The U.S. Court of Appeals for the Tenth Circuit―in Rajala v. Gardner, 709 F.3d 1031 (10th Cir. 2013)―has joined the Second Circuit and departed from the Fifth Circuit by holding that an allegedly fraudulently transferred asset is not property of the estate until recovered pursuant to section 550 of the Bankruptcy Code and therefore is not covered by the automatic stay. According to the court, its decision "gives Congress's chosen language its ordinary meaning, and abides by a rule against surplusage."
Bankruptcy Code Stays Acts to Obtain Possession of Property of the Estate
Section 362(a)(3) of the Bankruptcy Code provides that the
filing of a bankruptcy petition "operates as a stay,
applicable to all entities, of . . . any act to obtain possession
of property of the estate or of property from the estate or to
exercise control over property of the estate." Sections
541(a)(1) and 541(a)(3) of the Bankruptcy Code, respectively,
define "property of the estate" to include, with certain
exceptions, "all legal or equitable interests of the debtor in
property as of the commencement of the case" and "[a]ny
interest in property that the trustee recovers under section . . .
550" of the Bankruptcy Code.
Under section 550(a) of the Bankruptcy Code, a trustee may recover,
for the benefit of the estate, transferred property "to the
extent that a transfer is avoided under section 544 . . . [or]
548." Sections 544 and 548 of the Bankruptcy Code, in turn,
enable the trustee to avoid fraudulent transfers. The question
before the Rajala court was whether allegedly fraudulently
transferred property, prior to the recovery of that property
pursuant to section 550(a), is "property of the estate"
under section 541(a) and therefore subject to the automatic stay
imposed by section 362(a).
The Facts
Generation Resources Holding Company, LLC ("GRHC") was
formed in 2002 for the purpose of developing wind-generated power
projects. In June 2005, GRHC entered into a memorandum of
understanding ("MOU") with Edison Capital
("Edison") that contemplated Edison's purchase of
three GRHC wind-power projects, including the "Lookout"
project.
In late 2005, several GRHC insiders formed Lookout Windpower
Holding Co., LLC ("LWHC"). Not long after its formation,
LWHC closed a deal with Edison for the sale of the wind-power
projects that were the subject of the MOU with GRHC. The GRHC
insiders did so by causing a switch in the identity of the
projects' developer from GRHC to LWHC. In March 2007, LWHC
entered into a contract with an Edison subsidiary (the
"Lookout Redemption Agreement"), which provided that once
Lookout achieved commercial operation, Edison would pay 25 percent
of a "Final Installment" contingency fee to FreeStream
Capital, LLC ("FreeStream"), which GRHC had employed to
provide advisory services, and 75 percent of the "Final
Installment" to LWHC. Overburdened with $6 million in debt,
GRHC filed for chapter 7 protection in Kansas on April 28,
2008.
In April 2009, LWHC and FreeStream sued Edison in federal district
court in Pennsylvania for payment of the Final Installment due
under the Lookout Redemption Agreement. In September 2009,
GRHC's chapter 7 trustee brought suit against GRHC insiders
(and others) in federal district court in Kansas, asserting, among
other things, that the defendants had fraudulently transferred
GRHC's development and redemption opportunities to LWHC.
The trustee sought an order from the Kansas district court staying
the Pennsylvania action, arguing that any proceeds of the
litigation were property of GRHC's estate. The Kansas district
court denied the motion.
Shortly before the Pennsylvania case went to trial, the trustee
filed a motion in the Pennsylvania federal court for an order
staying the proceedings or, in the alternative, transferring the
litigation to Kansas. The basis for this motion was the
trustee's argument that the Lookout sale price was property of
the GRHC estate and therefore subject to the automatic stay.
The court denied the motion in part and entered judgment in favor
of LWHC and FreeStream for approximately $9 million. However, the
court transferred to the Kansas bankruptcy court the issue of
whether the judgment was part of GRHC's estate and ordered that
the judgment funds be deposited with the bankruptcy court pending
the outcome.
The reference to the Kansas bankruptcy court was then withdrawn to
the Kansas district court, where the Pennsylvania case was
consolidated with the trustee's pending claims.
The Kansas district court held that the bankruptcy estate does not
include fraudulently transferred property until recovered through a
fraudulent-transfer action, and it accordingly granted the motions
to distribute the $9 million judgment to LWHC and FreeStream. The
district court also held that because the Lookout Redemption
Agreement provided for FreeStream to be paid directly by Edison,
FreeStream's contingency fee could not be considered part of
GRHC's bankruptcy estate. The trustee appealed to the Tenth
Circuit.
The Tenth Circuit's Ruling
A three-judge panel of the Tenth Circuit affirmed. As an initial
matter, the court concluded that it had jurisdiction to review the
district court's order. According to the Tenth Circuit, because
the order "deemed § 362 inapplicable to the judgment
proceeds, [it] was essentially an order granting relief from the
automatic stay," which is generally considered an
"appealable final order." The court also rejected the
defendant-appellees' argument that the appeal was moot because
the trustee had no effective remedy, finding it likely that at
least some measure of effective relief could be fashioned were the
stay reimposed on the disbursed funds. In addition, the Tenth
Circuit affirmed the district court's ruling that
FreeStream's fee could not be considered property of GRHC's
bankruptcy estate because, among other things, the plain language
of the Lookout Redemption Agreement required FreeStream's
payment to come directly from Edison (as owner of Lookout).
