Categorizing categories: property of the estate and fraudulent transfers in bankruptcy.

• Author: Cedillos, Michael R.

11 U.S.C. [section] 541 defines "property of the estate" in bankruptcy, but courts have not interpreted that section uniformly. The Fifth Circuit has read the term broadly to include both interests in property that the trustee recovers under [section] 541(a)(3) and legal or equitable interests under [section] 541(a)(1) that have purportedly been fraudulently transferred but which the trustee has not yet recovered. The Second Circuit, however, has taken a more restrained approach, holding that fraudulently transferred property that the trustee has not yet recovered does not constitute property of the estate. This Note argues that courts should adopt the Second Circuit's restrained approach to "property of the estate." Canons of construction indicate that fraudulently transferred property is "property of the estate" only once the trustee has recovered it. Moreover, although the Fifth Circuit's expansive approach to [section] 541 attempts to equitably protect creditors, including fraudulently transferred property as "property of the estate" prior to its recovery is problematic for the administration of bankruptcy proceedings, potentially clouding title to property of the estate and thereby contravening bankruptcy's twin goals of giving the debtor a fresh start and efficiently and equitably distributing the debtor's property to its creditors.

TABLE OF CONTENTS INTRODUCTION I. THE CONTROVERSY SURROUNDING [section] 541 II. STATUTORY INTERPRETATION AND REALIZING [section] 541'S PURPOSE A. The Plain Meaning Approach B. The Rule Against Surplusage III. AVOIDING PRACTICAL AND LEGAL PROBLEMS UNDER [section] CONCLUSION INTRODUCTION

A key portion of the general Bankruptcy Title, 11 U.S.C. [section] 541, defines "property of the estate." (1) This section includes a long list of property interests, including both equitable and legal interests and causes of action, (2) "wherever located and by whomever held." (3) As present concerns about the real estate market and potential mortgage foreclosures lead us into uncertain times, defining what qualifies as "property of the estate" is of particular import. Indeed, as more of the credit extended to borrowers turns into debt to be discharged in bankruptcy, having a clear sense of what is properly "property of the estate"--the property that the bankruptcy trustee or debtor-in-possession (4) distributes on behalf of the debtor's creditors--will become increasingly important. Such a definition is by no means clear under current interpretations of the Bankruptcy Code.

In re MortgageAmerica Corp., (5) the Fifth Circuit read [section] 541's definition of "property of the estate" expansively to include not only "[a]ny interest in property that the trustee recovers" under [section] 541(a)(3) (6) but also legal or equitable interests under [section] 541(a)(1) that have purportedly been fraudulently transferred but which the trustee has not yet recovered. (7) Imputing to the debtor an equitable interest in purportedly fraudulently transferred property was well intentioned: the Fifth Circuit wanted to prevent debtors from skirting the law and to protect creditors' interests even though the trustee had not yet recovered the property. (8) The Fifth Circuit has confirmed its approach in subsequent cases. (9)

Meanwhile, the Second Circuit explicitly rejected In re MortgageAmerica Corp.'s statutory analysis in favor of a more restrained approach. It held that fraudulently transferred property that the trustee has not yet recovered does not constitute property of the estate under [section] 541(a)(1). (10) In so doing, the court followed In re Saunders, (11) a Florida Bankruptcy Court decision. The Fourth Circuit has highlighted the circuit split, with at least one of its lower courts approving of the Second Circuit's approach. (12)

While this particular distinction may seem esoteric, including purportedly fraudulently transferred property as property of the estate prior to its recovery is significant because it generates uncertainty regarding whether a trustee can properly distribute such property to a debtor's creditors. This uncertainty can wreak havoc on the bankruptcy process by clouding title to the property and prolonging the process. Such a result contravenes bankruptcy's twin goals of giving the debtor a fresh start and efficiently and equitably distributing the debtor's property to its creditors. The Fifth Circuit's approach admirably seeks to prevent debtors from skirting the law and to protect creditors' interests; however, the resulting uncertainty makes the court's expansive approach to property of the estate more trouble than it is worth.

