Chapter 14 Trustee's Avoiding Powers

• Jurisdiction: United States

Chapter 14 Trustee's Avoiding Powers

§ 14.1 ~ Introduction

We now turn to one of the topics that gives bankruptcy its distinctive character: the power of the trustee to "avoid" — invalidate or set aside — certain transactions between the debtor and a third party. We divide our treatment into two parts. In this chapter, we provide a general view of avoiding powers. In the next, we consider some issues that arise from the most basic of the avoiding powers: the power to set aside fraudulent transfers.

§ 14.2 ~ Two Hats

The trustee's avoiding powers are a mass of often-baffling details and technicalities. To get a grip on avoiding powers, it may help to begin by backing off from the detail and taking a look at the big picture.

The trustee wears two hats. Under one, he is successor to the debtor. For example, in a chapter 7 case he must collect and reduce to money the property of the estate.¹ The estate includes all legal or equitable interests of the debtor in property as of the commencement of the case.² So, for example, if the debtor had a file of accounts receivable claims against third parties, the trustee may sue to collect those receivables for the estate.

But the trustee is also the representative of the creditors. In that role, he may exercise rights that might have belonged to creditors before the beginning of the case. Equally important, but perhaps less obvious, he may preempt action by creditors who may no longer be able to act on their own.

The trustee's powers are in large part derivative of the powers of creditors from state law. So in order to understand a trustee's powers, we need to start with a review of the powers of creditors from state law.

§ 14.3 ~ The "Strong-arm power:" secured creditor vs. lien Creditor

We start with a hypothetical: Debtor owes $100 each to Clara, Ardath, and Berowne. Debtor signs a security agreement with Clara providing that if he does not pay her, she can have first dibs on his refrigerator magnet, also worth $100 and his only asset. Will Clara prevail over Ardath and Berowne? To answer this question, we turn to what may be the most important single section in the Uniform Commercial Code, UCC § 9-317(a)(2). It provides:

A security interest ... is subordinate to the rights of:

... a person that becomes a lien creditor before the earlier of the time:

(A) the security interest ... is perfected; or
(B) one of the conditions specified in Section 9-203(b)(3) is met and a financing statement covering the collateral is filed.

Section 9-203(b) governs the enforceability of security interests and generally requires (1) value has been given by the secured creditor, (2) the debtor has rights in the collateral or the power to grant rights in the collateral to the secured creditor, and (3) a signed security agreement with an adequate collateral description, or that the secured creditor has possession or control of the collateral.

So, § 9-317(a)(2) says that Clara, even though she aspires to priority as a "secured creditor," may lose out to Ardath or Berowne if either becomes a "lien creditor." A "lien creditor" is "a creditor that has acquired a lien on the property involved by attachment, levy or the like,"³ such as an ordinary unsecured creditor who goes to court and gets a judgment and does whatever he needs to do under state law to establish a lien.

What must Clara do to trump Ardath and Berowne? She has two options.

First, § 9-317(a)(2)(A) specifies that Clara will trump if she "perfects" her security interest before either of them gets a lien. To "perfect," she must have an enforceable security interest.⁴ She must also give some kind of public notice. Typically, this means that she must file a "financing statement" — a "UCC-1" — to assert her priority.⁵

Second, § 9-317(a)(2)(B) specifies that Clara will prevail even if she does not have an enforceable security interest, provided that she does have a financing statement on file and that she has taken one of the steps necessary under § 9-203(b)(3) (i.e., she has a signed security agreement with an adequate collateral description or she has possession or control of the collateral).

