause of action outside bankruptcy, the trustee cannot pursue that action in bankruptcy. ). 2

20 date, a split among the circuits has developed regarding whether a trustee can also assert state law claims of creditors under Section 541, to the extent that such claims would interfere with the administration of the bankruptcy estate or promote the policies of the Bankruptcy Code. 10 This line of cases focuses on whether the creditor claims that the trustee seeks to assert under Section 541 are generalized or individualized claims of creditors. The Third Circuit Court of appeals most recently advanced the ability of trustees to assert creditor claims under Section 541 in In re Emoral, Inc. 11 In Emoral, the Third Circuit held that personal injury causes of action arising from the wrongful conduct of the debtor and asserted against a third-party nondebtor corporation on a mere continuation theory of successor liability under state law are properly characterized as generalized claims constituting property of the bankruptcy estate and can only be asserted by the bankruptcy trustee. 12 Certain individuals (the Diacetyl Plaintiffs ) filed pre-petition personal injury claims against Emoral and others claiming they were harmed by overexposure to a chemical manufactured and sold by Emoral called diacetyl. Emoral subsequently sold the majority of its assets to Aaroma Holdings, a thirdparty corporation unrelated to Emoral ( Aaroma ) and later filed for chapter 7 bankruptcy. Emoral s chapter 7 trustee claimed that Aaroma did not pay adequate consideration for the assets and as a result, the assets were fraudulently transferred. Aaroma and the trustee settled the trustee s claims, and the trustee agreed to broadly release Aaroma from any causes of action that belonged to Emoral s estate. When the Diacetyl Plaintiffs brought suit against Aaroma asserting that Aaroma was a mere continuation of Emoral, Aaroma sought to enforce the release in the settlement agreement. The bankruptcy court denied Aaroma s request, finding that the Diacetyl Plaintiffs were alleging a particular injury[,] not [a] generalized injury suffered by all shareholders or creditors of Emoral. 13 On appeal, the district court reversed, finding that the cause of action for successor liability was a generalized claim belonging to the estate. The district court explained that if the plaintiffs succeeded on their mere continuation argument, it would benefit all creditors of Emoral. The Third Circuit affirmed. The Third Circuit framed the issue as follows: To determine whether the Diacetyl Plaintiffs cause of action against Aaroma constitutes property of Emoral s bankruptcy estate, we must examine the nature of the cause of action itself. While the 10 See In re Emoral, Inc., 740 F.3d 875 (3d Cir. 2014); St. Paul Fire & Marine Ins. Co. v. PepsiCo, Inc., 884 F.2d 688, 701 (2d Cir. 1989); Koch Refining v. Farmers Union Cent. Exch., 831 F.2d 1339, 1346 (7th Cir.1987); Baillie Lumber Co., LP v. Thompson (In re Icarus Holding, LLC), 391 F.3d 1315, 1319 (11th Cir. 2004); S.I. Acquisition, Inc. v. Eastway Delivery Serv., 817 F.2d 1142, (5th Cir.1987); but see Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972); Mixon v. Anderson ( In re Ozark Restaurant Equip. Co., Inc.), 816 F.2d 1222 (8th Cir.1987) F.3d 875 (3d Cir. 2014). 12 Id. 13 Id. at

21 Diacetyl Plaintiffs focus on the individualized nature of their personal injury claims against Emoral, we cannot ignore the fact, and fact it be, that their only theory of liability as against Aaroma, a third party that is not alleged to have caused any direct injury to the Diacetyl Plaintiffs, is that, as a matter of state law, Aaroma constitutes a mere continuation of Emoral such that it has also succeeded to all of Emoral s liabilities. 14 Applying New York and New Jersey law, the Third Circuit found that the factual allegations by the plaintiffs seeking to establish successor liability did not state claims unique to the Diacetyl Plaintiffs as opposed to all creditors of Emoral. The court also explained that the Diacetyl Plaintiffs failed to establish that their recovery based on successor liability would not benefit all of Emoral s creditors. The Third Circuit held that the Diacetyl Plaintiffs cause of action against Aaroma would be based on facts generally available to any creditor and recovery would increase the pool of assets available to all creditors. Additionally, the court explained that, under applicable state law, Aaroma was a mere continuation of Emoral. As a result, the Third Circuit held that the district court properly classified the Diacetyl Plaintiffs cause of action as a generalized claim constituting property of the estate. The Diacetyl Plaintiffs claims constituted released claims under the settlement agreement and the Diacetyl Plaintiffs lacked standing to pursue their claims against Aaroma in New Jersey state court. In sum, under the express language of Section 541, bankruptcy trustees have the power to assert any claim or cause of action that belonged to the debtor as of the petition date. However, courts have increasingly held that trustees can assert generalized claims of creditors under Section 541 on behalf of the bankruptcy estate and to promote the bankruptcy policies of an orderly, efficient and fair administration of the estate. II. Turnover The trustee or debtor in possession generally must take possession of property of the estate in order to liquidate an estate or to proceed under a plan of reorganization. This section discusses two provisions under the Bankruptcy Code that allow the trustee, debtor in possession, or certain third parties to obtain estate assets in possession of third parties. A. SECTION 542 First, Section 542 of the Bankruptcy Code requires any entity, other than a custodian, 15 to turnover to the trustee any property that the trustee may use, sell, or lease under Section 363 of the Code or that the debtor may exempt under Section 522 of the Code or the value thereof, and 14 Id. at 879. a similar official. 15 Section 101(11) of the Code defines custodian as an assignee for the benefit of creditors, a receiver, or 4

