CHAPTER 10 YOUR DEBTOR GIVETH, ITS TRUSTEE TAKETH AWAY: AVOIDANCE ACTIONS IN BANKRUPTCY CASES
| Jurisdiction | United States |
YOUR DEBTOR GIVETH, ITS TRUSTEE TAKETH AWAY: AVOIDANCE ACTIONS IN BANKRUPTCY CASES
Ann Cox Tripp 1
Hinkle Shanor LLP
Roswell, NM
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ANDREW J. (DREW) CLOUTIER is a partner in the Roswell, NM office of Hinkle Shanor LLP. He tries a variety of oil and gas cases, including administrative proceedings, for both the upstream and midstream segments of the oil and gas industry. Drew served as President of the State Bar of New Mexico in 2013 and as President of the Western States Bar Conference in 2018. He is also a long-time volunteer in Scouts BSA and served as a Scoutmaster of Troop 149 in Roswell for seven years and President of the Conquistador Council for five years. Drew and his wife, Carrie-Leigh, are co-handlers of a trained courthouse dog named Zia who comforts children who are victims of and witnesses to crime while testifying or being interviewed.
I. Basics of Avoidance Powers
Filing for bankruptcy protection simultaneously creates a bankruptcy estate under the Bankruptcy Code2 and triggers the automatic stay provision preventing post-petition attempts to collect debts from or perfect interests in the estate thus created.3 Either a trustee appointed by the court4 or, if a trustee is not appointed, a debtor in possession,5 manages the administration of the estate. The creation of the bankruptcy estate vests the trustee with the power to avoid certain
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transfers and statutory liens (§ 544 and § 545, the "strong arm" powers), pre-petition preferential transfers (§ 547, the "claw-back" power), and, certain fraudulent conveyances (§ 548), collectively referred to as avoidance powers.6 Avoidance and recovery powers discourage and deter creditors from "racing to the courthouse to dismember the debtor during his slide into bankruptcy."7 These combined avoidance powers allow the trustee to avoid transfers and obligations of the debtor, maximizing the interests and funds in the bankruptcy estate to ensure full, fair recovery and distribution among general and secured creditors.8 Avoidance actions are brought in adversary proceedings, which trustees conduct as individual lawsuits within the administration of a debtor's bankruptcy estate. The procedures followed in the conduct of adversary proceedings are governed by rules like the Federal Rules of Civil Procedure.9
Due to space limitations, this paper is not a comprehensive examination of all aspects of a trustee's avoidance powers and defenses thereto. Rather, it aims to serve as an introduction to the topic with an emphasis on transactions and issues that are relatively common in the extractive industries.
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II. The Strong Arm Powers: Avoidance by Trustee as Hypothetical Bona Fide Purchaser or Judgment Lien Creditor
Section 544(a) contains what are commonly referred to as the "Strong Arm Powers" of the trustee. These powers put the trustee in the hypothetical position—on the day the petition is filed—of a creditor who obtained a perfected judgment lien against the debtor's estate ("Lien Creditor") or of a bona fide purchaser of property in the estate for value and without notice ("BFP").10 These positions allow a trustee to avoid any pre-petition transfers by the debtor that a Lien Creditor could supersede or from which a BFP would take title free from said transfer. Substantive state property law determines the scope of the trustee's strong arm powers under § 544 and § 545.11 In the extractive industries, issues triggering the trustee's strong arm powers typically trace back to errors where a debtor failed to properly record transfers or a creditor failed to properly perfect a lien on either the debtor's real property, underlying mineral interest, or the debtor's personal property (e.g., proceeds derived from mineral property).12
A. Trustee as Lien Creditor
Section 544(b) allows the trustee to avoid any unsecured interests that an actual existing creditor may avoid.13 The trustee's Lien Creditor status enables him to avoid unperfected security interests and liens on the debtor's property.14 Regarding unperfected security interests in personal
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property, the governing non-bankruptcy law is Article 9 of the Uniform Commercial Code (UCC), as adopted by the states.15 Because it is commonly accepted that once the hydrocarbons are extracted from the ground they become the personal property of extractor,16 encumbrances or transfers relating to personal property can be avoided by the Lien Creditor if the interests are not secured before the filing of the bankruptcy petition.17 Additionally, the trustee's role as Lien Creditor may also impact mortgages and liens on real property interests depending on state creditor priority statutes.18
B. Trustee as BFP
Bona fide purchasers enjoy one of the most favored positions in the law. State law both defines the extent of real property a BFP takes as against the previous grantee, and because the Code ignores actual knowledge of the trustee,19 incorporates constructive or inquiry notice into the
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analysis. Thus, if a BFP under applicable state law could take the property unencumbered by the interest, the trustee may also avoid such an interest under § 544(a)(3).
