Chapter V Avoiding Powers

• Jurisdiction: United States

V. Avoiding Powers

A. Introduction

The Bankruptcy Code confers on the trustee several avoiding powers. The avoiding powers further the important bankruptcy policy of equal treatment of creditors. When a debtor files a bankruptcy petition, a bankruptcy estate is created. This estate is a pool from which all creditors share equally according to their priority status. Bankruptcy law does not like it when one creditor drains the common pool immediately before bankruptcy. Bankruptcy law also does not like it when the debtor transfers an asset for less than the asset's value to a friend or relative after the debtor has been sued, and the law generally does not like secret property transfers. The trustee's avoiding powers allow the trustee to recover assets that were transferred under all of these disfavored conditions.

B. Hypothetical Lien Creditor

Most importantly, the trustee has the power to avoid (invalidate or undo) a transaction that would have been avoidable under non-bankruptcy law by a lien creditor (a creditor that did not start off with a consensual lien) [§ 544(a)(1)]. Consider Clement, a creditor with a security interest in Delbert's forklift truck. Delbert also owes money to Leonard. Leonard does not have a security interest, but he does sue Delbert to collect the claim. After winning his judgment, Leonard sends out the sheriff to pick up the forklift truck so he can sell it and apply the proceeds against his claim. State law says that Leonard has a lien from the moment the sheriff takes possession of the truck. Leonard is therefore a lien creditor.

Between Leonard and Clement, who gets first dibs on the truck? The answer depends on the timing. The Uniform Commercial Code (UCC) says that Leonard wins if he gets his lien before Clement gives public notice of his security interest. A creditor with a security interest in a truck (or other motor vehicle) gives notice of its interest by noting it on the truck's certificate of title. If the certificate of title does not show Clement's security interest before the sheriff takes the truck, Leonard wins.

If the secured creditor has an interest in Delbert's business equipment, that creditor would perfect its interest by filing a financing statement in the Secretary of State's Office in Delbert's state. If the sheriff, acting for Leonard (assuming that Leonard could not get the truck), seizes the business equipment before the secured creditor files its financing statement, Leonard wins.

The trustee stands in the shoes of the lien creditor, so in the examples above, if Leonard wins, the trustee wins. Because the trustee has the status of a hypothetical lien creditor, no Leonard need exist. If the debtor has any secured creditors (including mortgage creditors) who did not give public notice of their security interests under state law, the trustee can set aside those interests and recover the property, free of those interests, for the estate. This power is known as the trustee's "strong-arm" power.³⁵

C. Fraudulent Transfers

The trustee also gets the power to avoid "fraudulent transfers." Fraudulent transfer law has a long history of its own, independent of bankruptcy. For purposes of this primer, it comes in two varieties.

First, the trustee may avoid a transfer if it was made with actual intent to hinder, delay or defraud creditors (also known as "actual fraud") [§ 548(a)(1)(A)]. Second, the trustee may avoid a transfer if it was made for less than reasonably equivalent value by a debtor who is either insolvent or knew that he was going to incur debts beyond his ability to pay (think "gift," and recall the ancient principle that a person must be just before he is generous (also known as...