This Note argues that courts should adopt the Second Circuit's restrained approach to "property of the estate" and hold that [section] 541 does not include fraudulently transferred property that the trustee has not yet recovered. Part I provides background and describes key cases dealing with the interaction between property of the estate and fraudulent conveyances. Part II argues that [section] 541's language and structure strongly suggest that fraudulently transferred property is property of the estate only after it has been recovered Finally, Part IH maintains that, while the Fifth Circuit's expansive approach to "property of the estate" attempts to equitably protect creditors, including fraudulently transferred property as "property of the estate" prior to its recovery has the potential to cloud title to property of the estate Part III concludes that such a result is problematic in terms of bankruptcy administration and that policy concerns also argue against including in the estate fraudulently transferred property that the trustee has not yet recovered.

1. THE CONTROVERSY SURROUNDING [section] 541

   Courts disagree over the interpretation of [section] 541 and the definition of "property of the estate." (13) This Part discusses the two seminal cases addressing the issue of including purportedly fraudulently transferred property as property of the estate prior to the trustee's recovery of such property: In re MortgageAmerica Corp. (14) and In re Colonial Realty Co. (15) Determining the effect each decision has on the bankruptcy process and the extent to which each decision conforms to the most plausible reading of the statute requires an understanding of the reasoning behind each of these decisions and the statutory text upon which the courts relied.

   Sections 548 and 550 allow the trustee to make a claim on property transferred by the debtor under certain circumstances Section 548 allows the trustee to avoid any transfer of an "interest of the debtor in property, or any obligation ... incurred by the debtor" that meets certain criteria on or within two years of filing for bankruptcy protection. (16) The trustee may avoid transfers the debtor made with "actual intent to hinder, delay, or defraud any entity to which the debtor was or became ... indebted." (17) However, a transferor need not voluntarily create a fraudulent transfer for the trustee to be able to avoid the transfer. (18) The trustee may also avoid transfers and obligations for which the debtor "received less than a reasonably equivalent value in exchange" (19) and that were made while the debtor was insolvent, (20) that left the debtor with an unreasonably small amount of capital for his business dealings, (21) that the insolvent debtor intended to be or believed "would be beyond the debtor's ability to pay as such debts matured," (22) or that benefited an insider under an employment contract. (23)

   Once a trustee has avoided a transfer under [section] 548, she may recover the property under 11 U.S.C. [section] 550. (24) Section 550 requires the transferee to disgorge the property received or its equivalent value (25) and to return it to the [section] 541 "estate," the general pot from which all creditors are paid. (26) Property recovered under [section] 550 is therefore property of the estate under [section] 541(a)(3). (27) The transferee can then attempt to recover the property through the bankruptcy proceeding. But because the trustee manages the property pot for the benefit of all creditors, (28) the disgorging transferee will likely receive at the end of the bankruptcy proceeding less than what the trustee forced him to return to the estate. (29) Transferees whose transactions are subject to attack by a bankruptcy trustee under [section] 548, often creditors, thus have an incentive to fight the trustee's assertion of authority and to keep the property out of the [section] 541 bankruptcy estate.

   In In re MortgageAmerica Corp., (30) the Fifth Circuit held that purportedly fraudulently transferred property under [section] 548 qualifies as property of the estate under [section] 541(a)(1) even prior to its recovery by the trustee. The court reasoned that

   [t]he transferee may have colorable title to the property, but the equitable interest--at least as far as the creditors (but not the debtor) are concerned--is considered to remain in the debtor so that creditors may attach or execute judgment upon it as though the debtor had never transferred it. (31) In In re MortgageAmerica Corp., Joe R. Long was the sole shareholder of RJF, Inc., which in turn was the sole shareholder of MortgageAmerica Corporation. (32) Previously, American National Bank of Austin had filed suit and received a $192,554.40 judgment against MortgageAmerica in Texas state court for breach of contract. (33) The bank then attempted to collect on that judgment from Long personally, rather than from his insolvent company, on the grounds that Long was personally liable for the company's obligations because he had deliberately stripped MortgageAmerica of assets to benefit himself while defrauding the company's creditors. (34) Specifically, American National alleged that Long made three fraudulent transfers in May and June 1981 totaling $2.3 million. (35) By August 1981, MortgageAmerica had entered into...