The Tenth Circuit then turned to the question of whether the
automatic stay applies to unrecovered property that is the subject
of a fraudulent-transfer claim. The court began by acknowledging
the circuit split on the issue. Under the Fifth Circuit's
ruling in Am. Nat'l Bank of Austin v. MortgageAmerica Corp. (In
re MortgageAmerica Corp.), 714 F.2d 1266 (5th Cir. 1983), property
alleged to have been fraudulently transferred is considered
property of the estate pursuant to section 541(a)(1) and is
therefore subject to the automatic stay even before it is
recovered, because the debtor continues to have a "legal or
equitable interest" in the property fraudulently transferred.
By contrast, in Fed. Deposit Ins. Corp. v. Hirsch (In re Colonial
Realty Co.), 980 F.2d 125 (2d Cir. 1992), the Second Circuit held
that, because section 541(a)(3) expressly provides that estate
property includes "[a]ny interest in property that the trustee
recovers under section . . . 550," the automatic stay does not
apply to allegedly fraudulently transferred property until the
transfer is avoided under section 544 or 548 and the property is
recovered under section 550.
The Tenth Circuit sided with the Second Circuit. First, citing the
"plain meaning" rule of statutory construction, the court
stated, "although § 541 is very broad, . . . it plainly
does not include fraudulently transferred property until that
property is recovered." Therefore, the court wrote,
"because the statute's plain meaning is not demonstrably
at odds with Congress's intent, it should control."
The court rejected the trustee's argument that the judgment
proceeds were estate property because GRHC retained an
"equitable interest" in the funds. After considering the
definition of "equitable interest"―an interest held
by virtue of an equitable title or claims on equitable grounds,
such as the interest held by a trust beneficiary―the Tenth
Circuit concluded that "[r]eading 'equitable title' to
include any property a trustee merely alleges to have been
fraudulently transferred would violate the concept of equity."
According to the court, fundamental principles of equity
jurisprudence demand that, before a complainant can have standing
in court, he must show that he has a good and meritorious cause of
action. "[A] mere allegation, without any showing of
merit," the court wrote, "cannot create 'equitable
title.' "
Again invoking principles of statutory construction, the court
explained that, "if it can be prevented, no clause, sentence,
or word shall be superfluous, void, or insignificant." In this
case, the court wrote, "§ 541(a)(3) provides that the
estate includes '[a]ny interest in property that the trustee
recovers' pursuant to his avoidance powers." The court
agreed with the Second Circuit's view in Colonial Realty that
"interpreting § 541(a)(1) to include fraudulently
transferred property would render § 541(a)(3) meaningless with
respect to property recovered in a fraudulent transfer
action."
The Tenth Circuit rejected the trustee's argument that section
541(a)(3) is "a belt and suspenders" designed to ensure
that assets will be available to satisfy creditor interests,
reasoning that "there are already several mechanisms for
safeguarding debtor assets." For example, the court explained,
the trustee may seek a preliminary injunction or temporary
restraining order pending resolution of a fraudulent-transfer
claim. Because this was not one of the "rare cases" where
the plain meaning of the statute leads to an absurd result, the
Tenth Circuit concluded that the plain meaning of the statute
should control.
Lastly, though not addressed by either party, the court noted that
a broad reading of section 541 could potentially violate the Due
Process Clause (U.S. CONST. AMENDS. V and XIV, § 1) by
allowing the trustee to enjoin another party's property rights
solely on the basis of allegations of fraud. For example, the court
explained, because the stay imposed by section 362 is automatic,
the "[m]ere filing of a fraudulent-transfer claim could
deprive a bona fide purchaser of his property without judicial
supervision, a finding of probable cause, the posting of a bond, or
a showing of exigent circumstances―let alone a
pre-deprivation opportunity to be heard." For this additional
reason, the Tenth Circuit was reluctant to adopt the trustee's
broad interpretation of section 541. Instead, the court adopted the
statute's plain meaning. It held that fraudulently transferred
property is not part of the bankruptcy estate until recovered, and
it accordingly affirmed the district court's determination that
the automatic stay did not prevent disbursement of the judgment
proceeds to LWHC and FreeStream.
Outlook
Rajala widens a rift in the federal circuit courts of appeal concerning inclusion in the bankruptcy estate of property that is subject to avoidance by a bankruptcy trustee, chapter 11 debtor in possession, or other estate representative (e.g., a creditors' committee or plan-liquidation trustee). The ruling is a cautionary tale. It places the burden squarely on estate representatives to be proactive in investigating potential avoidance claims and, where such claims are deemed to be meritorious, to seek provisional relief in a timely manner to ensure that potential estate property is preserved for the benefit of all stakeholders.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.