22 to account for such property. 16 In other words, property must be turned over to the bankruptcy estate under Section 542 if it is deemed property of the estate pursuant to Section 541 of the Bankruptcy Code. Further, [s]ince the trustee s right of use is ordinarily conditional on furnishing adequate protection for whatever interest the one in possession may have, the turnover also is ordinarily subject to the requirement of providing adequate protection. 17 Section 542 can be an incredibly effective tool for trustees, as it allows trustees the power to compel the payment of obligations owed to the estate as well as the turnover of books and records related to the debtor s affairs. 18 Since the scope of what a trustee is entitled to is both vague and broad, as reflected in the discussion above regarding Section 541, parties faced with a turnover demand may have difficulty in deciding how to respond and should err on the side of complying with a turnover demand. However, the Bankruptcy Code has inserted a few safe harbors, including a party s right to setoff against property demanded by a trustee, a party that lacks knowledge of the bankruptcy petition and transfers estate property in good faith, automatic U.S.C. 542 provides, in part, as follows: (a) Except as provided in subsection (c) or (d) of this section, an entity, other than a custodian, in possession, custody, or control, during the case, of property that the trustee may use, sell, or lease under section 363 of this title, or that the debtor may exempt under section 522 of this title, shall deliver to the trustee, and account for, such property or the value of such property, unless such property is of inconsequential value or benefit to the estate. (b) Except as provided in subsection (c) or (d) of this section, an entity that owes a debt that is property of the estate and that is matured, payable on demand, or payable on order, shall pay such debt to, or on the order of, the trustee, except to the extent that such debt may be offset under section 553 of this title against a claim against the debtor. (c) Except as provided in section 362(a)(7) of this title, an entity that has neither actual notice nor actual knowledge of the commencement of the case concerning the debtor may transfer property of the estate, or pay a debt owing to the debtor, in good faith and other than in the manner specified in subsection (d) of this section, to an entity other than the trustee, with the same effect as to the entity making such transfer or payment as if the case under this title concerning the debtor had not been commenced. (d) A life insurance company may transfer property of the estate or property of the debtor to such company in good faith, with the same effect with respect to such company as if the case under this title concerning the debtor had not been commenced, if such transfer is to pay a premium or to carry out a nonforfeiture insurance option, and is required to be made automatically, under a life insurance contract with such company that was entered into before the date of the filing of the petition and that is property of the estate. (e) Subject to any applicable privilege, after notice and a hearing, the court may order an attorney, accountant, or other person that holds recorded information, including books, documents, records, and papers, relating to the debtor's property or financial affairs, to turn over or disclose such recorded information to the trustee. 17 George M. Treister et al., Fundamentals of Bankruptcy Law 129 (Richard B. Levin, 5th ed. 2004) U.S.C. 542(b), (e). 5

23 payment of premiums to prevent the lapse of life insurance policies and demands for property that is of inconsequential value or benefit to the estate. 19 B. SECTION 543 Section 543 of the Bankruptcy Code addresses turnover with respect to a custodian in possession of estate property, together with any proceeds, products, offspring, rents or profits thereof, to turn it over to the trustee or debtor in possession on the date the custodian obtains knowledge of the commencement of a case, addressing the exemption of custodians from Section The most common example of a custodian is a court-appointed receiver. This U.S.C. 542(c)-(d). 20 Section 543 of the Bankruptcy Code provides: (a) A custodian with knowledge of the commencement of a case under this title concerning the debtor may not make any disbursement from, or take any action in the administration of, property of the debtor, proceeds, product, offspring, rents, or profits of such property, or property of the estate, in the possession, custody, or control of such custodian, except such action as is necessary to preserve such property. (b) A custodian shall-- (1) deliver to the trustee any property of the debtor held by or transferred to such custodian, or proceeds, product, offspring, rents, or profits of such property, that is in such custodian's possession, custody, or control on the date that such custodian acquires knowledge of the commencement of the case; and (2) file an accounting of any property of the debtor, or proceeds, product, offspring, rents, or profits of such property, that, at any time, came into the possession, custody, or control of such custodian. (c) The court, after notice and a hearing, shall-- (1) protect all entities to which a custodian has become obligated with respect to such property or proceeds, product, offspring, rents, or profits of such property; (2) provide for the payment of reasonable compensation for services rendered and costs and expenses incurred by such custodian; and (3) surcharge such custodian, other than an assignee for the benefit of the debtor's creditors that was appointed or took possession more than 120 days before the date of the filing of the petition, for any improper or excessive disbursement, other than a disbursement that has been made in accordance with applicable law or that has been approved, after notice and a hearing, by a court of competent jurisdiction before the commencement of the case under this title. (d) After notice and hearing, the bankruptcy court-- (1) may excuse compliance with subsection (a), (b), or (c) of this section if the interests of creditors and, if the debtor is not insolvent, of equity security holders would be better served by permitting a custodian to continue in possession, custody, or control of such property, and 6

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