The avoidance powers under § 544(a)(3) extend only to real property,20 and the determination of what constitutes real versus personal property remains a matter of state law. State law also governs the recording procedures for interests in real property and normally a BFP takes title subject to property interests which are properly recorded or where notice would be deemed adequate under applicable state law.21 Hence, a trustee may avoid any conveyance of the debtor's real property if said conveyance would not survive when challenged by a BFP purchasing the debtor's property at the time of the filing.22
1. Defective and Unrecorded Deeds
While unrecorded deeds may be sufficient in some states for passing legal title, unrecorded deeds are usually not enforceable against a BFP.23 In the oil and gas industry, many assignments
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of interests might not be recorded until a well is commercially viable.24 This practice, which severs the equitable interest in the property from legal title, created some confusion in the past as to the bounds of the bankruptcy estate. Under § 541(a)(1), all the debtor's legal and equitable interests in property are included in the bankruptcy estate. Prior to 1984, some debate pitted § 541(d), exempting equitable interests from the bankruptcy estate,25 as superior to the trustee's avoidance power under § 544(a)(3). Cases holding that §541(d) trumped § 544(a) relied on an implied policy that Congress would not want the "bankruptcy estate to benefit from property that the debtor did not own."26 However, courts have moved away from this interpretation in response to the 1984 amendments that revised the wording to limit Section 541(d).27 Thus, unrecorded conveyances and
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mortgages remain under the thumb of the trustee's strong arm, and are just one of many defects subject to attack.28
2. Liens and Mortgages, Generally
Perfection of a lien interest depends on the type of lien and the property to which the lien attaches.29 The Code recognizes liens created by agreement,30 judicial action31 and by statute.32 Perfection of each varies by state. Where statutory liens arise by specified circumstances, proper perfection of the lien must be in accordance with statutory provisions.33 While security interests need to be perfected before the commencement of the bankruptcy case due to the automatic stay
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provision,34 statutory liens may be excepted from the automatic stay if perfection relates back to particular activities performed.35
Properly recording mortgages on real property interests prior to the bankruptcy petition normally prevents a trustee from exercising her § 544 avoidance power.36 However, where mortgages in the oil and gas industry also contain language creating a security interest in the extracted hydrocarbons,37 holders should ensure that these types of mortgages are filed pursuant to the state law or UCC provisions to perfect an interest in as-extracted collateral.38
Even if state law allowed constructive notice of a defective mortgage or lien and could defeat the trustee as BFP, a defective instrument may still be subject to the trustee's power as Lien
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Creditor if notice is irrelevant to priority under state law.39 Liens created by statute and liens created by contract may also be avoided by different provisions of the Code.40
3. Liens Specific to the Oil and Gas Industry
In the oil and gas industry, common liens include mechanic's and materialmen's statutory liens ("M&M liens"), specific oil and gas statutory liens, and contractual operating liens—like liens arising out of joint operating agreements that are typically structured to extend and attach to the underlying minerals as well as the extracted hydrocarbons.41 Under § 544 and § 545, the trustee may avoid any lien a creditor fails to perfect prior to the bankruptcy filing.42
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For labor or services provided some states have specific oil and gas statutory lien statutes43 and some rely only upon M&M lien statutes.44 Under both schemes, it is generally the performance or deliver of labor, services, or materials that attaches the lien to the debtor's property.45 To perfect the lien, the lien claimant must typically file an affidavit or notice of lien in the county where the property is located within a statutorily set period of time, ranging from 100 days to 6 months.46
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Under § 546(b), the trustee's ability to avoid liens under § 544 or § 545 is subject to and limited by any M&M lien law that (a) permits perfection of an interest in property to be effective against an entity that acquires rights in such...
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