To the neophyte, this is likely to appear puzzling. The financing statement is not the security interest. How can one achieve rights in the collateral based on the financing statement alone without taking all three steps necessary to have an enforceable security interest under § 9-203(b)? The answer is that one cannot. But filing a financing statement and taking one of the steps necessary under § 9-203(b)(3) may help Clara get a leg up in priority once she obtains an enforceable security interest. Consider this sequence:

1. Debtor signs a loan and security agreement granting Clara a lien on the refrigerator magnet in which Debtor has the power to transfer rights. With this action, only two of the three steps necessary under § 9-203(b) for an enforceable security interest are met.
2. Clara files a financing statement covering the collateral (the refrigerator magnet).⁶ At this point, Clara has met both requirements under § 9-317(a)(2)(B) to get a leg up in priority over Ardath or Berowne. She still does not have an enforceable security interest, though, because she hasn't met all three of the § 9-203(b) requirements.
3. Ardath or Berowne gets a lien.
4. Clara advances $100 to Debtor under the loan agreement (which constitutes giving "value" under § 9-203(b)(1)), thus completing the steps necessary to give Clara an enforceable security interest under § 9-203(b).

On these facts, Clara wins per § 9-317(a)(2)(B). She filed the financing statement and has a signed security agreement with a description of the collateral (meeting one of the conditions required by § 9-203(b)(3)), and this establishes her priority, even though she didn't advance funds to Debtor and gain an enforceable security interest under § 9-203(b) until later.

§ 14.4 ~ Hypothetical Lien creditors

This is a book about bankruptcy. Why are we making so much of one subsection of the UCC? The answer is that the "lien creditor" language of the UCC dovetails neatly with a key provision of the Bankruptcy Code, § 544(a)(1). It provides:

The trustee ... may avoid ... any obligation incurred by the debtor that is voidable by ... a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists.

This is the trustee's "hypothetical lien creditor power." It means that the trustee gets whatever power a lien creditor would have had under state law. If Clara's financing statement remained unfiled (and if she does not have possession of the collateral) at the moment of bankruptcy, then the trustee trumps her. Clara retains her claim, but it will be unsecured. She goes to the back of the queue and shares pro rata with the other unsecured creditors.

Operationally, what this means is that the trustee, upon her appointment, notes all those creditors who are listed as secured. She checks to see whether they have met the criteria of § 9-317(a). If they have not, then she brings an action to avoid the lien.

All of this may be enough for an ordinary case. But here is a second thought: Recall that under revised Article 9 the secured creditor may have priority from the time of the UCC-1 filing, even if he has not yet completed his security agreement. That may work well enough in non-bankruptcy law: He files his UCC-1 first and finishes his security agreement later. But how can this work in bankruptcy? No matter what the agreement says, property acquired after the filing of the petition does not become collateral for the pre-bankruptcy debt. Similarly, funds advanced after bankruptcy do not — at least not without court approval — become secured by the pre-bankruptcy lien.

§14.5 ~ Background on § 544(a)

What is the point of § 544(a)? You may be able to understand it best in the context of its history, climaxing in a famous "wrong decision" from the U.S. Supreme Court.

Recall that "bankruptcy" began as a kind of class action, allowing the creditors to join together to police the debtor. The trustee succeeded the ownership rights of the debtor, but he was first of all an agent of the creditors, and it made sense to give him any powers that the creditors would otherwise have enjoyed.

All of this was part of the culture at the time of the 1898 Bankruptcy Act, although it may not have been spelled out with perfect clarity. So in York Manufacturing Co. v. Cassell,⁷ the Supreme Court considered the claim of a creditor/seller with an unfiled conditional sales contract. The seller's contract provided that he had first dibs on the property sold to the debtor. State law provided that the contract was invalid against creditors holding liens. No creditor held a lien. The trustee asserted that the lien was not valid against him. He conceded that the conditional seller had a claim. But he asserted that the conditional seller must share pro rata along with other creditors. In bankruptcy parlance, the trustee sought to "avoid the lien."

But the Court was not buying it. The Court held that the trustee only took what the debtor had to convey. The Court found that the trustee was not himself a lien creditor. It therefore concluded that he took the property encumbered by the conditional sales contract.

We think the decision was wrong from the get-go. It missed the historic character of bankruptcy as a "class action." Properly understood, the trustee should have been seen as a representative of creditors from the start. In any event, Congress responded swiftly to York, adding a sentence to the Bankruptcy Act specifically reposing in the trustee the powers of a lien creditor.⁸ The legislative history made it clear that the purpose of the amendment was to overrule York.⁹

Judicial gloss quickly...